Community Rating and Health Economics

Written by Right Side News

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If there is a single issue that most divides economists from non-economists, it’s the way they view prices. Economists view prices as creators of incentives for buyers and sellers. When prices change behavior changes. As a result, prices are mechanisms for determining the allocation of resources. If they are not allowed to perform this role bad things will typically happen on both sides of the market.

Non-economists too often ignore this very important social function. Many tend to view prices as merely reflective of power. A powerful buyer can push a price down. A powerful seller can push a price up. And since government is the most powerful entity of all, the non-economic way of thinking often looks to government to set prices. Many non-economists believe you can push a price up (such as a wage or the price of a farm commodity) or push a price down (such as the price of gasoline or housing rents) and nothing bad will happen. And of course the non-economist would be right, if prices didn’t influence behavior and if they didn’t allocate resources.

Everyone is aware that when government changes a price, there will be winners and losers. But many non-economists think this is all that happens. They think one man’s gain is another man’s loss and that there are no other social consequences of price changes.

Nowhere is this difference in thinking more apparent than with respect to community rating.

Can’t go on Everything I had is gone.

It’s hard to think of a public policy that more completely ignores the lessons of economic theory than community rating. In a free market for health insurance, premiums will reflect risks. To join an insurance pool, a buyer will have to pay a premium equal to the expected costs he brings to the pool. Since everyone is different, in principle you could have a different premium for every enrollee. With community rating, however, everyone pays the same premium. That means that virtually every price is the wrong price. Every buyer is paying the wrong amount and every seller is receiving the wrong amount.

Before continuing, a word about health economics. I have said before that when people turn to health policy, their IQs tend to fall about 15 points. (To which Uwe Reinhardt always asks if I include myself in that generalization. Perhaps. But at least I’m aware of the problem.) What I haven’t said before is that when economists turn to health policy, not only does their IQ take an unfortunate dip, they tend to forget everything they learned in graduate school. No, make that, everything they learned in Econ 101. (And no, this generalization doesn’t apply to me.)

A case in point is Paul Krugman (Nobel laureate no less) who tells The New York Times readers week after week that community rating is one of three pillars of ObamaCare, that it is a good thing and that ObamaCare will work. But where in all of economics is there a single journal article or a paper at NBER or at any other reputable place that shows you can charge every buyer the wrong premium and end up with a system that works? There isn’t any.

Suppose we had community rating for life insurance. If I am on my death bed, what would I do? I would buy a lot of it. Actually, I would do something different. I would ask my heirs to invest in their inheritance by paying the premiums. Then I would ask the viatical companies what rate of return they need on their investment and sell them the right to buy even more insurance on my life. As I and other people do these things, the premium for healthy people would almost certainly soar, if the insurance companies are to stay afloat. As the premium rises, the healthy will drop out of the market and in no time at all we would be in a death spiral ― with life insurance market headed toward oblivion.

To avoid this eventuality, the insurers would try their best to avoid the old and the sick and sell only to the young and the healthy. Perhaps they would locate in a tree house that is accessible only by climbing a long rope. Only kidding about that. But not about the principle.

In health insurance, the perverse incentives created by community rating are just as bad or worse. As I wrote in a previous post:

[BTW, risk adjustment in the ObamaCare exchanges ― taking money from some insurers and giving it to others ― may actually overpay for certain types of chronic illnesses, making them more attractive to insurers than healthy people. But any time there is non-market fixing of premiums and artificial risk adjustment, the total revenue for any particular enrollee is almost certain to be wrong ― in one direction or another.]

To anticipate an objection from people who are not regular visitors to this site, we do not need to destroy the price system in order to help people with pre-existing conditions ― the primary argument of ObamaCare proponents on the eve of its passage. About 107,000 people who were denied insurance because of a pre-existing condition were allowed to enroll in ObamaCare risk pools, paying roughly the same premium that would ordinarily be charged to healthy insurance buyers.

As public policies go, these risk pools are not a bad solution although a better idea is “change of health status” insurance, which we have described elsewhere. But the Obama administration insists that to help these people beginning next year, we need to muck up the market for everyone else.

But why? There are people who are too poor to afford the food they need. But would anyone think it reasonable to make 330 million Americans pay below-market prices in order to address that problem. There are people who can’t afford decent housing. But is anyone so foolish as to suggest that the government should regulate the price of everyone’s house in order to help the few who need assistance?

Yet this is what ObamaCare proposes to do with health insurance and Paul Krugman thinks this is just dandy. The law will impose price controls on the premiums faced by 10 million to 20 million people in the health insurance exchanges (no one knows exactly how many at this point) in order to help the 107,000. Go figure.

By the way, there is nothing new about community rating. More than 90% of people with private insurance obtained it from an entity that is not allowed to price premiums based on health status. Add to that the Medicare and Medicaid populations and you find that to the degree that people are charged any premium at all, almost everybody in the whole country is paying a community rated premium.

Far from being a solution to our problems, community rating is probably the single biggest cause of all the dysfunctions we are currently experiencing.

John C. GoodmanJohn C. Goodman is President of the National Center for Policy Analysis, Research Fellow at the Independent Institute, and author of the book Priceless: Curing the Healthcare Crisis.

The Wall Street Journal and the National Journal, among other media, have called him the "Father of Health Savings Accounts." Dr. Goodman's health policy blog is the premier right-of-center health care blog on the Internet.

It is the only place where pro-free enterprise, private sector solutions to health care problems are routinely examined and debated by top health policy experts across the ideological spectrum.


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