It’s Our Down Economy That’s Driving Up Health Insurance Premiums

In 2011, health insurance premiums in the United States are going to rise. In all likelihood, the price increase that consumers are going to see isn’t going to be trivial. As a result, two separate narratives are likely to develop between now and the mid-term elections. One will blame President Barack Obama’s health reforms for the price hike, and will be championed by those who want to see the health care reforms repealed. A second narrative will blame the down economy for the rise in premiums. This argument will be championed by those who support the reforms and want to see them continue unabated.

Which narrative is right and which is wrong?

As is so often the case, there is an element of truth to both arguments. It’s fair to say both the down economy and the added regulation from the reforms will lead to an increase in prices. However, while both factors have precipitated rising premiums, the recession has likely had a significantly larger impact on the price spike. Indeed, when we dig down at what is really driving this particular price increase, it suggests that one of the most contested elements of the reforms—the mandate that most Americans must buy health insurance—is going to be vital if we really want to limit insurance companies from denying coverage to those with a pre-existing condition.

The health care reforms were front-loaded with a number of elements that were supposed to be popular with the electorate and come into force soon after the bill was passed. In particular, the reforms required that current insurance plans cease placing lifetime limits on coverage and required insurers to allow children to stay on their parents’ plan until they’re 26 years old. The reforms also required that new plans that were introduced from last week onwards include free preventive services, grant women access to OB-GYNS without a referral, and reduce the cost of going to an out-of-network emergency room. These elements will increase the price of insurance (by making insurers expand their benefits), but in turn, the quality of the insurance coverage provided will also increase.

However, most evidence suggests that these regulations that stipulated the reforms will only have a small impact on premiums. Indeed, a range of estimates by non-political analysts seem to suggest that the increases that will stem from the reforms will be in the neighborhood of between 1 and 3 percent.  This is a far cry from the likely 10-20 percent increase in premiums we should expect.

In actuality, the primary driver of the health insurance price increases seems to be the slowdown in the economy and the stagnant recovery. Indeed, this explanation fits precisely with economic theory.

Insurance markets function by spreading the risk of illness across a group of individuals.  So, imagine we have a hypothetical insurance market with ten individuals in our risk-pool. Each individual has a probability of requiring medical intervention that ranges from 1 (low risk) to 10 (high risk). Now, for convenience, suppose each individual has a different risk level, so the risks in the market are 1, 2, 3 and all the way up to 10. In this risk-pool, the average risk of ill health is 5.5, so half the population is risky and the other half is not.

Insurance premiums are calculated by multiplying the probability of illness in the risk pool times the cost of getting sick (insurance companies also usually tack on an additional administrative charge as well). The higher the average level of risk in the population, the higher the premiums; the lower the level of risk in the pool, the lower the premiums.

In the U.S., at the moment, individuals can opt out of buying insurance coverage. In a recession, when money gets tight, some folks will decide not to buy insurance coverage in favor of other household essentials. For them, this is a largely sensible idea, since they don’t expect themselves to fall ill.

The problem is that the people who tend to drop their insurance in a recession also tend to be healthy. In our hypothetical model, those dropping coverage would be the individuals with risk scores of less than 6, who are less risky than average and are subsidizing the high-risk members of the pool. Unfortunately, when the healthiest individuals decide to leave the market, the average risk of illness in the population will rise because the population that once had risks of between one and ten now has a range of risks between two and ten. This rise in the average level of risk in the market will lead to a corresponding jump in prices because there are now more sick people in the insurance pool who’ll require care.

This is precisely what we’re seeing across the U.S. right now. As healthy people decide to go without insurance because money is tight, the price of insurance for the rest of us goes up because the average risk of the people who still carry insurance has gone up.  This is what economists refer to as adverse selection.

Unfortunately, there are only two ways to address adverse selection. One option is to tie insurance premiums much more closely to individuals’ health status, so that we all pay insurance premiums that are proportional to our level of risk. This is precisely what we now have in the market for individual insurance coverage in the U.S. However, this means that anyone who is high risk—precisely the people who need insurance the most—will be priced out of the market. In this scenario, premiums will skyrocket for the elderly, for anyone with a history of illness, and for those with a chronic condition.

The second option is to mandate insurance coverage. Here, we’d eliminate the risk of the healthy opting out by requiring that everyone obtain coverage. This would spread the risk of ill health more widely across the population. At the end of the day, if we want to ban insurance companies from denying care to individuals who have a pre-existing condition, then this sort of mandate is vital.

Unfortunately, the mandate for everyone to carry health insurance that was included in the recently passed health care reform won’t kick in until 2014. Until then, the more people decide to opt out of buying insurance coverage, the more our premiums will rise. So, while it’s easy to blame rising insurance premiums on health care reform, it’s actually the delay in enacting the reforms—and not the reforms themselves—that are leading to the price increases. In fact, the price increases we’re going to see over the next several years illustrate precisely why we need more health care reform, not why we should abandon it.

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Special Contributor Zack Cooper is a research officer with the London School of Economics. His monthly column for the Health Policy Forum considers health policy from the international perspective. “Special Contributors” are regular contributors to the Health Policy Forum who pose their own opinions and policy positions in the realm of health care and health policy. As a leading nonprofit health care research and consulting institute dedicated to improving human health, Altarum encourages open discussion and debate about the many challenges in health care today. All postings to the Health Policy Forum (whether from employees or those outside the Institute) represent the views of the individual authors and/or organizations and do not necessarily represent the position, interests, strategy, or opinions of Altarum Institute. Altarum is a nonprofit, nonpartisan organization. No posting should be considered an endorsement by Altarum of individual candidates, political parties, opinions, or policy positions. Read more.