EDITOR’S NOTE: We have our quibbles with a couple of the author’s points, but we all benefit from the robust exchanges that such quibbles prompt.

The appearance of a serious Obamacare repeal/replace bill, and the ensuing discussions, have once again led me to ponder the economic underpinnings of health insurance. One group of people thinks that only through the heavy, monopolistic government ownership of the health care sector can reasonable health care get delivered to the American public. Another group of people thinks that maybe forming a monopsony (single payer) is the right way to go because then government can “control costs”. Others prefer a more free-market approach, with the customers contracting with insurers who then negotiate prices with providers. And, finally, there is the libertarian point of view, which can be basically summarized as “no government regulation of health care delivery, prices, or insurance.” Let’s explore the economics behind health care, from a libertarian perspective.

For those who haven’t had the opportunity to study classical economics in depth, let me summarize the core principles that apply to libertarianism here. For a start, libertarianism pretty much presumes that there is a strong system of contracts, that are enforced. This requires, of course, a judiciary that balances contractual claims, since contracts are written by human beings and are thus never perfectly executed. Without strong contracts, it is not possible to have the kinds of transactions that a libertarian society must have to function; one cannot enter into a mutually-beneficial agreement with another party on the basis of that party fulfilling the terms of the contract, because it is possible that the other party is deceiving you. Adjudication of contracts isn’t perfect either, so if you entered into one even with a robust enforcement system in place, there’s a “risk premium” associated with failure of the other party to faithfully execute the contract, or your failure to adequately meet the terms of the contract from the other party’s perspective.

In other words, risk makes contracts harder to execute – and the greater the risk, the more likely it is that one party or the other will not definitely find the contract beneficial to them. In that case, no transaction takes place, even though numerically it seems like it should.

So, next, let’s examine what insurance actually is, and figure how it works into the overall transaction/contract/risk picture. Insurance, classically, is a means of placing a dollar value today on a specific event that might or might not take place in the future. Insurance only works when the contract between the insured and the insurer is enforceable and strong. Insurance is only offered if it is of unquestionable benefit to the insurer. On the other side of the equation, an insured only contracts to buy insurance if it is financially possible to do so, even if the insured would be better off in the long run.

The variety of policies that an insurer offers, even in a fully libertarian world, is therefore limited by the degree of risk that the insurer is undertaking. When that risk increases, the insurer is less willing to write policies unless the price increases too. The insurer who inadequately evaluates risk is not going to stay in business very long. In the context of, for example, life insurance, the insurer has precise control over the risks. The contracts that most life insurance companies offer have clauses in them describing precisely the payout, and the timing, and the premiums. This risk is well understood, and therefore life insurance doesn’t have much of a “risk premium” attached to it unless the insured has a terminal illness, or is actuarially extremely likely to die in the next few years, in which case the insurance company simply refuses to offer a policy, or offers a policy with very limited payout. In other words, they’ve contractually limited their risk, and that is why life insurance is generally cheap and affordable.

Contrast this with health insurance. Many libertarians have pointed out that buying lifetime health insurance from the company of one’s choice at an early age seems like the right model. So why aren’t companies falling all over themselves to offer that kind of insurance?

The answer is simple: risk. Paying for a person’s healthcare for their entire life is enormously risky for any insurer. The insured may be a parsimonious consumer of health care, but they may turn out to consume tens of millions of dollars worth, or more. The risks are not under control, not at all. If this insurance was priced fairly, from birth, with a fixed premium schedule, the risk premium for such an open-ended, uncancellable policy that spans an entire lifetime would be so large that almost nobody would be able to pay for it, even if in the end it turned out to be a good deal for them.

Unregulated health insurers therefore will not likely issue health policies of this kind, and it is not rational to expect them to do so, no matter how unregulated the market becomes.

What health insurers do offer in an unregulated environment are policies that have a great deal of contractual language that helps them control risk. Policies that can be cancelled at the sole discretion of the insurer are one obvious example, but there are other techniques, such as annual or lifetime caps on payouts, or requirements for authorization for medical treatments or procedures, or limits on the kinds of medications that are covered, or limits on the kinds of services that are covered. The other technique is raising premiums based on medical history. None of this is unexpected; there’s every incentive for an insurer to want to do these things in an unregulated market. Without these kinds of ways of controlling risk, it may not be possible for a health insurer to offer policies that most people can buy.

If we, as a society, want to make health care available to the most people, we therefore need to systematically address lifetime medical risk in some kind of way. Unfettered markets by themselves will not do this; the incentives are powerful and opposed. There are, nevertheless, many ways to achieve this goal.

But first, let us recognize that the high cost of medical care itself is the major issue underlying the problems inherent in a decent medical insurance market. The insurance model does not work well for health care because costs are so variable and are, essentially, open-ended.

Addressing underlying medical cost issues would therefore seem critical to relieving much medical lifetime risk. But let’s also understand that that’s not enough, by itself, because as medical science progresses and a society grows more affluent, one would expect more money to be spent on medical care. So there will always be economic forces that inexorably work to increase medical costs, and it is perfectly reasonable and predictable that free peoples will want to improve their standard of living through better medical care. Thus, unless we decide as a society to prevent the further advancement of medical care, the high lifetime medical risk that we currently see will continue for the foreseeable future. So we cannot expect to solve the problem through efficiency alone.

Nevertheless, it’s worth discussing what is needed to achieve greater efficiency in medical services. Top-down controls on prices typically do not work very well; economically speaking, these are a form of price-setting, which leads to shortages and surpluses. The only known way to reduce costs by increasing efficiency is by increasing the productivity of the delivery of medical services. One mechanism is known to be particularly good at promoting productivity, and that is competition.

For competition in medical services to function, several things must be possible. First, there must be multiple providers available for any kind of medical service, and there must be low barriers for people to make use of a different provider for whatever reason. Second, there must be information transparency – not only about price, but about quality of care. Both of these are currently in short supply in the United States, but with the proper reforms, it may be possible to build a more robust market for medical care, over time. The main problem with such a market is the complexity of medical care, and the difficulty of educating the consumer. But most health care dollars are actually spent by health insurers, under negotiated contracts, so health insurers are in a good position to publish cost and quality information for their insurees to make decisions with. In short, introducing robust competition in health care delivery looks entirely possible; itís just a matter of introducing the systems that would make it happen.

Next, let’s look at the other half of the problem: dealing with lifetime medical risk. Economics says that the more quantifiable (and lower) the risk, the more affordable the insurance – and without such an effort, medical insurance as it should be will not be something that is readily available. There are many ways to tackle this problem also.

One solution that has greatly excited the Left is the idea of so-called “single payer” insurance, where the government contracts for health services and sets reimbursement fees. This is based on two ideas: first, that the overall risk variance for a pool of insured will be minimized if the pool is as large as possible, and second that if the government creates a monopsony in medical payouts, they can force suppliers of medical care to accept lower prices. But, of course, this is another variant of price setting, with all of the distortions that that entails. Medicare, which sets prices very similarly to single-payer systems, at the moment arguably overpays for tests and underpays for doctor time, and that predictably leads to over-prescription of tests, and a dearth of physicians willing to cover Medicare patients due to low reimbursement rates. And, under single-payer, while the risk pool is large, the system is vulnerable to politics: instead of the insured choosing what treatments to pursue, political majorities decide what treatments that the government will pay for. This is a severe distortion because there is every incentive for government to pay only for popular treatments for common ailments. The diseases given priority will all have strong political constituencies. That’s very different from individuals spending or directing dollars towards their own illnesses.

Another solution is to subsidize health insurance premiums directly, in one way or another, in an attempt to make premiums be affordable. This has the benefit of making it possible for more people to participate in the system. But, it also severely distorts the insurance market, because insurers still see the same risks as always, and must price accordingly – and, even worse, subsidies of this kind encourage higher insurance premiums than would otherwise be the case (because when there is a subsidy, that is what happens). Nevertheless, this is the general approach of Obamacare, and to a lesser extent, of the American Health Care Act.

For the most robust health insurance markets, though, with a wide variety of offerings that a large percentage of Americans can afford, what we really want is a way of turning insurer risk into a fixed, quantifiable amount, and do this in such a way that health care reimbursement is nevertheless open-ended for those who have the misfortune of needing extensive medical care. This sounds hard, but it is actually easy to do. Suppose health insurers only pay for the first $250,000 (or so) of medical care that a patient receives, and after that the government picks up the bill for any additional care that is necessary? The arrangement described is a form of “reinsurance”, where a company brings in another insuring entity for the really tough cases, and allows them to shoulder those risks. But to keep insurance rates low, we’d instead want to bring in the government as the insurer of last resort. Such a setup has two huge benefits: it leads to a robust, healthy insurance market, with policies that can be offered without many risk restrictions, at much lower premium cost. But there’s a more subtle benefit too: while government is picking up the tab for the sickest individuals, it is nevertheless not in a position to control what treatments are offered or reimbursed. You get the benefits of insurance competition without the high prices resulting from open-ended risk, with no distortion of the practice of medicine by the government.

Even a libertarian might like that.

• About the Author

About Karl Wright

I am a long-time software engineer, with wide-ranging interests including music, the sciences, politics, economics, and medicine. I've been active for a decade in the open-source community and I work for a major mapping company.