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Unmanageable Competition

November 24, 2009

By Richard A. Epstein

The level of interference in private health care markets contemplated under both the House and Senate health care bills is so staggering that it is not possible to evaluate all provisions all at once. So let me put aside the endless taxes and subsidies, to concentrate instead on one critical assumption of both bills: the supposed failure of the voluntary private market for individual and small group health insurance plans to provide comprehensive coverage to all comers at reasonable rates.

The proposed Democratic cure is an elaborate set of federal mandates that require these private carriers to ignore all preexisting conditions, to guarantee the issue and renewal of insurance contracts to any and all current and potential customers, and to adopt community rating programs that limit the variation in premium levels by age--to two-fold in the House bill and four-fold in the Senate.

Let’s posit that these massive reforms are motivated by the laudable social concern that high-risk individuals can’t afford health insurance in a voluntary market. The plan is to introduce what Alain Enthoven once called “managed competition” to control the key features in the marketing and design of health care plans. (Enthoven is not a fan of the current bills.) But this move won’t work. The difficulty starts with the inveterate confusion between “market” and “social” insurance.

Market insurance is only intended to pool risk, which usefully allows all insured customers to smooth out their consumption over all future times, both good and bad. In unregulated markets, “unmanaged” insurance companies meet this demand by making accurate risk assessments. Once the rates are rightly determined, the insurance pool is stable because no one cares who else their insurer covers so long as he or she gets a policy worth more than it costs. Absent cross-subsidies, people will tend to keep policies that generate positive net benefits. They will have no incentive to game the system in order to put themselves into a favorable insurance pool.

For all its virtues, however, market insurance cannot make high future health care costs disappear. The sick person who has a 50% chance of incurring $50,000 in medical costs next year and a 50% chance of incurring $100,000 can either pay $75,000 for an all-in policy, or $25,000 for a policy with a $50,000 deductible. Health insurance only reduces variance. It does not let anyone duck certain future costs.

Social insurance tries to make that problem go away by, say, cutting premiums that insurers can collect from sick people. To do so, it has to introduce a complex system of cross-subsidies. When this happens voluntary pools start to unravel. People now care about whether their fellow insured customers are sick because if they are, their own rates will shoot up. Healthy people will flee the managed pool, because it is cheaper to do without than to insure other people. Fewer insured customers mean high surcharges for those who remain, encouraging further departures from the pool. As the cycle intensifies, the insurance market disintegrates. State coercion, like the Berlin Wall, is the only antidote against mass exodus. And so the plans that trumpet the right to health care end up imposing a duty to acquire health insurance on healthy people.

These difficulties are compounded if government tries to dull the blow to healthy individuals by limiting the rates insurance carriers can charge their customers when forced to take on all comers. The liberal myth holds that rate regulation will give insurance carriers every incentive to cut costs and eliminate waste. But insurers already have that incentive under market competition. Price controls and mandates for health insurance will work like rent control programs. Service quality will fall as revenues diminish. Companies will look for covert ways to screen out high-risk customers. Government regulators will respond with elaborate counterstrategies that drive up administrative costs. Extensive regulation will block new entrants into the business. The ensuing shortages will force people to wait in queues. The noble mission of managed competition will wreck the private market for all and pave the way for a state takeover of the entire system.

To avoid this downward spiral, we must reverse course. The current bills should be dropped forthwith. The new motto is “redistribution last.” Deregulation of an overheated market should be the new focus. Slash state mandates on health care coverage; allow interstate competition in insurance markets; relax interstate licensing requirements; permit nonmedical institutions like Wal-Mart ( WMT - news - people ) and CVS pharmacy to enter the primary care markets; reform medical malpractice law; and thin out senseless privacy diktats. Lower costs will revive the voluntary market and reduce costs and increase access for seriously sick people. The health care debate will continue to careen out of orbit until we return to the basic libertarian presumption that government intervention is an evil until shown to be a good.

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