Why the ACA's lifting of caps is a big deal [View all]

[athena]

Some weeks ago, I had a discussion with someone on this board, who was complaining because her old insurance, which she considered "good insurance," was being discontinued. As it turned out, this person's old insurance had an annual maximum of $100,000. In other words, the insurance company would not pay her more than $100,000 per year. If she happened to have an accident or a serious medical issue, she would have been out of luck. The person considered this a "calculated gamble" and would much rather have kept her old insurance. I tried to explain that the whole point of insurance is to cover catastrophic events. Thinking about it further on my own, I realized that such caps may have been playing a big part in rising health care costs in the United States.

Under the ACA, health insurance companies can no longer impose annual or lifetime maxima on essential health benefits. To understand why this is a big deal, let's go back to how insurance works.

Suppose I have a 50% chance of being in an accident that will cost me $1000. If I were to purchase insurance to cover me in case of such an accident, the expectation value of what the insurance company would pay me would be $1000 * 0.5 = $500. Since I have more than $1000 in the bank, however, I can weather such an accident. I will therefore not pay more than $500 for this insurance.

Now suppose I have a 0.01% chance of being in an accident that will cost me $1,000,000. Since I don't have anywhere near a million dollars in the bank, such an accident would bankrupt me. I would be willing to pay someone $500 to cover me in case of such an accident. In this case, the expectation value of what the insurance company would have to pay me is $1,000,000 * 0.0001 = $100. I would be willing to pay five times as much for this insurance, as I can't afford to pay $1,000,000 and don't want to risk bankruptcy.

Suppose 100,000 people make the same calculation and pay $500 for this insurance. The insurance company takes in $50M. Since the risk is 0.01%, 10 people have the accident. The company pays $10M. It therefore makes a profit of $40M, minus the cost of implementing the insurance program.

Any insurance system has costs. Insurance only makes sense if people are willing to pay more on average than what they are likely to get back. In other words, the amount you pay the insurance company has to be greater than the expectation value of your loss. People will only pay more if the event they are protecting themselves against is so catastrophic that they can't risk it. That's the whole point of insurance.

Now, let's suppose insurance companies refuse to cover people against catastrophic events. They say they will not pay anyone more than, say, $100,000.

In this case, the entire system falls apart. For one thing, anyone who has $100,000 will not be interested in purchasing this insurance. In fact, the system is no longer "insurance." Since we're no longer talking about truly catastrophic events, we end up with a situation in which "health insurance" covers only ordinary trips to the doctor, and people simply hope to pay into the system less than they get out of it. But insurance can't work if everyone pays less than they get back. The result is that costs spiral out of control. We have gotten to the point where simply going to the doctor is a semi-catastrophic event financially, which is why anyone still buys insurance.

Suppose you're a healthy 25-year-old. Will you buy "health insurance" that doesn't cover catastrophic events, if you rarely go to the doctor to begin with? Of course not. If the health insurance covered catastrophic events, however, you would be much more likely to buy it, since you probably don't want to risk starting your adult life with a bankruptcy.

This is how annual and lifetime maxima, which insurance companies thought were increasing their profits in the short term, were in fact discouraging healthy people from buying health insurance.

I think it was a stroke of brilliance to ban annual and lifetime maxima. While the ACA may not be single-payer health care, it is likely to immediately curb the increase in health care costs. Young and/or healthy people now have a compelling reason to buy health insurance. This will lead to insurance companies taking in more money. Due to the rules limiting the profit insurance companies can make, most of that money will have to go toward actual health care. In the long run, health care costs may actually go down!