No Easy Solutions by David Montgomery


Once again, attempts by the Senate leadership to design an Obamacare replacement that can gain 50 votes are back in the news. It should not be a surprise that this is a hard task. Very few politicians appear willing to admit that there is no way to give every American all the health care that he or she wants without making someone a great deal worse off.

It is not necessary to be an expert on health economics to diagnose the problems with Obamacare itself and every attempt to replace it. Nobel prize-winning economist Kenneth Arrow did so 50 years ago in an article that started systematic economic thinking on the subject. He emphasized the unique character of the doctor-patient relationship and gave names to three fundamental problems of health insurance: asymmetric information, adverse selection, and moral hazard.

Asymmetric information simply means that the prospective patient knows more about his or her health condition than the insurance company. This means that if everyone is offered identical insurance at identical premiums, those that are relatively healthy will decline to purchase insurance, leaving the insurer with only the less healthy as patients. This is the fundamental problem of adverse selection.

To prevent adverse selection, health insurers may require physical examinations, put limits on coverage of pre-existing conditions, and charge premiums that differ by age, sex, and other factors correlated with health status and unchangeable by the insured. It is also the reason that insurers offer a variety of plans, so that those who believe they are healthy can choose plans with low premiums and limited benefits.

A closely related problem is that having insurance leads to greater use of healthcare unless there is some form of rationing or coinsurance. This is the problem of moral hazard, in which the patient (and doctor) are likely to choose more costly and marginally more effective treatment if a patient has health insurance than if he or she does not.

Insurance companies use coinsurance to provide some incentive for the patient to avoid totally unnecessary expenditures, such as visits to the doctor or emergency room for the common cold. This has been augmented by managed care plans, requirements for pre-approval of procedures, and exclusion of certain treatments. Arrow thought that the relationship of trust between doctor and patient that he observed in 1963 would also reduce moral hazard.

Unfortunately, the healthcare system more broadly seems to defeat these efforts to limit moral hazard. When insurance covers a large portion of costs, hospitals cannot compete for patients on price and instead compete on quality by offering the best and newest equipment and the most famous surgeons. This inflates everyone’s costs Moreover, cost-based insurance reimbursement formulas for hospitals can also encourage premature replacement of equipment.

The elephant in the room for moral hazard is, of course, malpractice liability. A noticeable difference between the United States and countries that are claimed to have better and cheaper health care is that no other country allows the kind of lawsuits that have caused the cost of malpractice insurance and defensive testing and treatment to explode here.And those costs are fully reflected in the pricing of medical services.

The fundamental requirement of an insurance system is that it collect enough premiums to pay claims and build a reserve to cover the uncertainty of needs for medical care. Prior to Obamacare, health insurers used the practices I have described to attract enough subscribers to remain solvent. No one was forced to buy insurance so that premiums and coverage were tailored to maximize revenue while exclusion for pre-existing conditions kept costs down, to the extent permitted by regulators in each of the 50 states. The indigent were covered by subsidized insurance through Medicaid or by hospital emergency rooms that spreads the unreimbursed cost through their paying customers.

Obamacare broke this system by requiring everyone to purchase health insurance, requiring coverage of pre-existing conditions, and limiting the ability of insurance companies to charge higher premiums to groups likely to make higher claims. The result made nobody happy, because it ran into the iron law that the less one group pays into the system, the more others will have to pay in order to keep the system solvent. This is true whether the insurance provider is a for-profit insurance company, a non-profit insurance company or the government.

Despite its ironically inaccurate title of “Affordable Care Act,” the clear purpose of Obamacare was to make sure that every American family was covered by health insurance. This includes those who decided they did not need insurance at the premiums offered by insurance companies, those who could not afford insurance (which is another form of deciding not to participate), and those who were excluded due to pre-existing conditions.

The method of getting each group into the system differed.

The young and healthy were required to buy insurance whether they wanted it or not, and minimal coverage plans were prohibited to ensure that they put more than a toe in the water. This made all of that group unhappy.

Those denied coverage were guaranteed coverage, and insurance companies were prohibited from charging premiums high enough to pay for their expected claims.

Medicaid was expanded to increase subsidies to the poor so that they could afford insurance, and insurance companies were granted subsidies. This necessitated the tax increase that went along with Obamacare.

Premiums for all those who were already insured rose to help pay for all this, and premiums for those forced to buy insurance for the first time became even higher than the premiums they had previously declined to pay. This infuriated those who were getting what they wanted from the previous system.

The failure of Obamacare arose from incompatible goals: universal coverage, limits on premiums charged the highest-risk groups, lower rates or free insurance for the poor, limits on taxpayer subsidies, and no increase in premiums to those already insured.

Those goals proved impossible to achieve simultaneously given the current state of the broader healthcare system. To fix Obamacare, Republicans must decide which goal to sacrifice or else address those broader problems. As usual, politicians on all sides are pretending that there are not any hard choices of who to benefit and who to hurt.

If Obamacare continues to be dealt with in isolation, eliminating coverage mandates will just increase the insolvency of the system as those who never wanted insurance to drop out. That makes it necessary to increase premiums, increase taxpayer subsidies or limit coverage, since insurance companies cannot be forced to operate at a loss forever.

Simple repeal of the Affordable Care Act would work, and the politics are clear. Those who do not want the insurance they are forced to buy would be satisfied, and those who had insurance before would see their lower rates return. Those paying higher taxes to support the current system would also benefit from its repeal. Those with pre-existing conditions would face higher premiums or denial of coverage and Obamacare-based subsidies to allow the poor to afford insurance would cease.

Different political and ethical judgments about which of these groups is most deserving will lead to different preferences about how to change Obamacare, and it is clear that Republican Senators do not agree about those judgments. Unwillingness to admit that difficult choices must be made does not help with resolving such disagreements.

David Montgomery was formerly Senior Vice President of NERA Economic Consulting. He also served as assistant director of the US Congressional Budget Office and deputy assistant secretary for policy in the US Department of Energy. He taught economics at the California Institute of Technology and Stanford University and was a senior fellow at Resources for the Future.


Letters to Editor

  1. Dear Mr. Montgomery,

    Let me help you out here: “It should not be a surprise that this is a hard task. Very few politicians appear willing to admit that there is no way to give every American all the health care that he or she *deserves* without making *insurance companies* a great deal worse off.”

    “Having insurance leads to greater *preventative* healthcare *increasing cost savings as treatable and preventable illnesses are detected and addressed earlier.* *In this scenario*, there is *no* problem of moral hazard, in which the patient (and doctor) are likely to choose more costly and marginally more effective treatment if a patient has health insurance than if he or she does not. *Luckily, this problem is solved when health care is considered a human right and a moral imperative to which everyone has access.*”

    Honestly the venality and inhumanity of this essay surpasses all your previous efforts. How dare you claim that not being able to afford insurance is another way of deciding not to participate? Every other developed nation on this earth has figured out how to provide health care to all its citizens, with outcomes and satisfaction at least as good as they are here, often better. Surely you can’t believe that we are truly unable to compete in this arena.

  2. Let’s go back to first principles. Insurance is purchased to guard against financial loss due to rare, unexpected events – a stolen or damaged car; a house damaged or destroyed in a fire or by a fallen tree. Insurance protects the insured from a large expense at an inconvenient time. Insurance buys peace of mind. And a large insurance pool combined with the relative rarity of insured events makes affordable, competitive, private-sector insurance possible for both the consumer and the underwriter.

    Not so with health insurance. The whole notion of “health insurance” is a non-sequitur. A logical fallacy. We don’t need obscure actuarial tables to inform us that health crises are neither rare nor unpredictable across the population. Quite the contrary. To a greater or lesser extent, virtually every one of us is guaranteed to experience some sort of serious acute or chronic health crises throughout our life. In general and depending on how health insurance is structured, there is often not a sufficient base to sustain a free-market, profit-making, private sector insurance enterprise and still provide comprehensive and affordable insurance no matter how often Republicans try to jam that capitalistic square peg into what is an inherently a social round hole.

    Only a government-run system is in a position to operate within these realities such as a successful program like Medicare has demonstrated for half a century. Only an entity that has no profit motive, no investors, and no over-paid Wall Street executives can assume the risks and form an insurance pool large enough to make a comprehensive, affordable health care system work. Otherwise, we have to make trade-offs. You can have comprehensive health insurance, or affordable health insurance, or private-sector, free-market health insurance, but you can only have two at a time. Pick your ideology.

    As for the so called failure of Obamacare, Mr Montgomery fails to mention the concerted and sustained sabotage campaign the Republicans launched almost from its inception to undermine popular support. From Marco Rubio (1) to the 45th occupant of the White House, the Republicans have made it no secret of their flagrant administrative and legislative actions to torpedo the law. This is not to say that O’care doesn’t need adjustment and fine tuning just like every other piece of social legislation has needed. But the Republicans are determined to deny Americans even the most basic of health care as this latest attempt to repeal Obamacare is demonstrating and which has now been expanded to dismantle Medicare and Medicaid, as well. They are apparently prepared to throw the entire US health care industry into complete chaos and deny insurance coverage to millions of people only to score ideological points and curry favor with the Koch brothers and to quickly follow that up with a massive, unfunded tax cut for the rich that will explode the deficit.

    I guess the members of Cult45 will just have to be hit over the head before they realize they’re being played.


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