- Health care markets work best when devoid of cross-subsidies from the young to the old.
- In health insurance, average spending rises rather steadily by age.
- Artificially raising premiums for the youngest to pay for older plan members makes insurance a questionable proposition.
Your children should subsidize my grandmother's health care. Or so say advocates for the Affordable Care Act. In The New York Times, J.D. Kleinke argues that one of the main obstacles to the U.S. health care system functioning like a competitive marketplace are "limitations imposed by the problematic nature of health insurance, which requires that younger, healthier people subsidize older, sicker ones."
"While it's true that healthy participants subsidize those who become sick in virtually any health insurance scheme, it is dead wrong to conflate this idea with the pernicious myth that health insurance requires the young to subsidize the old." While it's true that healthy participants subsidize those who become sick in virtually any health insurance scheme, it is dead wrong to conflate this idea with the pernicious myth that health insurance requires the young to subsidize the old. Indeed, health care markets work best when devoid of cross-subsidies from the young to the old. And misguided efforts to force them to create such cross-subsidies through regulation often create more problems than they solve.
If this sounds counter-intuitive, consider the auto insurance market.
Car insurers charge male teen drivers rates often several multiples of those charged to their grandparents. Indeed, male teens often are charged more than their female counterparts. There is little objection to this arrangement since it is widely understood that this is "actuarially fair." The premiums merely reflect the higher accident risks faced by different cohorts of drivers which, in turn, are based on the average level of driving experience and behavior of each group.
From the standpoint of financial burdens, this arrangement might strike many as manifestly unfair: after all, young drivers generally have lower incomes than older drivers (or, to the extent that teen premiums are covered by parents, a typical family with two teenagers would face a substantially higher burden than an older couple without children etc.). But properly designed markets have nothing to do with "fairness" in that sense.
Absent intervention, well-functioning insurance markets achieve actuarial fairness in which premiums are in direct proportion to the risk posed by each class of insured individual. Thus, if 16 year old males have a fourfold risk of accidents compared to the average, they can expect to pay premiums that are roughly four times as much.
In health insurance, average spending rises rather steadily by age. Likewise, males and females exhibit very predictable differences in health spending.
Thus, in an unfettered health insurance market, we should expect (and do) see premiums vary in proportion to these expected costs. An insurer that sought to charge everyone the same rate would quick find itself in the red when people whose expected costs were higher than the flat rate raced to sign up. Conversely, an insurer that sought to charge a particular age/gender group twice their expected expenses likely would lose business to insurers who charged a lower premium that was still sufficient to recover their expected costs and the administrative costs required to provide the coverage. Competition among plans will ensure the Goldilocks result that premiums are neither too high nor too low for each category of insured.
ACA changes all this by prohibiting gender differences in premiums (even though such differences are perfectly permissible in auto and life insurance) and by restricting age differences to a 3:1 ratio (that is, for a given set of benefits, the premiums charged to the oldest plan members cannot be more than three times the amounts charged to the youngest plan members). Not only is this actuarially unfair, but it's typically unfair in the broader sense of imposing a higher relative burden on young workers who typically have much lower earnings than their counterparts age 45-64. (The typical household headed by someone age 15-24 has a median income of roughly $30,000 a year, compared with more than $70,000 for a typical household headed by someone age 45-54).
Moreover, artificially raising premiums for the youngest plan members to pay for older plan members makes health insurance a more questionable proposition, resulting in younger people dropping their coverage even as the reduction in rates for older people encourages more of them to enroll. Consequently, insurers will have to raise premiums for the entire pool to offset these shifts, creating an adverse selection spiral in which both younger and older people remaining in the pool end up with higher premiums than if regulators had not intervened in the market in the first place. This is neatly illustrated in the following chart borrowed from fellow Forbes contributor Avik Roy.
States that have imposed community rating in the individual market have discovered that the total number of uninsured people rises rather than falls, because the number of older people who gain coverage due to premium reductions is more than offset by the number of younger people who drop their coverage due premiums hikes. This phenomenon is well-explained by Wharton School health economist Mark Pauly in his excellent Health Reform without Side Effects-a short treatise well worth reading for anyone who wants to understand just how deeply flawed the health insurance "reforms" in Obamacare are.
The individual mandate under ACA was designed to forestall young people from dropping coverage. However, the penalties are far lower than the $5,000 average cost of single coverage in the group health insurance market (a figure that would be even higher in the individual market). And precisely because the law forbids insurance companies to reject an new applicants, young people may well decide it's cheaper to pay the penalty and then sign up for coverage after they are in an auto accident or have been diagnosed with a terminal disease.
Until the individual mandate takes effect in 2014, we really don't know how all of this will play out. What we do know from decades of scholarly work by Professor Pauly and others is that it is far more efficient to let the insurance market accurately and honestly price risks (as is allowed in the automobile and life insurance markets) and then to provide subsidies to those who have difficulty affording coverage at market prices (e.g., those with low incomes or those with extraordinarily high annual health expenses such as patients with MS). This is both more transparent and fair than the ACA alternative of essentially imposing an excise tax on health insurance and then desperately erecting regulatory barriers to prevent individuals or insurance companies from behaving naturally in the face of the resulting structure of perverse incentives these create.
This simple example illustrates the fundamental flaw that pervades the health law: the presumption that experts can and should displace the market to achieved a set of desired outcomes. An alternative, truly conservative approach would harness the power of the market to achieve efficient outcomes and rely on government only to assist the truly disadvantaged.
 Some notable free market scholars who have weighed in with comprehensive critiques include (alphabetically): Michael Cannon, James Capretta, Dianna Furchgott-Roth, Hadley Heath, Merrill Matthews, Tom Miller, Nina Owcharenko, Grace-Marie Turner.