The Rationally Uninsured

January 26, 2010

By David J. Gernhard

Consider this almost-universally misunderstood fact of life: excessive government regulations bureaucratize any industry. The reason is fairly simple; it’s that firms are forced to first comply with regulations and then attend to the profit motive. As a result, satisfying customers in the most efficient fashion is no longer the sole determining factor of production. Businesses must first satisfy the state agents and inspectors.

With an increase in the amount of regulation in a firm, there results a decrease in the firm’s responsiveness to profit and consequently a fall in its responsiveness to the customers. This is a universal result of government regulation, and a contributing factor to health insurance problems.

However, some government regulations have a pernicious effect that is unique to the health insurance industry.

In the early 1970s, states began requiring that insurance companies provide certain benefits to policy holders. As a prerequisite to selling insurance plans to businesses or individuals, certain states required that various conditions be covered in the plans offered within their boundaries. Blue Cross/Blue Shield publishes a report showing which states mandate any of thirty-five different benefits.

Mandating benefits prevents the tailoring of plans to the specific risk pool of a potential policy holder. Insurance providers are forced to combine risk pools that could be otherwise isolated and priced according to their respective risk level. Premiums are therefore higher for the low risk pool and lower for the high risk pool. This is, essentially, regulatory socialism managed by the market process, and it raises premiums for the healthiest people, while lowering them for the unhealthiest.  Under these conditions, it makes sense for healthy individuals to opt out entirely.

Consider the forty-three states that have mandated that all policies cover alcoholism treatment. Insurance providers in these states cannot offer lower premiums to teetotalers or other low risk applicants. Instead, all premiums must cover the alcoholism brought about by high-risk lifestyles. The cost of these high-risk lifestyles are born by all policy holders, and resources are systematically and predictably distributed from the group within the policy that has a low risk for alcoholism to the higher risk group. Such a condition would not exist in a real market economy, as companies would offer a lower premium to the low-risk group to capture business from competitors.

Instead, individuals face higher premiums that cover many conditions they are less likely than others to face. These individuals recognize that most of the risks simply do not apply to them. The choice is then between being “over-insured” at high premiums or to forgo insurance altogether. Consequently, young and healthy individuals are increasingly electing to do without health insurance because it simply doesn’t make sense with the high number of mandated benefits.

The problem is that this process reinforces itself. As low-risk individuals rationally drop out of the socialized programs, the percentage of high-risk individuals within each policy group goes up – increasing the average cost to the group’s members to meet policy claims.  The higher premiums influence the cost-benefit analysis of the remaining low-risk members, who become more likely to exit the policy.  Thus, the State has created the very conditions our politicians now seek to correct with additional regulation, outright nationalization, mandated policy subscriptions, or some combination of these devilish “solutions.”