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Sunday, December 12, 2010

Unbundling Health Insurance

Last month I read Mark Pauly's Health Reform without Side Effects, a short book analyzing our health care system. As a recipient of generous employer provided health insurance for most of my adult life, I found Pauly's discussion of the inefficiencies of the individual insurance market the most illuminating section of the book. The treatment of coverage for high risk individuals was also careful, but it led me to realize that health insurance policies contain a hidden component which I have not yet seen analyzed and did not include in my prior post on health insurance. In addition to claims administration, benefit coupons, and insurance against catastrophic illness, insurers are required to include, as part of their insurance plans, an option for the insured to purchase insurance at a later date at a (strike) price that does not take into account the individual's health history subsequent to acquisition of the option. It would be interesting to see how this option would be priced if it were unbundled from the rest of the health care plan.

If I buy healthcare insurance while I am in good health, and then have a heart attack, I feel betrayed if my insurance premiums rise precipitously the subsequent year. Thus I expect my yearly insurance premium to pay both for protection against any catastrophic illness in the policy year and for an option to purchase insurance in subsequent years at rates set for healthy adults of my age. If this option feature of insurance were made explicit, more carefully defined, and separated from the rest of the policy, people could decide exactly what such an option is worth. Insurers might then offer `points' on insurance like bankers do on mortgages. Paying a certain number of points in advance, one can lower the nominal interest rate on a mortgage. Insurers could sell points that allowed one to buy insurance at rates set for lower risk individuals. What purpose could such points serve since insurers would have no incentive to sell points at a lower cost than the difference between the premiums for the buyer's actual risk level and the desired lower risk level? Points introduce the possibility that an entity other than the insurer could sell the option contracts. Options would essentially become options to purchase points. Assuming competition kept point costs fairly uniform, sellers could offer `universal' options which could be exercised at many large insurers. An immediate benefit of such an unbundled system would be increased portability of insurance. If an employer's insurance plan provided an explicit option, then a high risk employee who wished to leave his job need not worry about a subsequent dramatic increase in insurance costs. He would simply exercise his option at his new place of employment (or in the less efficient individual insurance market).

Unbundling of options might lower their cost. If you wish to purchase an option today which cannot be exercised for ten years, then the seller of the option will factor in ten years of returns on investing the option premium when pricing the option. (Of course you must also consider your loss of use of the funds for ten years in valuing the purchase.) In buying insurance, we know we should rationally only purchase insurance for catastrophic events unless our insurance is subsidized. If you can afford to pay 2 years of the higher insurance premium charged to high risk individuals, perhaps you would only wish to purchase options which cannot be exercised until three years after the date of purchase, decreasing their cost further.

None of the potential savings consequent to the decoupling of options from insurance plans is large enough to offset the price inflation associated with third party payment of basic medical services, but the concept introduces numerous ways to decrease cost and increase flexibility.

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