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  • Constitutionality and the Affordable Care Act

    The news media is, correctly, abuzz with the monumental issue going before the Supreme Court this week. Indeed, people started lining up on Friday night for the right to get into the chambers today for the start of the three day hearing (the three days the justices have allotted this case is in itself a signal...it is the longest "hearing" granted to any issue in over 40 years at the SC).


    Unfortunately, I have yet to see/hear anyone get to the real issue here.  Most reports tout this as a case of individual liberty:  "...can the government force you to hold health insurance...."   I will not bother to present my opinion on this, as it is just that:  an opinion of one of several million registered voters in this country.  Basically, the opinion polls seem to indicate a split across the population on their position regarding this "mandatory insurance" part of the health care law.  However, the same polls indicate almost universal agreement with another tenet of the new law, the "no pre-existing conditions limits" part which means that insurers have to provide you with health insurance regardless of your personal health status (e.g. a pacemaker as one example).

    The problem is, you can't have the latter without the former. The issue is something economists call Adverse Selection.

    The Affordable Care Act (ACA) says that insurers must use a "community rating" system for pricing insurance.  Community Rating means that insurers cannot vary the premium across customers.  They charge the entire community the same premium, selected to be the average health care costs of this community.  [[To be honest, the Community Rating rules in the Affordable Care Act do allow for some differences in health insurance premiums based on Geography (the premiums in the south may be different than the north, for example), on age (higher premiums for older people) and on tobacco use (tobacco users can get premiums 50% higher than the community rated average premium everyone else pays).  But no other differences are permitted.]]

    This is key to the "No Pre-Existing Conditions Limitations" component, as insurers cannot charge high health risk people a high premium consistent with their expected health care usage.   Allowing such differential premiums would emasculate the "no pre-existing conditions limitations" part of the Affordable Care Act as premiums for some of the least healthy folks would be prohibitively high:  essentially a pre-existing condition exclusion.

    But here comes the "Adverse Selection" problem.  Consider a community of, say, several thousand people all paying the same Community Rated average premium as required under the Affordable Care Act.  That pool of people will contain all sorts of health levels.  Some will be people with serious health issues (aka pre-existing conditions" or lifestyle issues that lead to more impending health care costs).  And, at the other extreme, there will be lots of young single adults with incredibly good health who may not see a doctor for years.

    The problem is, these healthy people will very quickly understand that they are paying a premium far in excess of what is fair for them.  The community rated premium is essentially the "average health risk premium"  Since insurers are stuck offering just one premium, this average premium (plus a small markup for profit) will allow them to just break even. But, the healthy folks who never or hardly ever go to a doctor are paying a large chunk to cross-subsidize the high-risk folks who are paying the average risk premium (the community rated premium) which is not nearly enough to cover their high health care needs.

    Without a provision for MANDATORY health insurance (the issue before the Supreme Court this week) some segment of the very healthy folks will elect to discontinue buying insurance, and become "self-insured" (aka uninsured).  However, when this group of low risk folks drop out, the remaining pool of insured folks is now undoubtedly "sicker" on average than before.  Now the community rated "average health risk" insurance premium will have to be raised to reflect this new state of average health.  And, you can see where this is going.  But, this produces a new set of healthiest folks who were willing to pay the original premium for insurance but the new higher premium is too much for them to take and they bolt from the insured pool.   This loss of a group of low risk folks once again raises the average health risk of the remaining group which means the insurer must compute a new higher "average" premium to charge to each of the remaining customers, reflecting the less healthy nature, on average, of the remaining insured group.  So on and so on.  This phenomenon is called adverse selection: the community rating allows the healthy people to "select out" of the pool rather than pay premiums high enough to cover the unhealthy people, leaving just the sickest and most expensive people selecting to remain.

    So, the requirement to have community rating (everyone pays a common "average health risk" premium) is necessary to get around the "no pre-existing conditions limitations" but without a provision forcing people to buy insurance (the mandatory insurance provision the Supreme Court is considering today), the healthier folks will continue to leave the pool rather than pay an unfairly high premium to make up for the high health care costs of the sickest segment of the population.  If the Supreme Court finds the mandatory insurance provision is unconstitutional, the Community Rating provision, and hence the "no pre-existing conditions limitation" will also go out the door.


    Larry DeBrock
    Josef and Margot Lakonishok Endowed Dean, College of Business and
    Professor of Business Administration and
    Professor of Economics