After my previous post on the topic, a friend passed along a recent paper by Jeffrey Brown and Amy Finkelstein in the Journal of Economic Perspectives. I recommend reading it if you are interested in the topic because it provides a lot of good background information and explains some of why the market is the way it is.

They make some similar points to mine. For example (p. 138):

“First, the organization and delivery of long-term care is likely to change over the decades, so it is uncertain whether the policy bought today will cover what the consumer wants out of the choices available in 40 years. Second, why start paying premiums now when there is some chance that by the time long-term care is needed in several decades, the public sector may have substantially expanded its insurance coverage? A third concern is about counterparty risk. While insurance companies are good at pooling and hence insuring idiosyncratic risk, they may be less able to hedge the aggregate risks of rising long-term care utilization or long-term care costs over decades. In turn, potential buyers of such insurance may be discouraged by the risk of future premium increases and/or insurance company insolvency.”

They also show just how expensive private long-term care insurance is. By their calculations, the load on a typical policy is 32% (which means that the present value of benefits is only 68% of the present value of premium costs).  This is what you would expect in a thin market with a lot of adverse selection. (And one more note: The median cost of long-term care is a lot lower than in Massachusetts, the state I cited in my previous post. See this study to see where your state ranks.)

A lot of the paper is about Medicaid, which (along with other public insurance, such as Medicare’s limited benefits) currently covers a staggering 60 percent of total expenditures, with private insurance paying for only 4 percent (p. 122). Brown and Finkelstein argue that the availability of Medicaid is a major reason why the private market is so anemic. Essentially, if you have a modest income and a small amount of assets, most of the benefits you would receive from a private policy simply replace benefits you would have gotten from Medicaid anyway, so the policy isn’t worth much to you.

I think they are right, but I don’t think the implication is that we have to reform Medicaid to encourage the private market.* I think that the other problems with long-term care insurance, which they also discuss (the passage quoted above as well as behavioral issues), mean that a private solution is likely to fail even in the absence of Medicaid. As they point out, only one-quarter of people in the top wealth quintile have long-term care insurance, and, for them, the availability of Medicaid is unlikely to affect their choices.

The other problem is that a private solution is going to create a lot of uninsured, just as it does with health insurance, and without the Medicaid backstop, that means millions of elderly people who need long-term care but can’t get it. Are we really willing as a society to deny those people the care they need because they weren’t farsighted or rich enough to buy insurance when they were younger?

Hubert Humphrey once said, “The moral test of government is how it treats those who are in the dawn of life, the children; those who are in the twilight of life, the aged; and those in the shadows of life, the sick, the needy and the handicapped.”** The point of Medicaid long-term care insurance is that if you need long-term care, but  you have nothing, the rest of society (via taxes) will pay for it. Sure it’s inefficient. But is the alternative really better?

* To be fair, they don’t say that we should reform Medicaid, either. Instead, they say that it would be necessary to reform Medicaid in order to increase private market coverage. For example (p. 137):

“Substantial growth of the private market is signifificantly hampered by two features of Medicaid—means-testing and its secondary payer status—which combine to impose a large implicit tax on private insurance and to crowd out the purchase of private insurance for most of the wealth distribution. . . . The evidence today suggests that Medicaid reform is a necessary condition for substantial growth in the private long-term care insurance market, but it does not at all imply that such reform would be sufficient.”

I’m currently in the process of buying long-term care insurance—you know, so my daughter won’t have to take care of me when I’m old. I have a good agent who knows all about the market and has answered every question I’ve had. I understand personal finance, opportunity costs, discount rates, and inflation. I know my way around a spreadsheet (one benefit of my years at McKinsey). But I find it’s still hard to figure out what to do.

A bit of background: Long-term care insurance pays for your stay in a nursing home if you become unable to take care of yourself. Depending on the policy, it may also pay for care you receive at home instead of going into a facility. According to the insurer I’m considering, the median annual cost of a semi-private room in a nursing home in my state is $145,000, and the average stay is something like three years. To put that in perspective, in 2009, the median net worth of families where the head of household was of age 65–74 was $205,000 (including real estate assets).

Long term care is not covered by Medicare, except for a short period after each acute event. It is covered by Medicaid, but to be eligible for coverage you have to exhaust all of your assets. Despite that onerous requirement, Medicaid currently covers 40 percent of all spending on long-term care. (2011 Long-Term Budget Outlook, p. 39.) The Affordable Care Act of 2010 included what is known as the CLASS Act, which would have allowed anyone to buy long-term care insurance, with an average benefit of $75 per day, for a monthly premium of $123. The CLASS Act, however, has been suspended because the administration could not certify that it would be deficit-neutral over the long term. So the bottom line is: until you use up all your money, you’re on your own.

Still, shouldn’t you be able to buy protection in the private insurance market? The short answer is: not really.

The first problem is that private long-term care insurance is designed to help you pay for long-term care, but not to insure you against open-ended costs. Most policies have limits on both your maximum daily benefit and your lifetime total benefit, so a typical policy will only cover you for, say, three or five years. Unlimited duration policies do exist, but they are priced to deter people from buying them—because insurance companies don’t want that risk on their books. So an insurance policy will help you pay for long-term care, but won’t take away the tail risk—unless you’re rich enough that you can cover the tail risk yourself.

The second problem is that there’s no way to protect yourself against inflation. The “inflation protection” in the policies I looked at is a simple annual increase in your daily benefit by 3 percent or 5 percent. It isn’t indexed to actual inflation, let alone to actual inflation in the cost of long-term care, which is what you care about. This is important because, if you’re in your forties, you’re buying a policy you will probably need in about thirty years. Again, the insurance companies don’t want that risk, so you get to keep it. So if you buy the maximum, 5-percent protection clause, there is a decent chance that your benefit will keep up with actual costs, but there’s no assurance that it will.

The third problem is that you can’t protect yourself against your premiums going up in the future. The standard way to pay for long-term care insurance is to pay an annual premium that stays flat in nominal terms for the rest of your life. This means that you’re overpaying (relative to the actuarial cost of the insurance) in the early years and underpaying in the later years. But if the insurance company figures out that it has underpriced long-term care insurance in general, it can file for a rate increase and boost your premium payments down the line. And by that point, you’re stuck. You can’t switch insurers because the new insurer won’t take into account the overpayments you made to the old insurer, so it’s certain to charge you higher premiums.*

In a competitive market, doesn’t that just mean that someone will enter the market with a product that includes real inflation protection and a lifetime premium guarantee? Well, it hasn’t so far. But more importantly, that wouldn’t be real insurance either, because of the fourth problem. With long-term care insurance, you’re buying a product you probably won’t need for decades, at which point the world will have changed considerably. There is a decent chance that your insurer has mispriced the risk (more people will need long-term care than they expect, or long-term care will be more expensive, or medical advances will mean that people are living longer in long-term care)—in which case it will go out of business. And then your insurer won’t be around when you need it.** Insurance companies try to protect themselves by (a) not offering real inflation protection and (b) reserving the right to raise your premiums in the future; if they didn’t, they’d be even more likely to fail. But that still isn’t perfect protection, which means you’re taking on counterparty risk.

Then there’s the fifth problem, which applies to all private insurance without a governmental mandate: adverse selection.

In short, the private market doesn’t provide good long-term care insurance—because it can’t. The insurance you can buy is really just a way of reducing the amount you’ll have to pay for long-term care; it’s a financial planning tool that tightens the distribution of your expected long-term net worth. My spreadsheet says it’s worth it on that basis, so I’m planning to buy it (although I’m not accounting for counterparty risk or the risk of future premium increases). But it isn’t insurance against extreme outcomes.

If we want real long-term care insurance, there’s only one place where we could get it: the federal government. The government can offer unlimited coverage and real inflation protection (benefits based on actual costs at the time you incur them) because it has the ability to absorb long-term financial risks. It can mandate universal coverage, eliminating adverse selection. Because it can raise premiums (or other taxes), it will not go out of business. (Those potential premium increases, however, do mean that it can’t offer a lifetime premium guarantee.)

If this sounds radical, it shouldn’t. We already do virtually the same thing: it’s called Medicare Hospital Insurance, and it’s one of the most popular programs in existence. The Hospital Insurance trust fund is facing a long-term deficit, but that’s not because of its basic structure: it’s because the premiums it charges (payroll taxes) haven’t gone up along with health care inflation, so it’s systematically undercharging for the risk it’s taking on.

A federal long-term care insurance program would pool a major financial risk that most middle-class families today are facing alone. (Arguably, if you don’t have any assets, you don’t face any risk because of Medicaid.) This is exactly what governments are supposed to do: protect ordinary people from risks that they cannot absorb and that private markets do not provide good solutions for. It would probably also help budget deficits in the long term. The government already picks up 40 percent of all long-term care spending through Medicaid, for which it gets nothing; a real long-term care program could pay for itself through payroll taxes, reducing Medicaid spending.

Now I know the last thing that will happen today is a new social insurance program. Instead, middle class people will continue hoping they don’t need long-term care, elderly people will spend all their money on long-term care and then go on Medicaid, and government spending on Medicaid will continue to climb. But that’s a comment on our political environment, not on the proper role of government in society.

* You can accelerate your premium payments by paying the whole thing over ten years, which reduces this risk; but the people who can afford to do that are usually people who can self-insure for long-term care anyway.

** There are state guaranty funds that pick up policies from bankrupt insurers, but their benefits are likely to be less than what you originally paid for.

I am getting thoroughly frustrated with a facet of the health care debate – the singular focus on health insurers, with total disregard of other contributors to health care costs.  Yes, I am in total agreement with the concept of providing health insurance to folks who currently cannot afford it, or who do not have access at any cost (because of pre-existing conditions).  I also believe that the rate of increase of health spending needs to be significantly reduced.  But, I do not believe that we can achieve any meaningful health spending reduction just by bashing or financially squeezing the health insurance companies.

Before I go any further, let me state that I do not own stocks or bonds issued by any company in health care, health insurance, or related industry segments.  I have no health insurance clients.  And none of my relatives or friends work for a health insurer.

Lately, it has become quite fashionable to cite egregious moves of various insurers and imply that if such moves were eliminated, the cost of health insurance (perhaps even health care) would be reduced.  President Obama (and others) frequently cites Anthem’s 25% rate increase in California.  Kathleen Sebelius, the secretary of health and human services, according to a 3/9/10 NYT article (p. A18) has called health insurers’ profits “wildly excessive“.  The same NYT article quotes Senator Diane Feinstein: “I believe, fundamentally, that all medical insurance should be not-for-profit.“  Also in the Times, Robert B. Reich, a former labor secretary and a Professor of Public Policy at the University of California at Berkeley, writes in a 2/24/10 article, “. . . because big health insurers are making boatloads of money. America’s five largest health insurers made a total profit of $12.2 billion last year [2009].”

So, let’s try to answer two questions:

1.  What do we achieve by trimming “wildly excessive” profits of health insurers?

2.  Are these profits “wildly excessive,” when compared to other industry segments?

It was actually Professor Reich’s article that initially sent me looking for information, as his billions of dollars of health insurance profits were a meaningless factoid unless one placed them in the context of the actual revenues of the five top insurers.  In order to have a solid foundation of comparative data, I reached for the 2009 Fortune 500 rankings (based on 2008 financials), easily accessible on the CNN web site.  The Fortune numbers are somewhat different from Professor Reich’s data, as they represent prior year results, but one also gets an unbiased comparison with other industries.

In 2008, the top 10 health insurers combined had $264 billion in revenue and profits of $8 billion.  A little bit of arithmetic shows that the combined profit margin for this group was 3.1%.  The highest profitability among the top 10 was reported by Aetna: 4.5%.

Thus, even if we regulate all health insurers to eliminate all their profits, as Senator Feinstein would have it, we can only reduce health insurance spending by 3.1%.  So much for the boatloads of savings that Professor Reich talks about – the impact on our health insurance costs would be minimal.

Now, one might say that turning the health insurers into true non-profits would also free up the sums currently spent on sales and marketing.  While this is mostly true, the sums saved still do not present a panacea for rising health care costs.  A spot check of annual reports shows that the cost of sales for top 10 insurers is about 3-4%.

So, let’s move to the second question.  We cannot make a dent in health insurance spending, but perhaps it’s worth bashing health insurers because their 3.1% profits are obscenely high when compared to other industries.

Well, it is not quite so.  The same source shows that top 10 pharmaceutical companies reported 18.4% profits in 2008 ($49 billion profit on $269 billion revenue).  Interestingly, the top pharmaceutical company – Johnson & Johnson – earned ($13 billion) more than all top 10 health insurers taken together.  Other “pharma” players were not far behind.  Both #2 (Pfizer) and #4 (Merck) earned $8 billion each, or as much as the 10 top health insurers taken together.  The highest profit was 37.7%, reported by Gilead Sciences.

Similarly, the top 10 companies in the ”medical products and equipment” segment had 10% profit ($6 billion profit on $64 billion revenue).  It actually would have been closer to 15%, if not for the disastrous year experienced by the #3 player, Boston Scientific.

Once you internalize these numbers, it becomes clear that any meaningful reduction of health insurance costs can only be achieved by reducing the underlying health care cost structure.  We cannot hold health insurance rates flat if we allow pharmaceutical companies to average 18.4% profits and to grow their revenues.  That would be akin to freezing the price of cars while allowing price increases for steel, rubber, etc.

As I was thinking about what health insurance profitability would not be deemed “wildly excessive,” I also looked at other areas of the economy where we spend significant amounts of money without complaining too loudly.  Interestingly, the top 10 Computer Software companies reported 23.6% profits on average.  The top 10 in Household and Personal Products (ranging from hammers and batteries to toothpaste and lipsticks) averaged 11.2%. Even the regulated Gas & Electric Utilities earned10.3%.

So, the 3.1% profitability that health insurers reported in 2008 pales in comparison with other industries and, even if totally eliminated, will not make a significant dent in our spending.  Any meaningful cost reduction will require a disciplined approach to modify the way we consume and price health services, ranging from doctor and hospital fees to pricing of medications, equipment, and supplies.

David Lazarus of the Los Angeles Times has a horror story about Aetna, the large health insurance company. The basic facts are:

1. Aetna increased a customer’s monthly premium by $32 as of August.
2. On September 30, Aetna sent her a letter saying her premium had gone up. (This is the letter supplied to the Los Angeles Times by Aetna, which I think is pretty clear proof there was no earlier letter.)
3. Beginning in October, the customer began paying the higher premium.
4. In November, Aetna rejected payment for a doctor’s bill.
5. The customer contacted Aetna, who said she had missed payment for October–which wasn’t true (she had paid the higher premium for October).
6. When the customer appealed, Aetna wouldn’t let her simply pay the extra $64 (the difference for August and September), and insisted on rescinding her policy.

The customer in question is a cancer survivor who needs regular medication and checkups–hence the kind of customer that health insurance companies want to drop if at all possible.

When the LA Times intervened, Aetna agreed to reinstate her policy.

But what’s the penalty for Aetna? Zilch. What incentive does Aetna have to stop screwing its customers? None.

According to Alan Greenspan, the market can solve this problem: customers would leave Aetna because of its shoddy customer service. But most customers get their insurance through group plans and hence have little or no choice of their insurer, and the corporate HR departments for the most part select those plans based on price, since they are getting completely squeezed by rising health insurance premiums. There simply isn’t very much competition in insurance plans, which are sold on the state level. And the customer in this case was on COBRA, meaning she had absolutely no ability to switch (and would probably have had to pay a huge premium for insurance in the individual market because of her preexisting condition).

As far as I know, the health care reform bill wouldn’t actually solve this specific problem, since the general problem of companies screwing up their billing processes and then blaming their errors on the customer goes far beyond health insurance. (I think the simple solution is that companies should have increased liability for their own errors–some large multiple of the amount in question.) With reform, though, at least the customer could have gotten a new plan at a reasonable price (because of the prohibition on medical underwriting).

Thanks to Ted K. for passing this on (via email, in this case).

By James Kwak

Risk adjustment is the solution to the following problem. Imagine you tell all the health insurers that they have to accept the healthy and the sick, and they have to charge each the same insurance premium. You may not have to imagine for much longer; this is at the core of all the proposed health care reform bills. (In the Finance Committee bill you can discriminate based on a small number of factors, like age and tobacco usage, but that’s it.)

If you’re a profit-maximizing insurer, what do you do? You try to cherry-pick the healthy, since the revenues will be the same as for the sick and the costs will be lower. If you can do this successfully — say, by only advertising in gyms and in Runner’s World, or maybe by offering additional benefits that only the healthy will want — then you can dump the sick on someone else. That someone else will eventually (after all the private insurers get smart or go out of business) be the public option or the non-profit cooperative, whichever we end up with, which will end up losing money; the net effect is a transfer from taxpayers to private insurers. Now, the fact that insurers participating on exchanges have to take everyone should mitigate this problem, but it won’t go away. In effect, insurers will compete by marketing in ways that attract the healthy and hide from the sick, instead of competing to offer better health care at lower cost.

Risk adjustment is a transfer mechanism whereby money flows in the reverse direction, from insurers with healthy customers to insurers with sick customers. It requires some means of calculating the expected healthiness of a pool of people and the fair transfer payment. You can’t (I don’t think) base your transfers on actual healthiness, because then you are penalizing insurers that are actually good at making people more healthy. So the transfers need to be based on some measure of how sick the customers were when the insurers got them at the beginning of the year.

I haven’t found much on the blogs (maybe I’m reading the wrong blogs); when I searched Ezra Klein, my first resource on health care, for “adjustment,” I only came up with these three posts. What I really want to know is how risk adjustment will work under our proposed health care reform. But in the Baucus Bill, this is all I found:

“Risk-adjustment. All plans in the individual and small group markets would be subject to the same system of risk-adjustment. Risk-adjustment will be applied within rating areas (described below).

“The Secretary would be required to pre-qualify entities capable of conducting risk-adjustment and the states would have the option to pick among those entities. The entities pre-qualified by the Secretary cannot be owned or operated by insurance carriers. The Secretary of HHS would define qualified risk-adjustment models which can be used by states. States can also choose to develop their own risk-adjustment model but it must produce similar results and not increase Federal costs. After risk-adjustment is applied, reinsurance and risk corridors (described below) would apply.”

So it seems like the government will designate certain organizations that are allowed to do the risk adjustment calculations, and states can pick between them. (This reminds me of nationally recognized statistical rating organizations, but that’s perhaps an overreaction.)

There is also a reinsurance mechanism under which all insurers in a state have to pay an amount proportional to their insurance premiums into a reinsurance fund, which then pays out to insurers based on how many high-risk customers they have. That is probably a good thing, but it only applies for three years (2013-2015), and it doesn’t eliminate the incentive to cherry-pick; since contributions into the fund do not come from insurers with disproportionately healthy customers, you are still better off attracting the sick.

The overall goal here is to channel private-sector competition in a socially beneficial way. It does seem simpler to just have single payer and be done with it (then you don’t need any of these rules), but the basis of our proposed system is getting insurers to compete in some ways (lower administrative costs, lower medical costs through intelligent use of negotiated payment schedules) and not in other ways (cherry-picking). As far as I can tell, the bill points in the right direction, but it still seems terribly vague to me. Am I just missing something that’s in a different part of the bill?

By James Kwak

This is a point I’ve also tried to make before. Not only is employer-based coverage deteriorating, but the reasons for that deterioration imply that it is likely to only accelerate. As health care costs continue to increase, even if the rate of increase stays the same, the rate of deterioration will increase, because each year health care costs become a larger proportion of total costs and therefore harder to absorb. (Put another way, if health care cost inflation remains around 7% per year, each year it will be 7% of a larger proportion of employers’ costs.) Deterioration will take three forms – some employers will drop health coverage altogether, some will increase the share paid by employees, and some will shift toward less-generous plans.

Klein’s point is that it may be dangerous to premise health care reform on the idea that the employer-based system will remain what it is, because it won’t. My point was that because the employer-based system is slowly dying, people with employer-based coverage should not be thinking, “I don’t need health care reform, I’ve got my employer-based plan;” they should be thinking, “I’m afraid of what will happen when my employer drops its plan, so I need health care reform.” Unfortunately, I think both of us are right.

By James Kwak

President Obama’s ability to shape the debate on health care appears to be eroding as opponents aggressively portray his overhaul plan as a government takeover that could limit Americans’ ability to choose their doctors and course of treatment, according to the latest New York Times/CBS News poll.

Americans are concerned that revamping the health care system would reduce the quality of their care, increase their out-of-pocket health costs and tax bills, and limit their options in choosing doctors, treatments and tests, the poll found. The percentage who describe health care costs as a serious threat to the American economy — a central argument made by Mr. Obama — has dropped over the past month.

The article does cite several statistics from the poll, and does show several signs that are favorable to President Obama, including that the public overwhelmingly favors him over the Republicans when it comes to health care, and overwhelmingly thinks that he is trying to work with Republicans more than the converse. But the overall impression you get is that Americans are afraid of health care reform.

But are they?

Here are some of the raw numbers:

• The government should guarantee health insurance for all Americans, by 55-38.
• The government should “offer[] everyone a government administered health insurance plan,” by 66-27.
• Insurers should have to cover anyone regardless of medical history, by 76-19.
• It is true that 68% of people think that health care reform could limit their access to treatment; but 66% are concerned that without reform, they could lose coverage at some point.
• Similarly, 76% think that health care reform could increase their taxes; but 75% think that without reform, the cost of their health care will go up.

It seems to me that on the most important issues, America is solidly behind the House versions of health care reform.

But although Americans favor health care reform, by 59-31 they think the current bill will not benefit them personally – presumably, as I’ve argued before, because they are under the probably-mistaken assumption that they currently have good coverage and will not lose it. Now, this does not necessarily mean they would not favor the bill. As Ezra Klein wrote a while back, the administration could have made the argument for reform in moral terms – society has a moral obligation to provide basic health care to all people, and if it costs the better-off among us a few bucks, then that’s the price we should pay. But instead, it went for technocratic arguments instead – we have to “bend the curve” of health care costs. (In 2007, people thought that universal coverage was more important than reducing health care costs by 65-31; after months of being told by both sides that it is costs that matter, universal coverage still wins by 53-43.)

So at this point, I think the key message has to be that health care reform is good for everyone (at least everyone under 65; those over 65 already enjoy the benefits of reform), because it protects you against the risk of losing your job and getting sick.

By James Kwak

You do not have health insurance. Let me repeat that. You do not have health insurance. (Unless you are over 65, in which case you do have health insurance. I’ll come back to that later.)

The point of insurance is to protect you against unlikely but damaging events. You are generally happy to pay premiums in all the years that nothing goes wrong (your house doesn’t burn down), because in exchange your insurer promises to be there in the one year that things do go wrong (your house burns down). That’s why, when shopping for insurance, you are supposed to look for a company that is financially sound – so they will be there when you need them.

If, like most people, your health coverage is through your employer or your spouse’s employer, that is not what you have. At some point in the future, you will get sick and need expensive health care. What are some of the things that could happen between now and then?

• Your company could drop its health plan. According to the U.S. Census Bureau (see Table HIA-1), the percentage of the population covered by employer-based health insurance has fallen every year since 2000, from 64.2% to 59.3%.*
• You could lose your job. I don’t think I need to tell anyone what the unemployment rate is these days.**
• You could voluntarily leave your job, for example because you have to move to take care of an elderly relative.
• You could get divorced from the spouse you depend on for health coverage.

For all of these reasons, you can’t count on your health insurer being there when you need it. That’s not insurance; that’s employer-subsidized health care for the duration of your employment.

Once you lose your employer-based coverage, for whatever reason, you’re in the individual market, where, you may be surprised to find, you have no right to affordable health insurance. An insurer can refuse to insure you or can charge you a premium you can’t afford because of your medical history. That’s the way a free market works: an insurer would be crazy to charge you less than the expected cost of your medical care (unless they can make it up on their healthy customers, which they can’t in the individual market).

In honor of the financial crisis, let’s also point out that all of these risks are correlated: being sick increases your chances of losing your job (and, probably, getting divorced); losing your job reduces your ability to afford health insurance, either through COBRA or in the individual market; if your employer drops its health plan, that’s either because health care is getting more expensive (meaning harder for you to afford individually) or the economy is in bad shape (making it harder for you to get a job that does offer health coverage).

In addition, there is the problem that even if you are nominally covered when you do get sick, your insurer could rescind your policy, or you may find out, as Karen Tumulty’s brother did, that your insurance doesn’t cover the treatment you need. But while important, this is a second-order problem. The first-order problem is that as long as your health insurance depends on your job, your health is only insured insofar as your job is insured – and your job isn’t insured.

The basic solution is very simple. In Paul Krugman’s words: “regulation of insurers, so that they can’t cherry-pick only the healthy, and subsidies, so that all Americans can afford insurance.” I know that there are lots of details that consume people who know health care better than I do, and I know those details are important. But as an individual who is worried about his or her own health insurance (and that is the point of this post), that’s what you want. You want to know that if you lose your job, you won’t be shut out because you’re too sick,*** and you won’t be shut out because you’re too poor.

But we won’t get there as long as people remain convinced that health care reform is for poor people. It’s for everyone – everyone, that is, who isn’t independently wealthy or over the age of 65. Because all of us could lose our jobs. (Have I repeated that point enough?)

Now, I admit that if you are over 65, health care reform is not for you, because you are in the one group in our society that enjoys true health insurance – insurance that you cannot lose, that is paid for by taxes, and that is effectively guaranteed by the government. So maybe there’s nothing in it for you, except perhaps an improvement to the prescription drug component of Medicare. But I cannot believe that, as the only people who have reliable health insurance, you would oppose health care reform that would provide reliable insurance for the rest of us.

* This doesn’t necessarily mean that all those people lost employer-based health coverage because their employers dropped their plans; some of it could be that the employee contributions were increased to the point where they couldn’t afford it anymore. 1.1 percentage points of the shift is due to people becoming eligible for Medicare or military health plans.

** If you lose your job, or you get divorced from a spouse through whom you get health coverage, you are eligible for continued coverage under COBRA. However: (a) this only necessarily applies if your employer has 20 or more employees; (b) you have to pay the full, unsubsidized cost of your health plan, which can be particularly difficult after losing your job; and (c) it only lasts for eighteen months.

*** I said earlier that insurers can’t charge premiums that are less than the expected cost of your care unless they can make it up on the healthy customers, and they can’t in the individual market. But if all insurers are prohibited from doing medical underwriting (pricing based on healthiness), then they will all have to overcharge the healthy customers, and the system could work. This is still a tricky issue – and single-payer (like Medicare) would be much simpler – but it can be made to work even in a competitive market.

Update: A couple of small things. and one big thing:

First, I called rescission a “second-order” problem, which was probably surprising, given that my post on it got over 100,000 page views (thanks to the Huffington Post). I meant “second-order” not to mean that it isn’t important, but that it is logically subsequent to the question of whether you have health insurance in the first place, and this post is about whether you can count on having health insurance in the first place.

Second, J.D. points out in the comments that there is a problem with COBRA I didn’t mention: If you relocate to an area where your employer doesn’t have a plan, then you can’t count on it at all.

Third, a few people said that it was the fault of the administration (or the Democrats generally) that health care reform is framed as a “poverty program.” There’s something to that point, but I don’t think it’s quite right (and I didn’t put it right in the first paragraph above). I think it is a poverty program – but the vast majority of us are, actually, poor. The combination of job loss and serious illness could wipe out almost anyone (under the age of 65 – actually, anyone over 65 as well, since Medicare doesn’t cover extended nursing home care), and we all suffer serious economic insecurity because of it. The political problem is that the median American doesn’t identify as poor (although he probably thinks he needs more money) and thinks that poverty programs are for “other people.” I think that middle-class and upper-class people should support poverty programs for other people, but that’s an unnecessary discussion. My point here is that the vast majority of us are poor, when it comes to health care, and therefore we should get behind reform out of self-interest.

By James Kwak

High profits are excellent news. When corporate earnings reach record levels, we should be celebrating. The only way a firm can make money is to sell people what they want at a price they are willing to pay. If a firm makes lots of money, lots of people are getting what they want.

I agree that the pursuit of high profits is a good thing. That is what makes a free-market capitalist system work, and it’s what made me start a company eight years ago. But basic microeconomics says that high profits themselves are generally not a good thing.

In a competitive market, if one company is earning high profits, then other people will want to start new companies to compete with it. By entering the market, they increase competition, reducing profit margins for the original market leader; more companies and more competition also mean more innovation; both of these factors increase overall social welfare. In a true competitive market, one without barriers to entry or market power, companies should not earn any profits at all, because competition will drive price down to marginal cost. (Steve Goldman, one of my economics professors, once said that if you wake an economist up in the middle of the night and ask him or her, “what is price?,” he should answer, “marginal cost.”)

The real world is different, of course. Companies have to earn profits sufficient to cover their cost of capital. And if you invent a successful new product, you will earn excess profits for some period of time; but over time your competitors will catch up and those excess profits will go away (see the IBM personal computer, for example).

So if you see a company that has very high profits over a sustained period, there are two possibilities: either it is benefiting from a non-competitive market (e.g., it is a monopoly), or it is simply exceptional at innovating and staying ahead of the competition for years on end. If you see a whole industry that has sustained high profits, however, the latter explanation cannot hold, and you should immediately suspect a lack of competition.

In short, the thing that we should celebrate is not high profits, but competition. The pursuit of high profits is what motivates competition; but if a whole industry achieves high profits, then what you are seeing is not competition, but its opposite.

Now what’s going on in health care? Look at page six of this report. In most states, the combined market share of the top two health insurers is well over sixty percent. That is not a competitive market, but a market controlled by one or two companies.

In addition, there are good reasons why a free market is not how you want to allocate health care anyway. For one thing, as I have argued, a free market for health care is a market in which sick people die, because no one will sell a sick person an insurance policy that costs less than his or her expected costs under the policy.

Second, as Paul Krugman explains, health care is a good that does not conform to the basic assumptions that you need for free markets to produce optimal solutions. I won’t try to summarize, since he already summarizes elegantly. But before you dismiss Krugman as a liberal pundit, note that his main source is a paper by Kenneth Arrow – as in the Arrow-Debreu Theory, the centerpiece of general equilibrium theory and of mainstream microeconomics in general in the last fifty years.

Now, it is perhaps possible that private health insurers could be part of a well-functioning health care system – if, for example, they were not allowed to engage in medical underwriting (which is what makes sick people unable to buy insurance at any price they can afford). But that’s not the system we have now. Instead, we have local oligopolies, and if they earn high profits, that’s a product of market power and lobbying clout, not “lots of people . . . getting what they want.” (Do you know anyone who actually buys insurance – either someone in the individual market or someone who buys insurance for an employer – who is happy about what he or she is getting these days?)

Obviously companies should make profits; the need to make profits is what separates good companies from bad ones. And people should be able to get rich making excess profits that result from innovation; you can make a lot of money in the period between the innovation and the competition catching up with you. But if you see sustained high profits by an entire industry of corporate behemoths, you should be very, very worried.

By James Kwak

Since the Senate Finance Committee is taking up health care reform this week, I finally wrote that post today for The Hearing.

By James Kwak

The Wall Street Journal reported this week that Treasury will soon announce that it will use TARP funds to invest in life insurers, or at least those who snuck under the federal regulatory umbrella by buying a bank of some sort. The argument for the bailout is a version of the “No more Lehmans” theory: the failure of a large financial institution could have ripple effects on other financial markets and institutions that could cause systemic damage. For a bank, the ripple effect is primarily caused by two things: (a) defaulting on liabilities hurts bank creditors, and (b) defaulting on trades (primarily derivatives) hurts bank counterparties, if they aren’t sufficiently collateralized (think AIG).

My thought this morning was that life insurance policies are long-term liabilities that are already guaranteed by state guarantee funds, so we don’t have to worry about (a), and hopefully most life insurers were not doing (b) – large, one-sided bets on credit risk like AIG. So why not just let them fail and let the states take over their subsidiaries? But then I checked the facts, and it turns out that the limits on state guarantee fund payouts are pretty low. So the scenario is this: you hear bad things about your life insurer, you decide to redeem your policy (usually at a significant loss to yourself), turning it into a short-term liability, and then the insurer has to start dumping assets into a lousy market, pushing the prices of everything further down and hurting everyone holding those assets. Would this really cause a systemic crisis worse than we’ve already got? I don’t know, but no one in Washington wants to take that risk.

Ultimately, though, this goes back to the question of whether this is a liquidity crisis or a solvency crisis. If it’s a liquidity crisis – in which case you would expect to see lots of people redeeming their policies already – then there are better ways to prevent a run on the life insurers. For one thing, if the insurers really do have good assets to cover their expected payouts, the government could just boost the limits on the state guarantees, charge the insurers a premium for the guarantee (insurers already pay a premium for the backstop they get from the states), and pocket the money. Alternatively, the government could act as a reinsurer, taking on some of the payout risk in exchange for a corresponding proportion of the assets and premiums. Using TARP money might work, but since it just adds a few billion dollars to the insurer’s capital (without guaranteeing anything), it’s not a surefire solution.

If it’s a solvency crisis, though, we have to ask whether a few billion dollars of TARP money is enough. The Hartford estimates it is eligible for $1-3 billion of money. (I picked them because they are discussed in the WSJ story, not because I know anything else about them.) It also has $288 billion of assets. How do their assets compare with the assets of, say, a bank? In principle, insurance companies are more closely regulated, and their investment mix (in terms of bond ratings) is constrained. But it’s also true that insurers – especially the large ones – were investing in more sophisticated products in an attempt to earn higher yields. (For details, see pp. 156-76 of the Hartford’s latest 10-K.) And we know that you could lose a lot of money investing in AAA-rated assets. If this does turn out to be a solvency crisis, then this could be the first page of a long story.

1. The heart of the scheme will, most likely, be an insurance arrangement, in which the government (part Treasury and mostly Fed) insures a big part of large banks’ portfolio of toxic assets against further loss.  The devil is in the pricing of this insurance and how transparent that is – and we will put out more on this shortly – but the clear signal so far is that this will be a veiled major recapitalization of banks at taxpayer expense.
2. As announced yesterday, the government will set restrictions on the pay of executives in banks that participate.  But note that, under these rules, bonuses are not restricted.  Instead, they are just deferred and paid in shares.  In other words, if there is cheap recapitalization through government-provided insurance, these executives are getting an incredibly good deal.

Think about it this way.  While the macroeconomy goes badly, the government will pay out on the insurance policy and keep the large banks in business.  Once the macroeconomy turns around, as of course it will, the banks can pay off the government and pay out massive bonuses.

We are, in effect, insuring  incompetents (i.e., the executives who got us into this mess) against both the delayed consequences of previous bungling by themselves and any future missteps they may  make.

But even this won’t be enough for the top dogs on Wall Street.  We predict that banks will start resetting the strike price of previously deferred bonuses, along the lines of what we have already seen from Google.  Watch carefully and track what happens in your comments here.

What we really need is a simple, transparent recapitalization of the banking system. More complicated proposals are opaque and less likely to work.  And once people see through the illusions, there will be great disappointment and much resentment.

(This post was written jointly by Peter Boone and Simon Johnson)

Insurance is one of the industries I know pretty well, as my company made software exclusively for property and casualty insurers, and I must admit I didn’t expect the crisis to show up in insurance so quickly.

To date, the crisis has mainly hit companies that lend long and borrow short – banks, and financial institutions that behave like banks – who found it difficult to roll over their short-term liabilities. Insurance companies have virtually no short-term debt, because they have a continuous stream of cash flowing in from the premiums their customers pay every month. Most of the “liabilities” on an insurer’s balance sheet are unpaid loss expenses, meaning claims that haven’t been paid yet or haven’t been reported yet. Furthermore, insurance companies are generally assumed (although perhaps not correctly) to be relatively conservative in their investments, since they can predict their loss payouts with reasonable accuracy and buy bonds with maturities to match those payouts. (AIG, the big exception, got in trouble primarily because it was selling credit default swaps, not because of its traditional insurance operations.)

However, the problems are showing up on the asset side of insurers’ balance sheets. In an economic slowdown, an “ordinary” company – one that buys or manufactures stuff and sells it to other people – is vulnerable to declining demand and hence falling sales. An insurance company is vulnerable to falling asset values, because at any moment most of its money is parked in securities of various kinds.

I’m going to look in detail at the balance sheet of one large insurer, which I chose because they are big, my company has no relationship with them, and I have no inside information about them. And on second thought I decided not to name them because I don’t want anyone to draw the conclusion that I think they are risky; I just can’t tell, because even reading the notes to the financial statements you can’t tell exactly what they are holding. As of June 30, 2008 they had well over $100 billion in investments. Of that, only 4% was in direct mortgage loans and 2% in hedge funds, venture capital, and other exotic asset classes. 30% was in equities and 57% in fixed-maturity products – bonds – and 95% of the bonds were investment-grade or US government. So on the face of it you would think they were pretty safe.

However:

• Equities, as we know, have fallen over 30% (S&P 500) since the end of June
• 21% of the bonds were commercial mortgage-backed securities, including CDOs
• Another 12% were residential mortgage-backed securities, other mortgage-backed securities, collateralized mortgage obligations, or collateralized loan obligations
• 14% were bonds of financial institutions, which have been at the center of the financial storm
• 29% were other corporate bonds, which lose value as recession worries increase

Looked at another way, 23% of the fixed-income securities were Level 3, which basically means that they could only be valued using internal models. (In addition, they had credit default swaps with a face value over $6 billion, but in the majority of those swaps they were buying protection.)

With a portfolio like that, it’s entirely possible that the insurer has taken significant losses over the last month and a half. Because insurance policies are promises to make payments if customers suffer losses, insurers are regulated and required to maintain a sufficient capital margin; if their assets fall too far in value, they get nervous about that capital margin, hence the desire to get some from Treasury.

This still leaves open the question of whether the taxpayer should bail out insurers. The argument to do so is that, like banks, insurers play an important role in funding the real economy. Insurers take in vast amounts of cash from consumers and businesses – total premiums in the US are over $1 trillion per year and insurance company assets are over $4 trillion – and redistribute out the money to companies, primarily by buying their bonds. While we think of bank lending as the way that companies get credit, direct bank loans are overshadowed by the bond markets. If insurance companies start hoarding cash for fear of investing it – or start failing – that that money will not be available for the rest of the economy.

Of course, there’s a question of where it all stops; you could construct a similar (though not quite as strong) argument for bailing out just about anything, and I believe the auto companies are looking for their piece. But it’s hard to deny that insurers play an important role as financial intermediaries in the US.

Whatever the motivations of the House Republican plan – as distinct from the plan agreed upon by the Republican President, Republican Treasury Secretary, Republican Fed Chairman, Senate Republican leadership, and Democratic leadership of both houses – it is still a plan, and as such merits consideration. The “Common Sense Plan to Have Wall Street Fund the Recovery, Not Taxpayers”has two main elements: first, a Treasury Department insurance program for mortgage-backed securities that will be entirely financed by premiums collected from the holders of those securities, not taxpayers; and a combination of tax breaks and deregulation intended to attract private capital to the banking sector.

The insurance proposal amounts to more of the wishful thinking that has allowed the financial crisis to last as long as it has. Such a proposal would only work if the fundamental problem were an inability to distribute risk, and if there were no available insurance mechanisms. But the fundamental problem is not that banks can’t distribute the risk of deteriorating assets, but that they are holding assets that are already not worth very much, and therefore the insurance premiums for those securities would be prohibitive. (Instead of paying by writing down the assets, they would have to pay insurance premiums.) And there are insurance mechanisms already (remember credit-default swaps?), but that insurance is too expensive to buy. The only way a Treasury insurance program could change things is by offering insurance at artificially low premiums, which is just another way of handing taxpayer money to banks – with no recompense to shareholders.

The proposal to attract private capital to the industry is too little, too late. Washington Mutual, for example, was unable to find a buyer until the government used a forced bankruptcy to wipe out $28 billion of its debt; no one is lining up to offer capital to Wachovia. It is hard to see how offering tax breaks to banks (which is yet another way of handing taxpayer money to banks) will encourage new capital investment, at least as long as their mortgage-related assets remain under a cloud of uncertainty.

Given that few people want to lend to or invest in banks these days, it’s hard to see how a solution is possible without taxpayer money. The important thing is to make sure that the taxpayers get something in exchange for their money.

Update: Politico has a survey of economists’ reactions to the House Republican plan. The short version: economists were concerned by the original Paulson plan, but baffled by the House Republican plan.