How to Ensure Quality Health Coverage (Part 2)

Every day that Obamacare’s preexisting conditions “protections” remain mandatory, more and more Americans develop expensive medical conditions that should be insured conditions but instead become uninsurable preexisting conditions.
January 9, 2018 • Commentary
This article appeared on Health Affairs on January 5, 2018.

In “Is Obamacare Harming Quality? (Part 1),” I explain that new research shows that Obamacare is not working how it is supposed to work in theory: The law’s preexisting conditions provisions create perverse incentives for insurers to reduce the quality of coverage; those provisions are reducing the quality of coverage relative to employer plans; and the erosion in quality is likely to accelerate in the future. In this post, I explain why regulators cannot fix this problem, and why providing sick patients secure access to quality health care requires allowing consumers to purchase health plans not subject to Obamacare’s preexisting conditions provisions.

The Challenge Of Risk Adjustment

Those provisions require insurers to charge high‐​cost patients premiums well below those patients’ expected claims. They therefore create an upside‐​down world where insurers that offer the best coverage for the sick suffer the most losses: Whichever insurer offers the highest‐​quality coverage attracts the greatest number of patients who take out of the insurance pool more than they contribute. This creates a perverse incentive for insurers to make their coverage unattractive to the sick.

Obamacare’s risk‐​adjustment program attempts to provide insurers supplemental funds to ensure that the price an insurer receives for covering each high‐​cost enrollee matches the cost that enrollee imposes on the plan. If risk adjustment sets the prices too low, each insurer still faces incentives to make its coverage for high‐​cost patients worse than its competitors’ coverage. If it sets the prices too high, insurers will compete to capture those excess payments by making their plans inefficiently attractive to the sick. If risk adjustment gets the prices just right, insurers have no incentive to attract or avoid the sickest patients.

Research by economists Michael Geruso of the University of Texas–Austin, Timothy J. Layton of Harvard University, and Daniel Prinz of Harvard University shows that Obamacare’s risk‐​adjustment mechanisms are committing both overpricing and underpricing errors. The latter errors are causing coverage to get worse for all enrollees, but particularly those with multiple sclerosis and other illnesses, and are likely to get worse very soon and over time.

One Option: Assume A Can Opener

Geruso, Layton, and Prinz argue that when the risk‐​adjustment program makes pricing errors, “The answer is to make the necessary incremental improvements to the policies, not to scrap the ACA entirely with its important and widely popular limits on premium discrimination.” Interestingly, this argument assumes that Obamacare’s preexisting conditions provisions are popular when in fact polling consistently showsthe popularity of those provisions disappears if they reduce quality—which Geruso, Layton, and Prinz found they do. The principal weakness of this argument, however, is that it ignores the difference between how government price‐​setting works in theory versus reality.

In theory, a risk‐​adjustment program could constantly identify and correct its pricing errors. When government price‐​setters find evidence that prices are too low or too high, they need only make the necessary adjustments.

Experience shows that that is not how government price‐​setting works in practice. Looking just at health care, government price‐​setting agencies persistently get the prices wrong, even when they know the prices are wrong. Ubiquitous complaints from researchers and others about overpayments in Medicare Advantage; overpayments in Part D; overpayments for durable medical equipment; Medicare favoring specialty care over primary care; Medicare favoring procedures over time spent with patients; Medicare’s inability to negotiate with drug companies; site‐​of‐​service differentials; quality‐​blind payment; and so forth are all complaints about the government’s inability to get the prices right.

In Medicare and elsewhere, these pricing errors tend to persist for years or decades because government price‐​setters face both information and incentive problems. Central planners are not able to collect enough of the ever‐​changing information on clinical effectiveness, consumer preferences, availability of resources, competing demands on resources, technology, and so forth to determine the “right” prices for medical goods and services (read: the prices at which marginal cost equals marginal benefit, all marginal rates of substitution are identical, God’s in his heaven, and all’s right with the world).

Information problems make Obamacare’s underpricing errors particularly intractable. Some patient traits that predict higher claims, such as a preference for high‐​cost “star” hospitals, are not observable. Since the risk‐​adjustment program cannot observe such traits, it will always set prices too low for such patients. Insurers cannot observe those traits ex ante either, but they can make coverage worse for such patients, for example, by offering increasingly narrow networks. And indeed, they are.

Even when government price‐​setters do collect enough information to identify pricing errors, in the vast majority of cases they still can’t correct them. The reason is simple and also intractable. Every dollar the government spends on excessive prices is a dollar of revenue to somebody, and that somebody has a lobbyist. Incumbent providers and other interest groups fight to protect the overpricing errors that favor them, even at the cost of preserving underpricing errors that affect less‐​powerful groups. Congress faces incentives to please those politically powerful incumbent providers, and government price‐​setters face incentives to please Congress. So even if price‐​setting agencies are full of omniscient, selfless public servants, Congress can and does override them. The incentive problems facing government price‐​setters are so great, many observers have proposed government price‐​setting bodies that are quasi‐ or totallyindependent from Congress. Yet, an unaccountable government agency may create even bigger information and incentive problems.

To be clear, the problem is not just that government gets the prices wrong. Markets get prices wrong all the time. The difference is that market prices self‐​correct. Markets both take account of more information and create incentives for everyone involved to push market prices in the right direction. Government prices do not self‐​correct, both because government agencies cannot collect as much relevant information as decentralized market participants, and political actors face incentives to preserve pricing errors.

The upshot is that the government’s record of setting health care prices suggests that the pricing errors Geruso, Layton, and Prinz identify will persist, as will other pricing errors that inevitably emerge over time, such as from the expiration of the reinsurance program. Experience suggests that there will be more, not fewer, pricing errors eroding the quality of coverage available to the sick.

How, then, can policy makers make quality coverage more affordable and secure for the sick?

A Better Option: Incentive‐​Compatible Insurance

Health systems are like marriages. They succeed only to the extent that the participants actually want to be there. A health system that enjoys the support of only one political party, or that requires consumers, insurers, and government officials each to act against their perceived self‐​interest, is unlikely to deliver secure, sustainable access to high‐​quality care for the sick. A more sustainable system is one in which the majority sees it as in their financial self‐​interest to participate and that reserves coercion only for those cases where voluntary cooperation fails.

There is considerable evidence that a voluntary system of health insurance—in which all parties want to be there—continually strives to make access to care more affordable and secure for those who develop expensive medical conditions. It is no coincidence that it was in markets free from guaranteed‐​issue mandates or community‐​rating price controls that insurers developedinnovations such as guaranteed renewability and preexisting conditions insurance. Guaranteed renewability (as noted in Part 1) emerged as a response to virtuous incentives to make coverage better for the sick, protected enrollees from “risk reclassification” when they developed expensive conditions, and provided more secure access to care than employer plans. Preexisting conditions insurance made those protections available at an 80 percent discount—at least, until Obamacare outlawed both of these innovations.

Congress can make coverage more affordable and access to care more secure by repealing or letting consumers opt out of Obamacare’s preexisting conditions provisions and other health‐​insurance regulations. A studyconducted by McKinsey and Company for the Department of Health and Human Services estimated that the preexisting conditions provisions are the primary reason individual‐​market premiums are rising so rapidly. Repeal or an opt‐​out would free the vast majority of exchange enrollees to purchase low‐​cost, guaranteed‐​renewable coverage—or even lower‐​cost preexisting conditions insurance—at any time of year. In addition to greater freedom, those consumers would gain something else they currently lack: sustainable, long‐​term protection against the cost of illness.

A minority of exchange enrollees would be unable to find or afford coverage at actuarially fair premiums. As a matter of political reality, reform will include some form of subsidy for this group. One option is a high‐​risk pool. High‐​risk pools likewise exhibit quality and affordability problems—in part because they too suffer from government pricing errors. Yet, a voluntary insurance market combined with government high‐​risk pools need not be perfect to outperform Obamacare. The more direct, transparent, and equitably financed a high‐​risk pool’s subsidies are, the more politically sustainable those subsidies will be. Moreover, any imperfections of a high‐​risk pool are as much a feature as a bug. To the extent that government pricing errors lead to suboptimal quality in high‐​risk pools, they create incentives for people to purchase insurance in the voluntary market.

A proposal by Sen. Ted Cruz (R-TX) represented a true compromise between the warring tribes. As originally conceived, the Cruz compromise would allow insurers to sell non‐​Obamacare‐​compliant plans, so long as they continued to offer compliant plans to all comers. Exchanges would essentially become high‐​risk pools. Subsidies to those with preexisting conditions would become transparent. Healthy enrollees could only obtain non‐​compliant plans if there were enough political support for the level of subsidies necessary to entice insurers into offering compliant plans. Most important, the availability of guaranteed‐​renewable insurance would reduce the need for government subsidies by providing a voluntary and thus sustainable way to subsidize those who cannot afford the care they need.

The Trump administration could achieve much the same thing through executive action by redefining short‐​term health plans to allow them to be guaranteed renewable. Such a step would free consumers from all of Obamacare’s health‐​insurance regulations, even federal health insurance regulations that predate the Affordable Care Act. Creating a “freedom option” through executive action, moreover, would not condition the availability of non‐​compliant plans on the availability of compliant plans, as the Cruz compromise would. If the Trump administration proceeds with its plans to redefine short‐​term health plans, Obamacare supporters may want to give the Cruz compromise a closer look.


Obamacare’s compulsory system of health insurance creates perverse incentives for healthy people not to contribute to the medical bills of others, exacerbates incentives for insurers to skimp on care for the sick, and creates incentives for the government not to correct these and other errors. A voluntary system of health insurance would not need to be perfect to do better.

The clock is ticking. Every day that Obamacare’s preexisting conditions “protections” remain mandatory, more and more Americans develop expensive medical conditions that should be insured conditions but instead become uninsurable preexisting conditions. Congress and the president should act before Obamacare makes coverage for the sick any worse.

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