One of the strange things about the market for health insurance is that almost none of us ever sees a real price. More than 90 percent of people with private coverage get it through an employer. Employers, on the average, pay about three-fourths of the cost and the remaining share tends to be the same for every employee—irrespective of expected health care costs.

In most states, the only people who face real premiums are in the “individual market,” where individuals and families pay for insurance out of their own pockets. Yet the Affordable Care Act (ObamaCare) will outlaw the pricing of individual risk (medical underwriting) by year’s end. Health insurance, therefore, is very different from just about every other form of insurance.

In other insurance markets, a person newly entering an insurance pool will be charged a premium that reflects the expected cost and risk the individual brings to the pool. With respect to life insurance, disability insurance, homeowner’s insurance and (for the most part) even auto casualty insurance, you pay for what you get.

That practice, by the way, works quite well.

When premiums reflect expected costs, people are essentially paying their own way. When that happens it really doesn’t matter very much who chooses to buy insurance and who chooses to self-insure and bear the risk themselves. With life insurance, for example, you can have pools with a lot of old people; or pools with a lot of young people. You can have pools with a lot of people at high risk of dying; or pools with a lot of low-risk enrollees. Or you can have combinations of all of these.

When is the last time you heard anyone say that life insurance won’t work unless we mandate its purchase? Or that the life insurance market will fall apart unless we convince a lot of young, healthy people to buy it? Have you ever heard of a life insurance company spending millions of dollars on rock stars and sports icons and librarians and local civic associations to beg youngsters to buy the product?

Why are things so different in the market for health insurance? Because in this market premiums are regulated and that regulation is completely dominated by the idea that it’s unfair to charge real premiums. In fact the most common belief is that everybody should pay the same premium for health insurance, even if everyone’s expected health cost is different from everyone else’s.

It’s not easy to say where this idea came from, or why it is so widely believed. The health policy community often exudes a herd mentality. Once an idea is accepted, it tends to be repeated again and again—until a point is reached at which no one can exactly remember why the idea was ever proposed in the first place.

One reason why this issue has suddenly become a topic of discussion in the blogosphere and in the public policy community is that ObamaCare was sold to the public on deceptive terms. When he was campaigning for the presidency in 2008, Barack Obama made it sound as though his health reform was only designed to help people who couldn’t afford health insurance afford it. Everyone else was going to be left alone. (“If you like the health plan you have you can keep it.”)

Then, on the eve of passage of the legislation, the focus changed to those few people (very few, it turns out) who are denied coverage because of a pre-existing condition. At last count there are about 107,000 enrolled in newly created risk pools because of this problem.

But it has only been very recently that New York Times columnist Paul Krugman and others have been in print explaining that ObamaCare won’t work unless the government controls the premiums paid by everybody in the entire country! No one ever said that during the presidential campaign or during the congressional debate. As far as the general public is concerned, this is a brand new idea.

There is one other way in which government regulation has caused health insurance to be different. Traditional indemnity insurance basically doesn’t exist anymore. What we call health insurance is really a health plan. It is an entity that controls what care you are entitled to and who can deliver it. When you choose a health plan, you are not just choosing an entity that will pay your medical bills. You are also choosing a network of doctors and hospitals and a set of protocols that determine how medicine will be practiced.

Here’s why that matters. When premiums are regulated so that they cannot reflect expected costs, four things will happen:

1. On the buyer side, people who are under-charged will over-insure and people who are over-charged will under-insure. This is basic economics. If the price you are asked to pay is artificially low, you will buy more than you otherwise would; if the price is artificially high, you will buy less. If you are sick and require a lot of medical care but can pay the premium ordinarily charged to a healthy enrollee, for example, you will likely choose the richest plan you can find.
2. In order to avoid attracting high cost enrollees, health plans will respond by scaling back their benefits and their provider networks until the richest plans look pretty much like every other plan. In the individual market today, in most states you can buy a BlueCross plan that covers almost all doctors in your area and practically every hospital, including all the best hospitals. I predict those plans will never see the light of day inside the (ObamaCare) health insurance exchanges. BlueShield, for example, is offering a plan in the California exchange that includes only one third of the doctors and excludes some of the most highly regarded hospitals.
3. At the same time, health plans will seek to attract the healthy. Of course, to a certain extent they are doing that today. But with an electronic exchange in which healthy people tend to buy on price and sick people tend to buy on benefits and software that makes it easy to do those things, the insurers will be even more pressured to reconfigure their offerings to make them more attractive to the healthy and less attractive to people who need medical care.
4. Finally, the perverse incentives do not end at the point of enrollment. They continue. Health plans will have perverse incentives to over-provide to the healthy (to keep the ones they have and attract more of them) and to under-provide to the sick (to avoid attracting more of them and encourage those they have to go elsewhere).

[BTW, risk adjustment in the ObamaCare exchanges may actually overpay for certain types of chronic illnesses—making them more attractive to the health plans than healthy people. But any time there is non-market fixing of premiums and artificial risk adjustment, the total revenue for any particular enrollee is almost certain to be wrong—in one direction or another.]

There is something else that tends to happen in an insurance market where no one is paying a real premium. If you have problems and need help, you are likely to discover that the insurance company is about as accommodating as the Department of Motor Vehicles. Dealing with a vendor who doesn’t want your business can be unpleasant. When you call, you are put on hold. Or you never get to talk to a real person in the first place. You are shuttled from one office to another, buried in a complex web of bureaucracy and paperwork that seems intentionally designed not to meet your needs. (See a previous post at my blog on paying for medical care.)

[I know what you’re thinking. This is the way insurance companies already treat everybody! Yes, but there is a reason for that. In a world in which market forces have been completely suppressed, anyone who makes frequent calls to a health insurance company is probably someone with lot of health problems, paying a premium well below the cost of her care, who is prima facie a customer the insurer wishes it didn’t have to deal with.]

So how should the market for health insurance work? It should incorporate two features:

1. Whenever you enroll in a health plan, you want the premium paid to the plan to reflect the expected cost of your care—especially if you have medical problems. Otherwise, your new plan will have perverse incentives to skimp on what you need.
2. To be able to afford that premium in case you become ill, you should be able to purchase “change of health status insurance“ in addition to garden variety insurance. Such insurance pays the extra premium caused by a change in your health status.

In such a world, health plans would compete for the patronage of the sick just as vigorously as they compete for the healthy. Most likely, health plans would specialize—with plans carving out such markets as cancer care or diabetic care. Instead of running from problems, the insurers would see common, expensive illnesses as entrepreneurial opportunities—just like we observe in other markets.

Change of health status insurance doesn’t exist today and isn’t envisioned under ObamaCare. But we need it. If the providers of medical care are to have good incentives, we need to allow such insurance and encourage it.