The Unstable Economics in Obama’s Health Law

By disrupting the link between premiums and risk, the law weakens insurers’ business models

By Greg Ip
Aug. 17, 2016 12:55 p.m. ET

Barack Obama’s signature health-care law is struggling for one overriding reason: Selling mispriced insurance is a precarious business model.

Aetna Inc. dealt the Affordable Care Act a severe setback by announcing Monday it would drastically reduce its participation in its insurance exchanges. Its reason: The company was attracting much sicker patients than expected. Indeed, all five of the largest national insurers say they are losing money on their ACA policies and three, including Aetna, are pulling back from the exchanges as a result.

The problem isn’t technical or temporary; it’s intrinsic to how the law was written. By incentivizing insurers to misprice risk, the law has created an unstable dynamic. Total enrollment this year will be barely half the 22 million the Congressional Budget Office projected just three years ago. Premiums, meanwhile, are set to skyrocket, which will further hamper enrollment. It isn’t clear how this can be fixed.

Historically, millions of Americans went without insurance because they’re not poor enough for Medicaid, but too poor or too sick to afford private insurance. The ACA tackled their predicament directly by expanding Medicaid and giving individuals subsidies. It also did so by in effect requiring healthy customers to pay higher premiums than their actual claims would justify to subsidize sicker, older customers.

The premise of insurance, of course, is that the lucky subsidize the unfortunate. Most holders of auto or flood insurance will pay more in premiums than they collect in benefits unless their car crashes or their house floods. Nonetheless, insurers want premiums to reflect all the known risks of the insured. So if you have a teenager you pay more for auto insurance and if you live on a floodplain you pay more for flood insurance.

The future of the Affordable Care Act remains a point of contention on the campaign trail especially after Aetna became the latest insurance company to pull back from government exchanges. WSJ’s Shelby Holliday reports on how Donald Trump and Hillary Clinton are seizing the news to push their healthcare reform proposals.

The market for individual insurance—coverage that individuals didn’t get through their employer—was once similar. Older customers, women and people with pre-existing conditions paid higher premiums or paid more out of pocket. The ACA changed all that: Insurers can no longer charge or exclude coverage for pre-existing conditions or charge men and women different rates. They can’t charge older customers more than three times as much as the young. They must cap out-of-pocket costs.

By circumscribing insurers’ ability to underwrite risks, the ACA thus distorts how insurance is priced. Avik Roy, a health-policy expert who advised Republican Senator Marco Rubio during his presidential campaign, says the average 64-year-old consumes six times as much health care as the average 21-year-old. To adhere to the 3-to-1 maximum ratio, an insurer would have to charge the 21-year-old 75% more than his actual cost and the 64 year old 13% less.

The rational response to such pricing would be for young, healthy customers to stay away and sick, older customers to flock to the exchanges. The ACA included several mechanisms to prevent that: income-linked subsidies to purchase insurance; penalties for those who didn’t buy insurance; and three separate mechanisms to compensate insurers in the early years for outsize costs.

It hasn’t worked. The compensation payments have been much less generous than insurers were led to believe. Jonathan Gruber, a Massachusetts Institute of Technology health economist, says those missing payments would have eliminated most of insurers’ losses. Customers game the enrollment process by buying or changing plans only when their health changes. Third-party providers such as dialysis centers pay customers’ premiums so as to provide them with costly treatment. All this compounds the law’s unstable economics.

According to Avalere, a health-care consulting firm, enrollment drops sharply as subsidies shrink: 81% of people earning between 100% and 150% of the federal poverty level and eligible to enroll did so in 2016; just 2% of those earning more than 400% did. “The more consumers must pay themselves for what the ACA is offering, the less attractive they find it,” notes a report by 10 health policy experts, including Mr. Roy, issued by the conservative American Enterprise Institute last December.

So how can the ACA be fixed? Democrats’ solution is, essentially, more subsidies. Mr. Obama has called for a “public option,” a federal health plan to supplement private insurers. Hillary Clinton, the Democratic nominee for president, goes even further: She wants anyone over 55 to be able to opt into Medicare. Both would nudge the U.S. closer to a “single payer” model like Canada’s that liberal activists have long sought.

Yet this would require a lot more money and further erode market forces in health care.

Republicans have long called for repealing the ACA, yet their leading thinkers now concede the pre-ACA status quo isn’t an option.

The AEI report represents one promising alternative: every individual would receive a refundable tax credit, rising with age, to buy a basic plan. Insurers would be largely free to design a plan to fit that price point. This would stabilize the market by realigning premiums with risk. Some people with pre-existing conditions would need additional subsidies. For some individuals, the credit may only be enough for catastrophic coverage. But that, they note, is what insurance is supposed to do: “The insistence that only ‘comprehensive’ insurance coverage is really insurance
encourages a great deal of economic irrationality.”