A consequence of tax policies is that people who receive health insurance as a fringe benefit tend to want more health insurance than they would if they were paying for it themselves. Consider the following example. Assume for the moment that you are a patient with a health insurance policy with a $500 yearly deductible. (That is, you pay the first $500 for medical care each year, and the insurance policy pays 100 percent of everything over $500.) Assume also that you have a medical condition such as asthma, and you expect to incur at least $500 in yearly medical expenses. Finally, assume that you have $1,000 in a savings account. A friendly insurance agent offers you the following option.
The agent offers to sell you an additional health insurance policy to cover the first $500 of medical expenses each year. The cost of this policy is $600 ($500 to cover your expected medical costs, $50 to cover the administrative costs of the policy, and $50 to cover profit for the agent and the insurance company). Do you want to buy the policy? Would any reasonable person in your situation choose to buy this policy? It does not make much sense to purchase a policy to cover $500 in medical expenses when that policy costs $600. It makes more sense to politely refuse the insurance agent's offer and to pay the expenses directly, thus saving the $100 you would otherwise have to pay to cover overhead and profit for the insurance company. For people without a known medical condition, it makes even less sense to buy the additional policy. Your employer, it turns out, has had a very good year, and decides to give you a salary raise of $600 per year. Now consider option 2.
The agent has heard of your good fortune and again offers to sell you the additional health insurance policy to cover the first $500 of medical expenses each year. The cost of the policy is again $600, but the agent reasons that because you have received a raise of $600 you will now be more interested in the policy. However, you pay 44 percent of any additional salary in taxes. Thus, despite your employer's generosity, you receive only $336 more per year in take-home pay after the raise. For the same reasons cited in option 1, it still makes no sense to buy the additional policy.
Your employer, instead of giving you a raise in salary, offers to buy you the same supplemental health insurance policy to cover the first $500 in medical expenses each year. The cost of the policy to the employer is still $600. Now do you want to buy the policy? What is the cost of the policy to you, in terms of income you have to forgo? If you take the raise in pay as wages, you will receive $336 in net benefit per year. If you take the raise as added health insurance, you will receive $500 in benefit (the $500 you would otherwise have paid out of pocket for the care for your asthma). In this case, it makes sense to ask your employer to give you the raise in the form of added health insurance, even though you would never buy the same level of insurance if you were paying with your own money.
If you went out to purchase a car and you were guaranteed a government subsidy for 44 percent of the car's price, you would buy a very different car from what you would buy if you had to pay the full price yourself. The same is true of health insurance. This federal policy has led to people choosing, wanting, and expecting health insurance policies that are more comprehensive than they would select if they were paying with their own money. Based on these federal policies, employer-provided, government-subsidized private health insurance came to be the predominant model of health insurance in this country.Until the 1980s, this employer-based health insurance provided in nearly all cases what has been referred to as indemnity insurance. The company indemnifies the patient for the cost of health care. The patient seeks medical care, pays for it directly to the provider, and in turn is reimbursed by the insurance company.
Most of these employer-provided health plans used what is called "experience rating" in determining how much to charge the employer for the cost of care. Premiums were set according to a combination of factors: the projected cost of providing care for employees, administrative costs and profit for the insurance company, and the carry over of any losses from the previous year. So long as insurance companies were able to predict accurately how much it would cost to provide medical care for all the employees each year, premiums paid by employers would rise at a gradual, predictable rate. However, if medical care costs were to rise rapidly and unpredictably, yearly increases in indemnity insurance premiums could be quite large. For a period of time in the 1980s, this was precisely the situation confronting both employers and insurers. Due largely to the explosion in medical technology, health care costs began to rise more rapidly than anyone expected.
The result was that many indemnity insurance carriers found that the health care costs for which they were responsible were considerably more than they had predicted, resulting in a loss for the year. This "underwriting loss" would then be added to the premiums charged to an employer for the coming year. The employer was hit with a double increase, paying both for the projected increase in the cost of care for the current year and for the underwriting loss for the previous year. Employers faced increasing costs for their employees' health insurance based on the experience of their employees during the previous year (thus the name "experience rating"). In essence, the insurance company passed on to employers the risk involved in insuring their employees for the cost of health care.
Many of the indemnity insurance companies acted mainly as pass-through agents, taking a share of all premiums to pay overhead and profit while assuming relatively little risk. A number of large companies concluded that it would be cheaper to pay for their own employees' health care directly than to pay an insurance company to do it for them. They established self-insurance plans that lowered administrative costs, and they kept the part of the premium paid to cover insurance company profit. The money that they would have paid for health insurance premiums was put aside in a special health care fund.When employees got sick, they simply gave the bill to their employer, with no insurance intermediary.Many companies hired consulting firms to handle only the administration of the plan. At one point in the early 1990s, just before the explosion in managed care, nearly half of all employers and more than 80 percent of companies with over five thousand employees provided health insurance through these self-insured plans.
However, the cost of medical care continued to rise sharply. Paying for the cost of health insurance was an increasingly large part of the cost of doing business. Insuring employees based on the indemnity model, in which most physicians and hospitals could still count on a fee for every service they performed with little oversight or constraint on the use of services, was proving to be unworkable. Thus, in 1993, when President Clinton proposed a national system of care based on managed care and managed competition, many employers were initially supportive. They saw health maintenance organizations and other managed care plans that had developed in the previous twenty years as attractive options to traditional fee-for-service, indemnity insurance.
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