One of the most important factors in buying health insurance (either an individual or group policy) is whether the insured person has a “pre-existing condition.” Generally speaking, if you have a medical condition that has required medical attention—and you still have it at the time that you apply for new insurance—you’re going to have some difficulty buying a standard policy.

Why are pre-existing conditions such a big deal?

Most policies limit or deny coverage for people with pre-existing health problems. Politically, this is a major issue; actuarially, it’s just common sense. In the last year or two, the politics has been getting the better of the common sense. In this column, we’ll consider the matter from both perspectives, so that you can understand how to make the best insurance-buying choice. Even if you have a pre-existing condition.

It’s a central tenet of free-market insurance that any person can buy coverage—as long as that person is willing to pay high enough premiums and accept low enough coverage limits. If the premiums are too high and the coverage limits too low, a rational individual will choose to avoid health insurance and pay cash out-of-pocket for whatever (hopefully minor) medical expenses he or she incurs. This option not to buy overpriced health insurance coverage is an important signal to insurance companies about how effective their pricing models are. Take it away and prices tend to rise for everyone. Why? Because, when a healthy person chooses to opt out of the available health insurance marketplace, he or she leaves people who tend to be in worse health—on average—than in the pool of insureds. And, if many healthy people leave, a kind of negative critical mass occurs: So many sick people remain that they drive up claims costs sharply.

Economists call this “adverse selection.”

Some insurance experts argue that adverse selection causes insurance costs to rise so fast that no rational healthy consumer will ever buy available coverage. The only people left in the risk pool are those who expect to make claims greater than the premiums they pay. This leads to a counter-intuitive conclusion: If an insurance company can sign up a customer with a preexisting condition at an exorbitant premium, the insurance company probably doesn’t want that customer. Why? Because that customer has decided that the coverage he or she will receive in exchange for the seemingly-high premium will outweigh the seemingly-high cost. And will be inclined to make claims.

Some insurance experts have written that people with preexisting conditions “are better at predicting” their future medical needs than healthy people who don’t have as much experience in using health care services. But the federal government doesn’t seem to believe this theory.

Currently, the Affordable Care Act (ACA) has established a government-run Pre-Existing Condition Insurance Plan (PCIP) that offers health insurance coverage to those denied coverage because of their conditions. The program’s current financial status hints at the high costs that come from insuring people with histories of cancer, diabetes, heart attack, stroke, etc. The health care cost per participant in the PCIP is currently projected to be nearly $30,000 a year; this more than double what government actuaries projected when the ACA was passed into law.

Of course, the PCIP is merely a transitional program. By 2014, the ACA will prevent insurers from discriminating in any manner based on pre-existing conditions: by law, cancer victims and stroke survivors will be able to buy insurance at the same price as healthy applicants of the same age and gender.

In other words, under the ACA, all people are required to buy government-approved health coverage. The healthy can’t opt out; they have to subsidize the sick.

This is the scheme’s vaunted hedge against adverse selection—the so-called “individual mandate.” But this mandate blinds the health insurance marketplace to its critical pricing signals.

Suppose the Company X offers all insureds the a medical insurance policy for $10,000 per year, based on data showing that the annual medical costs of all insureds is about $8,000, on average. A consumer who expects his expenses to total just a few hundred dollars—and there are some people who have such few and minor health problems—won’t sign up. The coverage isn’t worth it.

But consumers who decide that they will use more than $10,000 in medical services each year will enroll.

Now, suppose that Company X researches loss histories for people who’ve had cancer and concludes that its average annual medical expense for each of them is $15,000. On first glance, Company X should be able to charge an annual premium of $20,000 to people who’ve had cancer and stay well ahead of the projected medical expenses. But things don’t always work so logically. In fact, rising premiums often create a so-called “death spiral.” Each time Company X raises its premiums, it chases away more relatively-healthy people and attracts an increasingly expensive set of sick insureds.

Again, this is why the individual mandate is so important to the ACA—if everyone is forced to buy health insurance, the healthy will end up paying in more money which funds the medical care provided to the sick.

The origins of the ACA’s tools against adverse selection reach back almost 50 years. In December 1963, Stanford economist Kenneth Arrow published a paper in the American Economic Review titled “Uncertainty and the Welfare Economics of Medical Care.” Arrow identified five principal “distortions” in the market for health care insurance:

1. Uncertainty of Demand. People’s needs for health care are unpredictable, unlike other basic expenses—like food and clothing.
2. Expected Behavior of the Physician. You can’t just set up shop on the side of a road and practice medicine; you need a license to be a physician—and getting that license requires years of training. And physicians want to be compensated for that.
3. Concepts of Trust and Delegation. Trust is a key component of the doctor-patient relationship; the patient must trust that the surgeon knows what he or she’s doing.
4. Supply Conditions. Doctors usually know far more about medicine than do their patients; therefore, the consumer of medical services is at a disadvantage relative to the seller.
5. Pricing Practices. Patients don’t see the bill until after the non-refundable service has been provided, so they’re rarely able to shop around for medical services on price and value.

Arrow argued that the only good solution to these pricing problems was to force everyone to buy the same, basic coverage.

Recently, the Forbes magazine columnist Avik Roy wrote a lengthy article in The Atlantic magazine which argued that there are several free-market solutions to the issues Arrow raised all those years ago. Specifically:

Arrow’s prescriptions for addressing health care’s distorted market involve…further distortion. [Y]ou can’t shop for health care when you’re unconscious, or when you’re in acute or emergent situations. Does this justify nationalizing the health care system? No. At most, it justifies nationalizing a subset of health-care decisions that take place in acute settings. …it seems to me, those who strongly believe in the shopping argument for socialized medicine should adopt a hybrid approach. Let’s have a free market for the 70-plus percent of health care where market forces can most directly apply, and let’s have universal catastrophic insurance for those situations where market forces work less well.

Until that day, U.S. already has a hybrid market: Medicare/Medicaid for the old and the poor and a relatively free market for health insurance for the younger and employed. While the status quo has flaws, it couldn’t be worse than the Feds at communicating important pricing signals.

Photo credit: http://www.sxc.hu/profile/Mattox