There are three keys to letting markets provide real lifetime health insurance. First, all levels of government must allow insurers freely to charge sick people higher premiums, and healthy people lower premiums. This is exactly the opposite approach of much existing regulation and most health-care reform proposals, which try to force insurers to take all comers at the same price. Such regulations lead insurers to avoid the sick, and overprice insurance for the healthy. Insurance companies refuse coverage, deny preexisting conditions, or more subtly avoid or mistreat sick people, only when they can’t charge those people enough to cover their costs. If they can charge enough, they’ll cover anyone and compete for their business.
Second, and most critically, we must clear the way for markets to offer “health-status insurance,” so that people who become sick will have enough money to pay higher premiums.
Much current regulation and many policy proposals instead attempt to strengthen employer-provided health insurance in various ways, so that the premiums of the healthy can cross-subsidize the sick for long time periods. Since the above two keys would allow a private, individual-oriented health insurance market to work, the third key is to reverse this trend, so that individuals purchase lifetime insurance no matter where they work (or even if they don’t work), and so individuals have perennial ability to shop for better insurers rather than be tied to one pool or company.
Here’s how the combination of medical and health-status insurance can work. Each year, you purchase a medical-insurance policy that provides one year of coverage. The premium depends on your health status; premiums are higher for people with long-term expensive illnesses than they are for healthy people. The insurance company then pays your medical expenses for the year, less copayments and deductibles, just as now.
You also purchase a health-status insurance policy. Suppose that during the year you get a long-term illness that moves you into a more expensive medical-insurance premium category. The health-status insurer then pays you a lump sum equal to the present value of the cost of those higher medical-insurance premiums. With that lump sum, you can now pay higher medical-insurance premiums to your insurer or any other insurer, with no change in out-of-pocket expense.
Health-status insurance payments should be deposited in a special health-status insurance account that can only be used to pay medical-insurance premiums and perhaps certain medical expenses. (This provision is part of a private contract, not a necessary regulation.) First and most important, large lump sums are a temptation to fraud – get a fake disastrous diagnosis, take the money, and disappear. That’s much less tempting if all you can do with the money is buy medical insurance, from a company that will surely notice when your horrible disease suddenly vanishes. Second, if you can become unexpectedly healthier (i.e., if medical insurers’ premium categories allow once-sick people to qualify for lower annual premiums when they recover), you should return part or all of the lump sum, since you no longer need it to pay higher medical-insurance premiums. (Contracts without this provision work, but this provision makes the contract cheaper.) This provision is much easier to enforce if the lump sum is placed in a dedicated account that operates like a private trust. Third, people who receive a large lump-sum payment may choose to spend it on other things and then show up in the emergency room, unable to pay their bills. It is in both consumers’ and insurers’ interest to pre-commit against this option, and doing so incidentally helps to solve a social and policy problem.
Health-status insurance accounts are not the same as health savings accounts. Health savings accounts are tax-preferred savings vehicles. You are allowed to withdraw money for some non-medical purposes and to pass the assets on to heirs, as well as to pay for medical expenses. Health-status insurance accounts implement an insurance contract. They are funded by health-contingent payments from the health-status insurance company, and ideally they should not be inheritable or used for any other purpose.
However, the institution of health savings accounts is a great first step, as it establishes the legal and regulatory framework for accounts that are limited in some ways to health payments. Now, markets need only create a variant of something that exists, rather than something totally new.
Competition and Freedom
Such contracts would solve the central problem with our current health insurance market: the lack of real health security. You can be insured for life, no matter if you lose your job, are divorced, grow up, move, take some time out of the labor force, and so forth.
Even more important than security, this system would give great freedom to each individual. No matter how sick you are, you would be completely free to take your health-status insurance account and change medical insurers, change jobs, move, and so forth. You could always afford the higher premiums a new insurer will demand, just as easily as you could afford pay the higher premiums your current insurer will require. You would not depend on the good treatment of one insurer, or the vagaries of one pool, the link to one employer, or one government-provided plan -- you can always leave with your health-status insurance account and find something better.
Freedom for consumers would force much greater competition among medical insurers and medical-care providers. Medical-insurance companies would compete for the business of sick, expensive, high-premium customers, rather than try to get rid of them, or “contain their costs.” Where current policy proposals would limit healthy people’s choices (to keep them around and subsidizing the expenses of sick people), medical-insurance companies would freely compete for healthy people too, offering them better service or lower premiums. Constant competition for every consumer will have the same dramatic effects on cost, quality and variety of service in health as it does in every other industry.
Suppose a healthy 25-year old male will incur $2000 worth of medical expenses in a year, on average. This average includes a large probability of no medical expenses, but also small chances of substantial expenses. A competitive medical-insurance market will offer him insurance with a $2,000 premium, plus administrative costs and profit.
Suppose that, along with potential short-term illnesses, he has a 1 percent chance of developing a chronic condition that will raise his average medical expenses to $10,000 per year. Again, this number averages over all the possibilities, but it is the actuarial average for people with this condition. If he develops the condition, a competitive medical-insurance market will still cover him in following years, but his annual medical-insurance premium must rise to $10,000, plus costs and profit. This would be a large financial setback.
Suppose he only wants medical insurance until age 65, when he will transition to Medicare. To really be insured, then, he needs a lump sum payment to be deposited into a health-status insurance account, enough that the account custodian can pay $8,000 per year of extra medical-insurance premiums for the subsequent 44 years. At a 5-percent interest rate, that sum would be $148,370.  Therefore, his initial outlay will have to include 1 percent of that value ($1,483.70) per year, plus administrative costs and profit, as a fair premium for health-status insurance.
In sum, he pays $2,000 for one-year medical insurance, plus $1,483.70 for health-status insurance, for a total of $3,483.70 in out-of-pocket expense. Now he is completely covered, both for short-term and for chronic medical expenses. He is also free to change medical insurers at any time, with no change in out-of-pocket expenses.
This example is simplistic, of course. Bradley Herring and Mark Pauly use data on the incidence of a long list of chronic diseases to provide a realistic estimate the sum of medical- and health-status insurance premiums. Their annual medical-insurance premium for a low-risk individual rises from $800 at age 25 to $3,038 at age 55; while a high-risk person would pay $2,300 at 25 rising to $10,023 at age 55. Clearly, jumping from low-risk to high-risk implies a large financial penalty. Ignoring health-care cost inflation, they estimate that the combined medical- and health-status premium would start at $871 at age 25 and rise to $3,936 at age 55. These amounts are surprisingly close to the one-year medical-insurance premium charged to low-risk people, only $71 more at age 25 and $898 more at age 55. Transitions to high-risk are in fact rather rare, especially early in life. Total premiums in their calculation also rise uniformly with age, unlike in my example. This fact reassures us that young healthy people, who typically have lower incomes than later in life, will not shy away from health-status insurance due to a front-loaded payment stream.
Guaranteed-Renewable Health Insurance
Why don’t we just change insurance so that you can’t be dropped for getting sick, and you always have the right to renew at a preset rate? With insurance like that, it would seem the problem would go away. This is “guaranteed-renewable” health insurance. It is the other major vision for how a free market could insure people against long-term risks. In fact, it is already available. Life insurance is usually guaranteed-renewable. Individually-purchased health insurance must now be guaranteed-renewable, and 75 percent of policies were so even before the mandate was passed. The only reason more of us don’t have it is that we have been prodded by taxes and regulation into employer-provided insurance.
Does guaranteed-renewable health insurance work? One worries that once you become sick, the insurance company is going to lose money on you for the rest of your life, and has every incentive to treat you badly or try to get rid of you. However, perhaps this is not such a huge problem. The effects of reputation and our legal and regulatory system may be strong enough to enforce long-term contracts on large companies. A deeper problem is that healthy people will want to leave. After we find out who is sick and who is healthy, the insurance company cross-subsidizes sick people’s expenses from healthy people’s premiums. Therefore, another company can offer healthy people a better deal. But if the healthy leave, the original insurer will go out of business, and therefore won’t end up insuring anyone. It is neither realistic to force (healthy) consumers to stay with one insurer for their entire lives, nor would it be possible to enforce such contracts, and guaranteed-renewable health insurance does not try to do so. Much existing policy and many proposals instead try to limit health-insurance competition in order to take away healthy consumers’ freedom to find a better deal.
However, this problem can also be solved with a sufficiently clever insurance contract. Mark Pauly, Howard Kunreuther and Richard Hirth show that you can structure a guaranteed-renewable contract so that nobody ever wants to leave, at least for financial reasons, by charging everyone the same price that is charged to the lowest-risk person. Herring and Pauly find some evidence that individual health insurance premiums reflect some of this feature.
In my illustration, suppose you can develop the chronic condition once at age 25 only. After that, you’re either sick forever, costing on average $10,000 per year, or healthy forever, costing on average $2,000 per year. The medical- and health-status insurance payment I analyzed above is then $3,483.70 in the first year and $2,000 per year thereafter for everyone. The average medical costs for all individuals are, for every year of life. A conventional “guaranteed-renewable” policy would therefore charge $2,080 per year. This would fall apart in a competitive market, however, since after the first year all the healthy people could be wooed away by a competitor charging $2,000 per year. If insurers were instead structured the guaranteed-renewable policy to charge everyone $3,483.70 in the first year and $2,000 in every following year, no one could woo away the healthy people ex-post. Pauly et al. call this an “incentive-compatible” guaranteed-renewable contract. By the same math as above, the insurance company breaks even. Therefore, no one can woo the healthy away ex-ante either with any other incentive-compatible contract.
The example shows an important point in comparing health-status insurance and guaranteed-renewable insurance: The premiums of any incentive-compatible guaranteed-renewable insurance contract are exactly equal to those of a sequence of medical-insurance and health-status insurance contracts.
A health-status insurance contract is no more than a guaranteed-renewable contract in which the insurance company periodically “marks to market” its long term obligations to the consumer, or the two parties occasionally “settle up.” At the end of the first year in a guaranteed-renewable contract, the insurance company’s accountants should look at each patient with the long term illness and say “this person is going to cost us $8,000 per year. We should write down the company’s value by $148,370.” In the health-status insurance model, they instead actually pay out $148,370 and now have no more obligations.
Though the contractual difference is small, the implications of periodically settling up a long-term contract are profound. After this settling up, both sides are free. The consumer does not depend on a continuous tie to one insurance company to provide medical coverage for the rest of his life. Freedom to leave is a much more effective way of keeping insurers and providers on their toes than are reputations, long-term contracts, and courts. The guaranteed-renewable and medical-plus-health-status insurance models are similar. Health-status insurance, however, could provide greater freedom to healthy and sick consumers, would force insurers to compete for sick consumers, and would ensure that no consumers would be stuck with an insurer they find objectionable.
However, guaranteed-renewable insurance is a great start and probably provide the best stepping stone to the end result. Health-status insurance as I have described it seems like a radical innovation. It seems to require reversing a half-century’s worth of regulation, on the hope that some totally new system will work. Yet we can gradually free this market without taking any big leaps into the unknown.
Greater emphasis on guaranteed-renewable individual insurance, which already exists, is the natural first step. Restoring insurers’ freedom to risk-rate their offers will make guaranteed-renewable insurance more “incentive-compatible” and force insurers to compete for all customers. (I discuss below how to help high-cost individuals who could see a spike in their premiums during the transition period.) Demand from consumers who want the freedom to change insurers will push the next step, in which insurers add “marking to market,” or periodic settling-up clauses, and health savings accounts are slightly modified to become health-status accounts and carry the payments.
Each step can coexist with the last. In particular, since health-status insurance just makes a small modification to guaranteed-renewable insurance, rather than create an alternative scheme, competition can easily sort out just how much health-status insurance is optimal, i.e. how to and how frequently to settle up. There is no need for regulators or policy wonks to decide between the two visions. Over time, deregulation and market innovation can gradually and seamlessly create fully portable, long-term health insurance.
The contracts I have described, combining one-year medical insurance and health-status insurance with payments held in a custodial account, show most cleanly how the contract works. Markets may devise other ways to achieve the same end, however, and it is not my intention here to design the exact formulation and marketing plan that will be most attractive to consumers, insurers, and regulators.
Health-status insurance can be handled by a separate company. Since this is largely a financial transaction, a financial services company might be able to handle it better than a medical-insurance company. On the other hand, consumers might prefer to have the two forms of insurance bundled as “long-term health insurance” and not worry about two separate contracts.
The health-status insurance account does not have to be settled every year. You could have a guaranteed-renewable medical-insurance policy, and a health-status account is created or updated when you want to leave. On the other hand, with insurance as in all human relationships, there is less chance of fighting between consumers and insurers if the settling-up is done more frequently and in smaller chunks than in one large chunk after the consumer has already decided to leave.
The health-status account really isn’t even necessary. You could just have a “transferability” right. Your current insurer would agree that, when you want to leave, it will pay a lump sum to any new insurer, such that new insurer will now be willing to take you in a plan of similar quality with no change in out-of-pocket expenses. The sum could be the same sum that your current insurer charges to take on a new customer of your age and health status. That obviously would not give consumers quite as much freedom as a health-status insurance account with real assets. But it could work almost as well in practice and might be simpler for people to understand.
Alternatively, rather than have an account with a dollar figure in it, health-status insurance could simply promise to pay any additional medical-insurance premiums over a set amount, as long as you’re alive (or until Medicare eligibility). The exact kinds of payment would have to be spelled out in some detail, either by specifying the qualifying plans or by specifying how much extra will be paid out for various risk conditions, but that’s fairly straightforward in practice. In this implementation we don’t have to worry about the insurer retrieving lump-sum payments if you get healthier. You would be dependent on a long-term contract, but it is much more reliable to receive an annuity from a financial services company than it is to rely on a long-term promise by a medical-insurance and delivery company. Plus, you still could have the right to choose any medical insurer you want.
Changing Tastes and Quality
Suppose you purchase a bare-bones medical plan and health-status insurance that pays for a change in the present value of the bare-bones plan premiums. You contract a high-cost condition. What if you then decide you want to move to a better medical plan, one that charges substantially more?
Insurance can cover external misfortune, but it can’t cover changing tastes. If you want to move to a fancy plan, you’re going to have to pay more. However, you could buy, and companies could sell, bare bones medical insurance and a health-status plan that covers changes in fancy medical-plan premiums. That will cost a little bit more, but when you get sick, a much larger sum would be deposited in your health-status insurance account. This would be an attractive option for young people or people in temporarily reduced circumstances. Home and car insurers will not let you be “overinsured,” declaring too high a value, for obvious incentive reasons. But there is no such worry with health-status insurance since you can’t do anything but buy medical insurance with the payouts.
Premium Categories and Contract Simplicity
More generally, in the real world we don’t have to insure people down to the last dollar, so it is not necessary to key health-status payments precisely to an individual medical plan’s exact schedule. Home insurance markets work, even though the payment is never equal to the exact value of the home. Health-status insurance companies could offer three or four levels of coverage, keyed to surveys of the costs of three or four standard levels of medical coverage. Similarly, medical insurers would probably have a short number of classifications, say a 1-10 scale of “low risk” to “high risk”, rather than publish a premium schedule for every conceivable disease history. This would make their job and the health-status insurer’s job much easier at a small cost.
I have also emphasized the theoretically perfect case that health-status insurance pays precisely the annuitized lifetime present value of the expected change in premiums. Really, though, any large approximate payment will do, especially if the premium insurer can recover unused funds at death or if the consumer becomes healthier. A health-status insurance contract could then simply have a schedule of preannounced payments, “pays $50,000 if you are reclassified from category 3 to category 5,” with $50,000 the advised level of coverage for someone in a A- level plan. People could freely choose a better contract, say one that pays $70,000 in this event, the advised level for A+ plans, at a slightly higher cost.
The main disadvantage of health-status insurance relative to lifetime guaranteed-renewable insurance is the contracting cost of establishing how much the severance payments should be, and deciding when to make them. In these ways, however, the contracting costs could be quite small and the procedure quite efficient if, as with home insurance, people can tolerate some minor slippage.
Health-status insurance has another strong advantage over most other proposals: it provides long-term security through any interruptions or changes in medical insurance. In a long-term pool or a long-term contract, as soon as you stop making payments you lose any right to low premiums and the treatment of your now preexisting conditions, thus losing the implicit coverage for long-term illness.
This happens. For example, people who lose their jobs often have the right to continue health insurance, at least for a short time, if they pay the entire premium including what used to be the employer’s contribution. But people who just lost their jobs often have trouble paying premiums, especially if the job loss coincides with an expensive illness. People who take time off from work to raise a family, or lose their connection to health insurance through divorce don’t even have the right to continue coverage and are in even worse positions.
By contrast, anyone with health-status account can switch to a lower-cost medical plan, or miss some period of medical coverage entirely, to adapt to economic misfortune, and retain protection against the costs of their long-term illness. When they’re ready to reestablish medical insurance, or move back to a better and more expensive medical-insurance plan, the health-status account is there and waiting.
Lifestlyle Choices – Smoking, Weight, Drugs, and so forth.
Some potential indicators of long-term health are to some extent under people’s control – weight, exercise, smoking, drugs, risky sexual behavior, and so forth. If people do not suffer the financial costs of these choices themselves, they will have less incentive to behave well. That will make insurance more expensive for everyone, suboptimally reduce public health, and potentially price people who know they will behave well out of the market.
This “moral hazard” is a problem for all forms of insurance, including guaranteed-renewable health insurance, and health insurance provided by government or employers. Nevertheless, it is still worth thinking through what moral hazard means for health-status insurance.
Allowing medical insurers to charge different amounts based on health status, and to adjust premiums annually would help reduce moral hazard. If insurance costs more for smokers, people who are overweight, or if premiums depend on blood sugar or blood pressure readings, people would have a forceful annual reminder to do the right thing. Restricting insurers’ freedom to vary premiums eliminates the market’s ability to induce these healthy behaviors.
However, if you start to smoke and your medical insurer raises your rates, but your health-status insurer covers the difference, we’re back where we started. The natural answer is for health-status insurance simply not to insure events that are subject to moral hazard. Home insurance does not cover arson. The health-status contract could cover changes in health classification due to illness (cancer, stroke, etc.), but could refuse to cover those due to unhealthy behaviors (smoking, drug use, unhealthy weight levels, etc.). Better yet, it could make only partial payments into one’s health-status insurance account, to reflect the fact that some behaviors (e.g., weight gain) are not totally under people’s control. If the payouts to those customers’ health-status insurance accounts are less than the surcharge that insurers impose, then those unhealthy behaviors would still trigger an annual but manageable reminder that the customer should take better care of himself. Alternatively, the health-status insurer could offer full coverage for all health-classification changes and charge higher premiums for unhealthy behaviors itself.
This lack of complete insurance is a strong argument for premium insurance, as opposed to employer-purchased or government-provided insurance. The latter two remove most of the financial incentives to maintain even easily observable determinants of good health. We shouldn’t insure everything.
What about People Who Are Already Sick?
Private markets cannot provide insurance against events that have already happened. You can’t say to an insurance company, “My house just burned down. How about home insurance?”
Many people feel that government should provide insurance against events that have already happened, especially when no insurance was available so the unfortunate are in some sense blameless. If so, health-status insurance, with health-status insurance accounts, offers a very clean way for the government or private charity to help people who are already sick. Either could deposit the appropriate lump sum in an individual’s health-status insurance account and then get out of the way. This is much more straightforward, flexible, and less distortionary of insurance markets than directly providing coverage in a government-sponsored health-insurance plan, or forcing private insurers to take such patients as part of a forced pooling arrangement.
Still, this consideration is most important at startup, when long-term insurance first becomes available and we can’t realistically expect people to have bought any. Once it is instituted, parents can buy family insurance that provides for individual premium insurance accounts for their children. Then, children who develop rare long-term diseases will still be covered for life without needing government interventions. Premium insurance can potentially apply to unborn children, and thus privately cover genetic defects from birth.
What about Adverse Selection?
People who know they are sick and can hide it tend to buy more insurance, which can cause insurance markets to unravel. Realistically, adverse selection is not that much of a problem for health insurance markets. True adverse selection refers to things patients know that the insurer cannot know – what economists call “asymmetric information.” Does a patient who knows his or her aches and pains really know more than can be learned by looking at his or her entire medical history and a careful exam? (Hiding a history is fraud, and can invalidate a contract.) When we now observe only sick people signing up for insurance it seems like adverse selection but it is not. It is the result of artificially forbidding insurers from charging more for people that everyone knows are going to be expensive, not a fundamental information problem that would stop a deregulated market from emerging. Markets with blinders on cannot see.
As in current health and life insurance, health-status insurers would mitigate adverse selection by charging higher premiums to people who are more likely to get long-term illnesses, and could refuse to cover premium increases triggered by certain conditions that appear in the first few years of a contract. You still have to buy insurance before your premiums increase. Markets cannot insure people after the fact. This fact does not mean we’re back where we started. In a premium-insured world, you have to buy health-status insurance before you find out if you have a long-term illness. In our world, most health insurance does nothing to help healthy people insure against developing a long-term illness.
Adverse selection is exactly the same for health-status insurance as it is for lifetime insurance with a single company. The portability engineered by lump-sum payments doesn’t make adverse selection any better or worse. So at a minimum, this isn’t a special issue for premium insurance.
 The contracts in this article are described more fully, with all the equations you could ever want, and with responses to additional objections, in “Time-Consistent Health Insurance,” Journal of Political Economy 103 (June 1995) pp. 445-473.
 Herring, Bradley, and Mark V. Pauly, 2005, “Incentive-Compatible Guaranteed-Renewable Health Insurance Premiums,” 2005, Journal of Health Economics, 25, 395-417. As I explain below, the “GR” or guaranteed-renewable premiums shown in their Figure 3 and Table 3 are identical to the combination of health and health-status insurance payments described here.
 Mark Pauly and Bradley Herring, Pooling Health Insurance Risks (Washington: American Enterprise Institute, 1999).
Mark V. Pauly, Howard Kunreuther, and Richard Hirth, 1995, “Guaranteed Renewability in Insurance,” Journal of Risk and Uncertainty 10, 143-156; Mark Pauly, Andreas Nickel and Howard Kunreuther, 1998, “Guaranteed Renewability with Group Insurance,” Journal of Risk and Uncertainty 16, 211-221.
 Herring, Bradley, and Mark V. Pauly, 2005, “Incentive-Compatible Guaranteed-Renewable Health Insurance Premiums,” 2005, Journal of Health Economics, 25, 395-417.
 See Mark V. Pauly and Robert D. Lieberthal, “How Risky Is Individual Health Insurance?” Health Affairs Web Exclusive w242, May 6, 2008, http://content.healthaffairs.org/cgi/reprint/hlthaff.27.3.w242v1.pdf.