Health care's new hidden danger

NEW YORK (Fortune) -- In the battle over health care reform, two ideas seems to bridge the divide between Democrats and Republicans: Private insurers should be required to cover Americans with pre-existing conditions and be banned from charging older, sicker people much more. But where the two camps jibe could also cause the most damage to health care.

Now that President Obama's vision of sweeping reform appears to be dying, the odds are excellent that Republican and Democratic will join hands to forge targeted legislation aimed at incremental "improvements."

The path forward, they say, is to tackle reform in pieces by mining the current House and Senate bills for the best ideas. So look for a measure that's marketed as a bi-partisan, common-sense, economically sound solution to a chronic problem that everyone agrees needs a radical cure.

The goal is certainly laudable, but the weakness of the House and Senate rules that would form the foundation of a new bill is that they impose two regulations that have already failed at the state level: Guaranteed Issue and Community Rating.

Guaranteed Issue forces private insurers to accept any and all applicants, regardless of their medical condition. Community Rating bans carriers from charging a different rate, say, for someone with diabetes than a buff tri-athlete. It also imposes tight bands on premiums for customers of different ages, even though older patients cost far more to insure than younger ones.

So what is the problem with obliging insurers to accept everyone and try to keep pricing uniform? First, the young and healthy -- the group whose premiums carriers count on to make insurance work -- will be less likely to buy in. Community Rating forces them to pay far more than their anticipated medical expenses. Shunning insurance actually makes sense: They can wait to sign up if they get diabetes, cancer or another chronic condition. Remember, under Guaranteed Issue, insurers can't turn them down.

So in markets that combine both rules, the private insurance pool attracts mainly older, sicker patients. As more and more of them sign up, premiums rise for everyone, further encouraging young and healthy customers to drop out.

The pool dries up. Eventually, private insurers leave the market. That's precisely what's happened in New York, Maine, Vermont and several other states that combine the two regulations.

Before Community Rating and Guaranteed Issue became law in 1994, New York State had 750,000 residents enrolled in private plans; now, the figure is less than 35,000. The crushing rates are a major reason 2.6 million New York residents don't have insurance, which is 14% of the state's non-elderly population and close to the national average of the uninsured.

The large numbers of uninsured in New York attests to the failure of a model that politicians from both sides of the aisle want to impose on the entire country. "A big goal of 'reform' was to substantially lower the number of people lacking insurance," says Steve Parente, a finance professor at the University of Minnesota.

But while costs exploded, he adds, the ranks of those without coverage barely changed. The principal victims are young people forced to pay far more than their actual cost. More than half of New York State's uninsured are under 40 and in good health.

In New York and Massachusetts, states bound by both rules, a single 25-year-old shoulders $5,000 to $6,000 in premiums. That's five to six times what Texas and Pennsylvania residents pay, which allows carriers to base their premiums on actual cost. Family policies in New York and Massachusetts cost over $13,000 -- twice the national average.

A system mandating that insurers take all comers at close to the same premium can work -- but only if it also imposes a powerful "individual mandate" requiring that everyone buy insurance. In that scenario, younger people would have to pay those high premiums or face fines that are even higher, if not criminal penalties.

It's remarkable that both the current House and Senate bills proposed penalties so light that their plans were practically guaranteed to collapse as the healthy shunned coverage while the suddenly sick grabbed it. In the Senate legislation, the fines started at $285 a year in 2014, and reached only $2,250 for most large families by 2016.

Economists and actuaries of every political stripe recognized the problem. But remarkably, it's gotten little press. So it's important to review their objections, since we're likely to see the same proposals under a bi-partisan banner extremely soon.

In January, the American Academy of Actuaries issued a report on the House and Senate bills that warned, "The financial penalties associated with both bills are fairly weak compared to coverage costs. Low-risk individuals will be more likely to pay the penalty and forgo coverage, putting upward pressure on premiums."

Another ardent critic is progressive economist Paul Krugman, who rightly claims that an "incremental" bill without big penalties would prove a disaster. "If Congress didn't require that healthy people buy insurance, there would be a death spiral," Krugman wrote recently in his New York Times column. "Healthier Americans would choose not to buy insurance, leading to high premiums for those who remain, driving out more people, and so on."

Fortunately, America can avoid that "death spiral" and still insure patients for pre-existing conditions. One solution is fully portable insurance policies that allow workers to buy policies across state lines from states that don't require Community Rating and Guaranteed Issue. They would also be able to purchase a wide variety of high-deductible plans that offer true insurance: covering for cancer or stroke, and even annual checkups, but the policy-holder pays for routine tests in cash. Those plans charge premiums far lower than the rich plans required in states such as New York and Colorado.

With fully portable policies, Americans would pay the same or slowly rising premiums even if they get seriously ill -- that's how the policies should work and it's how they're written today. The rub is that customers may sour on their insurer's service, or move to another state where the carrier doesn't have a network of physicians or hospitals.

Even with portable plans, policy-holders would have to face enormous increases in premiums if they change insurers and then develop pre-existing conditions. John Cochrane, a professor at the University of Chicago's Booth School of Business, proposes a creative solution. To make it easy for customer to switch companies, Cochrane recommends an innovative product called "Health Status Insurance."

By paying a small additional premium, patients could transfer to a new insurer even if that carrier demanded a higher premium. The old insurer would cover the difference. The extra cost wouldn't be big, for a simple reason: The original insurer is spreading the risk you'll get sick across a vast population of customers, and it will no longer have to cover your medical expenses once you change carriers.

For people who aren't working and suffer from chronic illnesses, the government's role is crucial. Thirty-four states already have high-risk pools that cover otherwise uninsurable patients. The federal government should encourage the development of these plans in states that lack them by offering block grants, and establish minimum standards for accepting applicants.

One idea floated by the insurance industry: The pools would be obligated to take anyone who can't find private insurance at less than 150% of the cost of the average patient of the same age. Say Henry Jones, a retired 62-year-old with diabetes, can only find one private policy costing $20,000. If the average premium in Henry's state for someone age 62 is $12,000, he's automatically eligible for the high-risk pool (because the best offer exceeds the 150% or $18,000 threshold). His premium is then capped at 150% of the average, or $18,000.

That's a big number. So state and federal governments also need to provide a sliding scale of subsidies that rise as family income declines, so that the Henrys of this world can afford coverage. The Senate and House bills now require those kinds of subsidies for a broad swath of the middle class.

Where they're really needed is for today's truly sick. And if tomorrow's customers are equipped with their own fully portable plans that include Health Status riders that enable them to change plans, they won't need subsidies at all in future years.