In the FT this week, Tim Harford writes about health insurance. He starts with the public case of a woman denied a new breast cancer treatment and the difficulties of trading-off problems in a public health care system. He then proposes that the best insurance for health concerns would be simply to give patients a check if they are diagnosed with an illness (according to some scale) and let them choose what treatment to spend it on.

Harford has a point: this would result in real insurance. To see this, notice that health insurance currently works to restore health but whether it be private or public treatment, patients have few options. For instance, a patient does not internalise the cost of the treatment at all. When a claim comes in they may as well take treatment because it is free to them. However, for all we know, a patient factoring in all of the risks (including that the treatment might not work), even if they had the money, would not choose it. If that is the case, there appears to be an inefficiency. When we are talking about expenditures in the 100s of thousands, this inefficiency is hardly trivial.

Harford’s solution breaks through this by giving the patient the money instead of the treatment. At the very least, they will spend that money on the treatment. But they could do something else. They might choose not to spend it (telling us that is probably the efficient thing) or they might put the money towards a more expensive treatment that is currently denied them by their insurance provider. Again, a more efficient outcome has occured because the patient has signaled their willingness to pay for the additional cost.

While theoretically sound as a base idea, as usual practical issues abound as always happen when you give people money they might look for ways to get their hands on it (other than being truely ill). But, nonetheless, it is certainly worthy of closer examination.

As is the case every year, the Federal Government has announced how much it will allow private health insurance companies to increase their premiums. One might wonder why the Government should play a role in setting private health insurance premiums. And the answer is simple: it is paying for 30 percent of them and so has an interest in what they are.

But why, you might ask, can’t competition between insurers ‘regulate’ the price? And the answer again is: the Government is paying a 30 percent premium. That means that if individual households search around for lower premiums, in effect, they only keep 70 percent of the savings. Not surprisingly, the Government distrusts that households will use their powers of consumer choice so as to allow competition to work. Add to that the possibility that consumers aren’t necessarily so shrewd and rational when it comes to such things and the fact that it is hard to compare health insurance offerings anyway (it is a good example of a ‘confusopoly’) and we can’t expect competition to be effective.

What we are left with, in contrast, is a terrible regulatory regime whereby the health insurers petition the Government for a fee rise based on their own cost increases and usually get it (or most of it). This reduces their incentives to contain costs and lo and behold we are footing the bill. Not just the average $150 rise in premiums but an additional $45 in public expenditures. This is not the sort of regulatory deal we put up with in other sectors such as energy and even telecommunications. (Boy, would Telstra love the health insurance deal!)

What is more is that there are several simple options at the Government’s disposal to change this situation. One option is to change the health insurance rebate. As Stephen King and I have demonstrated a lump sum (or dollar) payment rather than a percentage would remove many distortions: including that to the incentives of consumers to search for lower premiums.

Another option would be to move to a modern system of price regulation. Incentive regulation sets the caps on prices (or in this case premiums) independently of short-run changes in the costs of individual firms. This is usually done by referencing some benchmark. While the choice of benchmark can often be contentious, in health care, benchmarking for the Government is easy: it could base the annual rise in private health insurance costs on the increase (if any) in Government expenditures on relevant public health services. Something it not only observes but can control.

Better still, if Government could get rid of the rebate entirely and subsidise private hospitals and medical expenses directly based on the same cost benchmarks as the public system. The would eliminate the need for regulation altogether and put the annual round of increases into the past. Indeed, this is only one of the benefits that might come from this more major type of reform.

You can read more about this in the book by myself and Stephen King, Finishing the Job (published in 2003) or in this op ed or this short article.

Only by doing something like this can we, as health consumers, get some real insurance — over premiums as well as health expenditures.