In 2012, U.S. personal health care expenses were $8,915 per person—17.2% of gross domestic product. This did not, however, mean that the typical American spent nearly $9,000 on medical treatment. In fact, in any given year half the population incurs only minor medical expenses. But a small percentage of the population faces huge medical bills, with 10% of the population typically accounting for almost two-thirds of medical costs.

Is it possible to predict who will have high medical costs? To a limited extent, yes: there are broad patterns to illness. For example, the elderly are more likely to need expensive surgery and/or drugs than the young. But the fact is that anyone can suddenly find himself or herself needing very expensive medical treatment, costing many thousands of dollars in a very short time—far beyond what most families can easily afford. Yet nobody wants to be unable to afford such treatment if it becomes necessary.

Private Health Insurance Market economies have an answer to this problem: health insurance. Under private health insurance, each member of a large pool of individuals agrees to pay a fixed amount annually (called a premium) into a common fund that is managed by a private company, which then pays most of the medical expenses of the pool’s members. Although members must pay fees even in years in which they don’t have large medical expenses, they benefit from the reduction in risk: if they do turn out to have high medical costs, the pool will take care of those expenses.

There are, however, inherent problems with the market for private health insurance. These problems arise from the fact that medical expenses, although basically unpredictable, aren’t completely unpredictable. That is, people often have some idea whether or not they are likely to face large medical bills over the next few years. This creates a serious problem for private health insurance companies.

Suppose that an insurance company offers a “one-size-fits-all” health care policy, under which customers pay an annual premium equal to the average American’s annual medical expenses, plus a bit more to cover the company’s operating expenses and a normal rate of profit. In return, the insurance company pays the policyholder’s medical bills, whatever they are.

If all potential customers had an equal risk of incurring high medical expenses for the year, this might be a workable business proposition. In reality, however, people often have very different risks of facing high medical expenses—and, crucially, they often know this ahead of time. This reality would quickly undermine any attempt by an insurance company to offer one-size-fits-all health insurance. The policy would be a bad deal for healthy people, who don’t face a significant risk of high medical bills: on average, they would pay much more in insurance premiums than the cost of their actual medical bills. But it would be a very good deal for people with chronic, costly conditions, who would on average pay less in premiums than the cost of their care.

As a result, some healthy people are likely to take their chances and go without insurance. This would make the insurance company’s average customer less healthy than the average American. This raises the medical bills the company will have to pay and raises the company’s costs per customer. That is, the insurance company would face a problem called adverse selection, which is discussed in detail in Chapter 20. Because of adverse selection, a company that offers health insurance to everyone at a price reflecting average medical costs of the general population, and that gives people the freedom to decline coverage, would find itself losing a lot of money.

The insurance company could respond by charging more—raising its premium to reflect the higher-than-average medical bills of its customers. But this would drive off even more healthy people, leaving the company with an even sicker, higher-cost clientele, forcing it to raise the premium even more, driving off even more healthy people, and so on. This phenomenon is known as the adverse selection death spiral, which ultimately leads the health insurance company to fail.

This description of the problems with health insurance might lead you to believe that private health insurance can’t work. In fact, however, most Americans are covered by private health insurance. Insurance companies are able, to some extent, to overcome the problem of adverse selection two ways: by carefully screening people who apply for coverage and through employment-based health insurance. With screening, people who are likely to have high medical expenses are charged higher-than-average premiums—or in many cases, insurance companies refuse to cover them at all. The problem that screening creates is that those people who need health insurance the most are more likely to be denied coverage or charged an unaffordable price. This is yet another reason behind the support for passage of the ACA, which expanded coverage to everyone regardless of their health history. The next section explains how employment-based health insurance, a unique feature of the American workplace, also allows private health insurance to work.

Employment-Based Health Insurance One way insurers have overcome adverse selection is by selling insurance indirectly, to peoples’ employers rather than to individuals. The big advantage of employment-based health insurance— insurance that a company provides to its employees—is that these employees are likely to contain a representative mix of healthy and less healthy people, rather than a group of people who want insurance because they expect to pay high medical bills. This is especially true if the employer is a large company with thousands or tens of thousands of workers. Employers require their employees to participate in the company health insurance plan because allowing employees to opt out (which healthier ones will be tempted to do) raises the cost of providing insurance for everyone else.

There’s another reason employment-based insurance is widespread in the United States: it gets special, favorable tax treatment. Workers pay taxes on their paychecks, but workers who receive health insurance from their employers don’t pay taxes on the value of the benefit. So employment-based health insurance is, in effect, subsidized by the U.S. tax system. Economists estimate the value of this subsidy at about $150 billion each year.

In spite of this subsidy, however, many working Americans don’t receive employment-based health insurance. Those who aren’t covered include most older Americans, because relatively few employers offer workers insurance that continues after they retire; the many workers whose employers don’t offer coverage (especially part-time workers); and the unemployed.