The ACA Individual "Tax" Date: Why it Matters

A not-so-small and controversial mandate exists within the Affordable Care Act (ACA).  It has libertarians up in arms and liberals up in hopes.  It’s the ACA’s individual mandate—or tax individuals would have to pay for not purchasing health insurance.  While the mandate seems radical, it’s not—and it will probably lower your healthcare premiums!  The idea of our government strongly encouraging us to buy insurance isn’t new.  We have to buy car insurance if we own a car.  People generally don’t complain about that, because they want to be reimbursed if someone damages their car—imagine if someone who didn’t have car insurance hit you.

Yes.  The individual mandate is key to lowering your insurance premiums.  Hey, it's working in Massachussetts!

The conventional reasoning behind the individual mandate is straight forward.  Individuals who are more likely to be sick (high-risk consumers) are precisely those that apply for and enroll into health insurance plans.  This is called adverse selection.  These are individuals that recognize they will probably need care that is either long-term, intensive, or both—and therefore high cost.  Without insurance, they would likely be unable to pay for their out-of-pocket, and, recognizing their situation, also purchase health insurance.  To the insurer, however, high-risk consumers are expensive and expect to pay more for their coverage.

Individuals who are less likely to get sick (low-risk consumers)—usually the young and single—tend to avoid purchasing health insurance because they can reasonably assume their chances of needing expensive, intensive, and long-term care are very low (in fact, one in three young American between 18-34 did not purchase health insurance).  This tends to also reflect the fact that younger adults within the labor force are relatively poorer compared to their middle-aged or older counterparts that have worked 20+ years and have accumulated wealth and higher incomes over time.  Just as the low-risk individuals recognize their low chances of needing expensive care, so do insurers.  Insurers expect to pay significantly less for their coverage compared to their high-risk counterparts.  They are cheaper to insure.

So what does this have to do with ACA’s individual mandate? 

Insurance companies calculate premiums based upon the total cost they expect to pay to insure all their customers who have purchased health insurance.  For simplicity, we add together the expected cost of insuring high-risk consumers with the expected cost of insuring low-risk consumers.  This is the expected total cost of insuring all consumers.  To calculate the premium each consumer must pay, we divide the total cost by the number of consumers in total (high-risk + low-risk).  The premium is therefore an average price that high and low risk consumers pay. 

The low-risk pay more in premiums than what they receive, and that “left over” care provides for high-risk, who pay less in premiums than what they receive in care.   So, the low-risk consumers pay for the high-risk consumers’ “extra care. “ (This gets a little more complicated when we add in that companies also have to make a profit, but here we will assume the company is just breaking even in its commitments to cover its consumers.)

But what happens when the low-risk are relatively low-income young laborers who have decided health insurance is an unnecessary extra cost they want to avoid?  This means the average premium rises, because there are less low-risk consumers and less “left over” care for the high-risk.  Consequently, insurers raise their premiums to make up for that lost “left over” care. 

The individual mandate requires all (with few exceptions) consumers to purchase health insurance and therefore drive the average premium down. 

The mandate protects against this adverse selection.  And it protects against upward spiraling costs.

However, one of the major arguments against the Healthcare bill has been that the mandate is too weak!

            “The adverse selection death spiral

The problem, as PwC points out, is that the individual mandate is too weak. “While the new market rules [regarding pre-existing conditions] are implemented in full in [2014], the individual coverage requirement is…phased in gradually.’”