HealthCare Exchanges: Insurance products and other similar products whose risks and profitability models are dependent on the number of consumers buying should not be fully privatized.

The idea of exchange as I see is a mechanism to let loose market forces under a controlled environment. Setup a framework by having a set of well-defined laws, clearly define, quantize and standardize the value of whatever to be exchanged and finally give access to whomsoever would like to participate in the exchange activity. Simple as that, as they say and moreover it is , faster and cheaper than the lawyer-intensive process of negotiating bilateral licenses for intellectual property, the high cost of which discriminates against small companies. Too add more adjectives; it is collaborative, transparent and meritocratic.

I would argue that it is not that simple, because we need a solid in depth understanding of the nature of the concept ‘value’ that is being exchanged at the exchanges. We need to understand how it varies individually and also in groups (when coalesced together with other ‘value’). Strictly speaking, the exchange ‘value’ of anything (let us say commodity) is not identical to its price, but represents rather what (quantity of) other commodities it will exchange for, if traded. If that is the case, then price is a metadata tag with which we give the commodity a meaning in the world of finance. If we call this a notional price then the real price at which the commodity might exchange may be different i.e. the market price.  So there is a distinction between value of a commodity (notional price) and a market price.  Identification of the notional price is very subjective; depend on the present owner of the commodity and his/her perception of what he owns. Typically it will be cost of production plus markup. Market price is dependent on the demand-supply and the ability of the market participants to pay or as modern finance will say, it is dependent on the concepts of arbitrage-free, risk neutral valuation.

Notional price is the ‘value of a commodity’ as determined by the owner after considering its unique characteristics, cost of production, and owner’s perception of market swings and so on. While for certain products (like say vegetables in the vegetable market), it is rather simplistic representing the average quantity of human labor which is necessary to produce them, for others like financial instruments it is little deeper. The nominal price should not only represent the labor (all the research and other works) needed to produce; it also has the additional task representing the risk of that which it represents. Sometimes the price of this risk is way more than the cost of production of a financial instrument itself.  Say a stock, which represent the risk of performance of the underlying company or a bond which represent the credit risk of the bond issuer.

For most of the cases, be it a commodity ( like wheat, apples, fish) or simple financial products ( like stock and bonds ) the magnitude of the value of this risk is primarily not dependent on buyers of this product. Yes we can argue all the sides like the perception risk (dependent on buyer) and so on but for all practical purpose it is not, at least not like the way insurance products are dependent on. This I think is fundamental problem to be addressed in a healthcare exchange phenomenon or as a matter of fact for any exchange of insurance products. Two fundamental concepts on which insurance products values are dependent on are

·         law of large numbers (LLN) : According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed.

For example, if a fair coin (where heads and tails come up equally often) is tossed 1,000,000 times, about half of the tosses will come up heads, and half will come up tails. The heads-to-tails ratio will be extremely close to 1:1. However, if the same coin is tossed only 10 times, the ratio will likely not be 1:1, and in fact might come out far different, say 3:7 or even 0:10.

·         concept of a  ‘weighted probability.’: a technique to find the total expected value of multiple events.

So let’s play this game:

• We are a small insurance company that insures 1000 people.
• Let’s say that 1 house will get flooded per year.
• So the probability of a house getting flooded is (1/1000)
• Therefore the probability of a house not getting flooded is (9999/1000)
• If a house gets flooded, we will have to pay $500,000
• Every person pays you $50 a month, $600 per year

According to the formula: (E[X] = x₁p₁₊ x2 p2+....xkpk) where X can take value x₁ with probability p₁, value x₂with probability p_2.

-500,000*(1/1000) + 600*(999/1000) = -500 + 599.94 = 99.94

So we will make $99.94 on average per person insured. Therefore you’ll make 1000*(99.94) = $99940.

The LLN guarantees stable long-term results for the averages of some random events. For example, while a casino may lose money in a single spin of the roulette wheel, its earnings will tend towards a predictable percentage over a large number of spins. Any winning streak by a player will eventually be overcome by the parameters of the game. It is important to remember that the LLN only applies (as the name indicates) when a large number of observations are considered. There is no principle that a small number of observations will coincide with the expected value or that a streak of one value will immediately be "balanced" by the others (i.e. gambler’s fallacy).

The nominal price and thus the premium amount of an insurance product is dependent on the above two concepts which in turn is related on the number of consumers consuming the product. This relationship is direct and will determine the existence of the product. There is almost none or little influence of financial economics of no arbitrage, risk neutral pricing on the market price. Market price of an insurance product is determined by actuarial probability, then why do we need an exchange ( in the sense NYSE operates)  like market place to manage competition. We can have a market like the vegetable market, where there are buyers and sellers, usually buyers do not become a seller.  There exists a profitability model for insurance product and competition for that profit is in distribution i.e. how many consumers can you enroll.

Anything that has profitability model can be privatized or rather to privatize any service we need to find out a profitability model.  Most common thinking is that well defined profit motive makes an organization more efficient, reduces waste i.e. deliver more for less. On the whole this is good for a society. This is the thinking behind privatization of the health care industry.

I would argue this is not always true; profit motive can make an organization more efficient but not more effective. Services , not only health care, but those which affect a large number of people , should and will always have certain other well defined goals other than pure profit.  In that scenario, single minded focus on profit, or marketplace built to just enhance that will defeat the very purpose of the existence of the service.

There should be a balance, while controlling costs, organizations should try to meet all the goals to justify its existence. Not sacrifice everything to the altar of profit and costs.

It is for this reason I believe that healthcare insurance and many other similar services in involving a large number of people should be semi private. Slight privatization will bring in the cost efficiency while the part public will harness motivation of providing quality service with other more larger goals in mind.