Focus on profit keeps insurers in good health

Economics: How depressing that, so far, none of the parties election policy platforms give centre stage to the most important issue facing the economy: reforming the microeconomy and reducing the cost of living.

The Government's recent White Paper on energy suggests a glimmer of hope. Another glimmer is the fact that, the so-called Barrington group will issue its report on the vexed issue of risk equalisation. (Today the Supreme Court may decide whether to lift or uphold the equalisation payments, putting the issue into election space).

All the ingredients you would want in a debate about the micro economy are here - the role of the State, the degree of competition in the marketplace and the Government's appetite for reform.

When, in the 1990s, EU law forced the government to liberalise the market for health insurance, the VHI faced a problem. From a position of having a virtual monopoly (which does not encourage efficient operation), it faced losing significant market share to rivals that would - or so it was feared - "cherry pick" its younger and less claim-prone customers with lower premiums, leaving the VHI burdened with the most expensive customers.

Beneath that problem is another underlying issue, the principle of "community rating". According to that principle, older people should not pay more for health insurance than younger people, despite their greater risk of illness.

Just as high unemployment and high taxation were accepted as facts of life in the 1980s - never to be questioned or changed - this principle is one of those holy cows that has persisted into the 21st century.

The elderly have, by and large, amassed masses of housing equity and have by definition accommodation costs and other living costs (eg childcare costs) that are a fraction of those borne by younger citizens. Why, gaining as they do from its positive swings, they should be compensated for its negative roundabouts is something I've never quite figured out. A far better way of protecting the elderly would be to have universal health coverage from the age of 18. Under that system, each person would "self-risk equalise" by spreading the risk of higher age related health costs over their own lifetimes.

For the moment community rating is a holy cow (despite opposition of perhaps the leading expert in the subject, Dr Ray Kinsella) and risk equalisation - whereby the VHI's competitors compensate it for the VHI's older customer profile - is mantra chanted repeatedly before it. That it is the best approach is not yet clear. Despite the VHI having two competitors during 2006, Vivas and Bupa, it not only held market share but actually gained membership. But let's go with the flow and assume that some transfer of resources to the VHI from its competitors is needed.

If so, it throws up huge issues for competition in the marketplace, questions that the Barrington report will be hard put to answer.

To illustrate the first of these, consider the basic maths of risk equalisation. Let's say an incumbent and its rival in the health insurance market both earn €100 million in premiums. Having an older customer profile, the incumbent's claims amount to €95 million. With operating expenses of €15 million, it makes a loss of €10 million. Having a younger customer profile, the rival pays only €75 million in claims. Assuming that it has the same operating expenses of €15 million, it makes a profit of €10 million.

Now if the Government orders the rival to transfer say, €10 million, of its revenues to the incumbent, then what economists refer to as "supernormal profits" eg, profits above and beyond those needed to stay in business, are wiped out. A fair outcome, I hear some of you say. But this is only a stylised example. In the initial phase at least, entrants to the market will face relatively higher costs of operation as they incur higher advertising and marketing costs establishing their brand, not to mention other fixed costs.

Their revenues need to be lower, given the inertia that binds many customers to incumbents in any market. For these reasons, if operators like Vivas and Bupa are making profits, it must be because they have compensated for the fixed-cost pressures associated with market entry by keeping day to day running costs significantly lower than the VHI.

With the three-year derogation from payments now gone, risk equalisation will penalise market entrants for being efficient and productive. This is an aspect of Ireland I thought we had left behind. Obviously, I was wrong.

In rejecting Bupa's challenge to risk equalisation in the High Court, Justice Liam McKechnie appeared to acknowledge that the policy would make it hard for the company to earn profits in the long run. Without Bupa's big pockets or established brand - which just about make entry viable for it - smaller entrants won't have a chance.

Assuming community rating and risk equalisation are things we are stuck with, the Barrington report must address how real and fair competition can thrive in the market place. Whatever some people might say, allowing the profit motive to work is the only effective way of guaranteeing quality and cost-effective services in the long-run. The chronic absence of that motive right across the health service is the core reason why its record on cost inflation, productivity and efficiency is so lamentable compared to the rest of the economy.

Of course, there is a far better way of achieving community rating than risk equalisation: simply take a proportionate share of the VHI's older customers and transfer them lock, stock and barrel to its rivals. The idea is not just accepted, but actively promoted by both of the VHI's rivals. It would avoid devising messy and controversial formulae to calculate risk equalisation transfers and put all competitors at the same starting line for the race to come.

Come to think of it, it would also spare commentators like myself from having to write about one of the most horrendously complex issues in modern economics. Go for it, I say.