How to Choose a Cost-Effective Health Insurance Plan
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
Choosing a health insurance plan can be one of the most economically consequential decisions you’ll make. It’s also incredibly complicated. A recent study found that as few as 14% of Americans were able to define the basic cost-sharing concepts fundamental to most health insurance plans. In addition, trying to decide amongst several highly differentiated plans can be nearly impossible. It’s no wonder that a majority of Americans select suboptimal healthcare plans, resulting in thousands of dollars of unnecessary spending each year.
In what follows, I breakdown the fundamentals of health insurance and provide a straightforward way to compare the costs of different plans. With open enrollment right around the corner, my goal is to help you save time, stress and money by helping you select the most cost-effective plan possible.
Fundamentals of Health Insurance
Insurance is built on the idea of risk pooling, or cost-sharing. Individuals who suffer an unplanned financial loss are subsidized by those who don’t. Consider your homeowners insurance. The risk of losing your home to a natural disaster or fire is shared across thousands of policy-owners, each of whom pay a premium to their insurance company whether they go on claim or not.
Health insurance works much the same way. Plans typically have the following basic components: premiums, deductibles, copayments and/or coinsurances, and out-of-pocket (OOP) maximums. Your premium is the minimum amount you’ll pay each month, even if you never require care. If you do, your deductible is the amount you’ll pay before your insurance pays any benefits. Copayments (copays) and coinsurance are two kinds of cost-sharing measures, which kick-in once you’ve met your deductible. Copays are a set amount of money you pay for specific services, while coinsurances are a set percentage of the costs you pay for specific services. Your OOP maximum is the highest amount you’ll pay for care, including copays and coinsurances and in addition to the premium, over the course of a year.
Compare Out-of-Pocket Costs
The fundamentals of risk management remind us of the importance of protecting ourselves from risks with high severity losses. Having to replace a broken cell phone, or even a totaled car, is unlikely to significantly disrupt your financial future. In contrast, having to pay out-of-pocket for medical care if you become seriously hurt or ill can alter your financial plans dramatically. From a financial perspective, this means selecting a health insurance plan that provides maximum protection against the risk of a large financial loss. In practice, this means focusing on plans with low combined OOP maximums and premiums. Although low copays and coinsurances are nice, financially speaking, they are not the most important feature of your health insurance.
Consider the following plans.[1] At first glance, it’s not clear which is the most sensible. Each has its pros and cons. Plan A has the lowest premium and deductible. Plan B has the lowest coinsurance rate. And Place C has the lowest OOP maximum.
Let’s first compare Plan A and B, by plotting total out-of-pocket costs (Y-axis) against total medical costs (X-axis).[2] As compared to no insurance (grey dashed line), both plans provide protection against runaway out-of-pocket costs. If you require no (non-preventative) care throughout the year, you’ll only pay the annual premium (first dot). If you require some care, you’ll pay out-of-pocket until you reach your deductible for the year (second dot). If you require additional care, you’ll pay a percentage of that care (coinsurance) until you reach your OOP maximum for the year (third dot). Once you reach your OOP maximum, your insurance picks up the tab for the remainder of the year.
In this example, Plan A dominates Plan B, meaning it will always cost you less money, no matter how many medical bills you rack up. (Graphically, each point on the orange line is lower than the blue line.) From a financial perspective, you always prefer Plan A over Plan B.
Now, let’s consider Plan C. First, Plan C dominates Plan B, meaning we can focus our attention on comparing Plans A and C. Second, you’ll see that the lines for Plan A and Plan C cross one another at some point. This means that once your medical costs reach about $10,000 for the year (black X), you’re better off choosing Plan C, and vice-versa.
Because you can’t perfectly predict your future medical expenses, it’s impossible to pick the best plan with absolute certainty. However, the fundamentals of risk management remind us to focus on reducing the risk of high out-of-pocket costs. Also, behavioral finance tells us that people prefer avoiding losses to obtaining equivalent gains. Therefore, selecting Plan C is your best option. Although it has a higher premium, deductible and coinsurance rate than Plan A, its lower combined OOP maximum and annual premium makes it the safer option. Even though you might save some money with Plan A if you happen to need relatively little care during the year, you’ll be relatively better off with Plan C if you happen to need a lot.
Balance the Costs and Benefits
Choosing a health insurance plan, whether it’s through your employer, statewide marketplace or Medicare, can be challenging. To be successful, first eliminate plans that don’t meet your immediate needs. For example, certain plans may not cover your current provider(s), include certain benefits you require, or offer out-of-network coverage. Next, compare the basic components of each plan and eliminate any that will always cost you more money, no matter how much care you require. Lastly, select a plan that provides maximum protection against out-of-pocket costs if you need relatively more care during the year, while providing reasonable protection if you need relatively less. In practice, this means focusing on plans with low combined OOP maximums and premiums.
Footnotes
[1] For simplicity, I assume these plans have coinsurance and no copays. If a plan has copays, either in addition to or in place of coinsurance, the analysis can be more involved.
[2] Thank you to Rick Connor for the idea of plotting out-of-pocket costs vs medical costs. His article at HumbleDollar is one of the best I’ve read on the topic of choosing an employer health plan.