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Victims of regulatory capture

01 October 2007 Robert W Vivian, Hugh-David Hutcheson, University of the Witwatersrand

Robert W Vivian, Professor of Finance and Insurance and Hugh-David Hutcheson, Lecturer in Insurance at the School of Economic and Business Sciences of the University of the Witwatersrand takes a critical look at the South African medical scheme industry, the regulatory capture that has taken place and the impact thereof on the consumers.

Are South African medical scheme contributors victims of regulatory capture? To answer this question, we must understand what regulatory capture is. This can be explained by way of an example. Say the government is convinced that certain suppliers are exploiting the public by charging excessive prices, when in fact the public is not being exploited. To 'protect' the public, the government passes price control regulations.

Excessive prices

Now the suppliers who previously could not charge excessive prices because of competition, can get together and make application to the government to approve its new prices. This is something they could not do in an unregulated market, but are mandated to do in the regulated market. Because of price controls, they can agree on excessive prices and exploit the public. The result is that they can make monopoly profits.

Regulatory capture then, has occurred - the suppliers have captured the regulations made for the benefit of the public, for their own benefit. The regulations have the opposite effect for which they were intended.

The question is then: has regulatory capture occurred in the highly regulated medical schemes market? A look at how the free market system works will elucidate the answer to this question.

No cross-subsidisation in a free market

There is a view that the purpose of insurance is cross-subsidisation. There is, however, very little scope for cross subsidisation in an unregulated, competitive insurance market. Insurance is priced not on actual losses incurred by an insured but the expected losses of that insured. The premium is paid before the loss occurs. In order to establish the premium the insurer must examine not losses paid on behalf of the insured but risk characteristics of the insured. Equal risk characteristics result in equal premiums.

For example, men and women can be charged different premiums for health insurance because men and women have different risk characteristics. Women, for example, can give birth to children, a medical procedure to which men are not subject. In a free market, insurers compete with each other and an insurer may wish to ignore risk characteristics and charge men and women the same premium.

Discrimination

In our example, men would be cross-subsidising women. Economically speaking discrimination occurs when someone is asked to pay a higher price than that person should pay. Men are being discriminated against. However, if men do subsidise women in a free market, another insurer can come along and price the risk correctly and offer men lower premiums. The men would then purchase insurance from the new insurer at the lower price.

The old insurer will end up having only women to insure and the premiums would rise to cover the costs. Women's insurance would then be priced correctly.

An example of how the market works is the recent entry into the motor insurance market by an insurer offering women motor insurance at a premium lower than that paid by men. The new insurer has done this because its research has shown that women, as drivers, are a lower risk than men.

It is clear that in an unregulated comprtitive insurance market, very little cross-subsidisation occurs. It is interesting that those who say they want to regulate the insurance market to prevent discrimination, in fact wish to regulate the market to introduce discrimination.

Community rating South African style

South Africa's medical schemes system is the most ambitious health social engineering scheme ever undertaken. It is an attempt to put in place a national health scheme while calling it private medical health. Increasingly everything is controlled by regulation. It is a private scheme in name only. The only thing the government does not take responsibility for is the financial viability of schemes.

The medical scheme levies are not set by competitive forces. The government, by law, introduced a system it called the 'community rating' system. Community rating, is a well known controversial American concept, requiring the same rate to be charged irrespective of certain risk characteristics such as age and gender.

However, the South African system is not the same as the American system. In South Africa, the levy is supposed to increase with income. The levy is thus a form of dedicated progressive income tax, used to fund the 'private national health' scheme. Since the price is not set by competitive forces the danger of regulatory capture exists.

Consumers at the short end

The substantial cost of medical schemes the vast majority are paying, then does not benefit the public at all. It benefits the suppliers. It is evident that competitive forces are not at work to keep the prices down, if one considers the recent disclosure of the existence of the very substantial compulsory kick-backs being paid by suppliers to hospitals, to a designated closed corporation. These kick-backs should be investigated in much greater detail than it appears is happening.

It is not surprising to note that the largest cost paid by medical schemes is to hospitals. In this case, the extensive payments by the public to hospitals benefit the beneficiaries of the closed corporation, not the public.

With the extensive degree of regulation which exists in the medical schemes market, it is almost certain that regulatory capture has taken place. It is a matter that should be examined.

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