For large companies, the evolution of the prepayment concept means that each year’s premiums are determined by last year’s costs. Employers pay in health insurance premiums an amount equal to the cost of whatever their employees consume. That is one of the reasons why so many large employers self-insure, sometimes using insurance companies to administer their plan. In a sense, self-insurance merely formalizes a relationship that was previously implicit between the employer and the health insurance company. Moreover, because large employers have many employees, they have a self-contained insurance pool, and their total costs are reasonably predictable.

Insurance as prepayment for the consumption of medical care has wreaked havoc among small employers, however. The principal reason why small businesses purchase health insurance is to avoid the risk of having to pay unexpectedly large medical bills. However, because the policies they purchase are not real insurance, when a small company generates a large claim, the insurer may triple or quadruple the company’s premiums and may even cancel the policy. Thus, employers who thought they were buying insurance are surprised to find out that there is very little risk sharing and, instead, they are mainly expected to pay their own way.

Before turning to solutions, it is worth contrasting small group insurance with the market for individual and family policies - about the only market where real insurance is still sold. In most states, insurers cannot raise an individual’s premium without raising all other premiums (for the same type of policy) by an equal amount. Thus, insurers can’t single out those who get sick and charge them more than others. Moreover, the more they raise the premiums for all policyholders, the greater the risk that healthy ones will leave the pool and buy a low-priced policy from some other insurer. Problems in the market for small groups are now stimulating reform movements in almost every state, but some reforms will only make the problem worse.

One of the reasons why many of our health care institutions evolved was to prevent the development of a competitive health insurance market. In the 1950s, opponents of unfettered insurance markets favored "community rating," a system under which everyone paid the same premium, regardless of age, sex, occupation, or any other indicator of health care risk. Such a system was bound to fail. If everyone is charged the same premium, it will be too high for healthy (low-risk) people and too low for less healthy (high-risk) people. As fewer healthy people buy health insurance, the premium needed to cover the health care costs of those who do buy will rise, in a continuous upward spiral.

Today, the intellectual heirs of community rating favor its return, either in a pure or modified form. Central to all their reform proposals is the notion that insurers should be forced to sell to anyone who wants to buy ("guaranteed issue") at prices that do not reflect real risks. Of course, the modern versions of community rating face the same problems as the older version. That is why the modern advocates also often favor employer or individual mandates which would force people to buy health insurance whether they want to or not. The ultimate reform along these lines is national health insurance, a system under which everyone is forced to pay a tax (price) that is also unrelated to real insurance risks. Opponents of competitive markets usually think the purpose of health insurance is to pay medical bills. By contrast, in a competitive market, the purpose of health insurance would be similar to the purpose of any other type of insurance—to allow people to protect their assets by transferring risk to others. Accordingly, an ideal system would place a high value on pricing risk accurately and encouraging a competitive market that will accomplish that task. As in the case of life insurance, however, once people have purchased a policy, insurers should not be able to change the rules of the game simply because an individual’s probability of filing a claim suddenly increases.

Many of the problems in the market for small group insurance would disappear if small group insurance functioned in the same way as individual insurance does. One way of moving in that direction is to individualize employer-provided health insurance. Many of the problems in the market for individual insurance would disappear if health insurance more closely resembled life insurance.