Jon Walker writes about the decision of private health insurers in Massachusetts to withhold offers for new plans in the state’s Health insurance "Connector." That follows the Boston Globe report of a decision by Massachusett’s insurance regulator to deny most of the requests by insurers to raise their insurance premiums.

Jon traces the problem to the absence of a public option, which could guarantee consumers an alternative/safety net if the private insurers withhold their products. He also faults the ability of private insurers to sell insurance outside the exchange/Connector. I think he’s right, but there’s an even more fundamental problem at work here, and it reminds me of what happened in California’s electricity market.

The short version is that Massachusetts appears to be inadvertently fostering an artificial shortage in health insurance. And they’re doing it for the same reasons that California authorities inadvertently created or exacerbated artificial shortages in electricity that repeatedly caused blackouts during the 2000-2001 crisis.

We’ve seen this before, and unless Massachusett’s Governor and regulators are smarter than California’s Governor and Public Utility Commission, this is not going to turn out well. So what’s going on?

One way to think about this is to ask how the Massachusetts Connector, its health insurance exchange and the model for the exchanges in the national health bill, is supposed to work. The academics who sold this concept to Republican Governor Romney and the Democratic Legislature convinced officials that private health insurers would charge reasonable prices if they were forced to compete in a transparent "market" by offering more or less uniform products whose quality and features were ensured by regulatory oversight. In other words, the competition itself would lead to efficient prices.

On top of this, state insurance regulators would retain some limited authority to review premiums charged by the insurers. But that implies that the scheme’s creators weren’t convinced the market would produce fair prices. They’d have to be limited by regulation.

When the State’s regulators disallowed almost all of the insurers’ proposed premium increases for the Connector/insurance exchange, the State was effectively saying, "the exchange market doesn’t work, and we can’t rely on the consumers shopping on the exchange market to drive prices down to reasonable/fair/efficient levels." In short, the entire premise of the "market structure" just collapsed.

But if the flawed insurance market can’t produce efficient prices, then by definition we’re in a regulatory cost-of-service paradigm. There is a whole body of literature and a hundred years or experience explaining how you regulate utility rates.

The essential principle is a "regulatory bargain," in which the service provider — the utility — is obligated to serve (think guaranteed issue in the insurance sector), but the regulator has an equally important obligation to set rates at levels that will allow the utility/service provider to recover all of its prudently incurred costs plus a reasonable opportunity to earn a reasonable rate of return of/on capital. The profits from these rates have to be sufficient to allow a reasonably managed firm to attract sufficient capital to continue meeting the provider’s obligation to serve.

In this regulatory framework, when Massachusetts authorities rejected the insurers’ proposed premium increases, the insurers translated that to mean the State had broken the regulatory bargain. In their view, the regulators were not allowing them to pass on rapidly rising health care costs and were thus forcing the firms to do business while losing money. In essence, they’re saying, "we cannot stay in business by operating at a loss, so we will withdraw from the market."

Of course, regulators disagree; they claim that lower premiums would be sufficient to recover costs, and costs don’t appear to be rising as fast as proposed premium increases. In a large state, such regulatory decisions usually take months to consider and document, after combing the utility’s books and extensive contested hearings. It’s not clear that happened here.

But of course, the designers of the health insurance market never assumed that all suppliers might react to a negative decision by withholding supply and creating a shortage. They expected the market to drive prices down to marginal costs, but it didn’t. Now what?

In California, when the Governor and PUC failed to understand this problem, that convinced lots of electricity suppliers to withhold power from the market, causing artificial shortages. The State dug in its heels, the market collapsed, and the lights went out because many suppliers refused to operate without being paid. [Different generators were withholding for different reasons, some legitimate, some not.]

Eventually, two of the largest utilities in the world were driven into insolvency/bankruptcy, along with several independent power companies. The state took over power contracting for the bankrupt utilities, and it spent almost 10 years trying to get out of the terrible contracts they negotiated. But ratepayers still had to pick up the tab when the smoke cleared.

And what happened to Governor Gray Davis? He got Terminated.

So good luck to Massachusetts officials. If your market doesn’t work to set reasonable prices, then you need to acknowledge that and start thinking like serious regulators; you’re going to have to get a lot deeper into cost-of-service regulation than you ever imagined.

And setting rates is more than making consumers happy; you also have to allow premiums that keep the insurers from withholding service or withdrawing completely. Welcome to cost-of-service regulation of essential public services.