Uwe E. Reinhardt is an economics professor at Princeton.

One controversial feature of the health reform bill winding its way through Congress is “community rating.” The term has a mellow ring but is apt to be divisive. It allows opponents of the legislation to claim, with a straight face, that it will substantially drive up health insurance premiums.

It also allows proponents to claim, with a straight face, that the measure will drive down premiums and provide coverage to Americans who otherwise could never have afforded it.

I will discuss this concept in this week’s post as I would teach it to a freshman economics class, ending with a question. Next week, I shall argue that community rating has long been widely accepted in the United States — especially among members of Congress — and in virtually every other industrialized country.

“Community rating” refers to the practice of charging a common premium to all members of a heterogeneous risk pool who may have widely varied health spending for the year. It inevitably makes chronically healthy individuals subsidize with their insurance premiums (rather than through overt taxes and transfers) the health care used by chronically sicker individuals.

The purpose of any insurance, of course, is to do precisely that: redistribute the financial burden from the unlucky to the lucky members of a risk pool. The crucial distinction is whether that redistribution occurs “ex ante,” through the premiums paid into the pool, or “ex post,” through the claims made on the pool. It is a subtle point.

We can use the stylized numerical example in the table below to illustrate the point. To make the example textbook-simple, we assume that individuals either will not have medical bills at all in the coming year or, if they do, these bills can have only one of three distinct sizes. In real life, of course, individuals would be spread over medical bills of many more different sizes. We assume further that there are two distinct cohorts, A and B. Once again to keep it simple, let’s assume they are of equal size — e.g., 100,000 members each — although this is not a crucial assumption. It just makes the math simpler.

If cohorts A and B were perfectly segregated by expected risk, as we assume here, then within each cohort it would be impossible to predict which member would end up in which row of the table. In the real world, an unregulated, price-competitive market for individually sold health insurance will in fact tend to segregate populations into such pure risk classes.

To continue with our illustration, suppose that the members of each risk cohort decide to form a cooperative into which each member will pay a common premium P at the beginning of the year, after which the pool will pay 100 percent of any medical bill incurred.

The premium P has two components: (1) the money needed to pay medical bills and, which we shall call the “pure premium,” and (2) an overhead allowance for managing the insurance scheme.

Let’s focus strictly on the pure premium, that is, the money needed to pay claims. Call that pure premium X. Actuaries would calculate it as the sum of the sizes of medical bills, with each bill-size multiplied (weighted) by the expected frequency of its occurrence.

For risk pool A, for example, actuaries would calculate X as

X = (.85)$0 + (.11)$5,000 + (.03)$30,000 + (.01)$100,000 = $2,450.

If every member of cohort A paid $2,450 into the risk pool and the actuary had been accurate in predicting what fractions of that cohort would have medical bills of different sizes, then the sum of paid-in premiums would be just large enough to pay the medical bills of any member requiring care during the year (abstracting, once again, from administrative overhead).

For risk pool B, the similarly calculated pure premium would be $6,600.

Now imagine a country half of whose citizens fall neatly into risk cohort A and the other half into risk cohort B. The country’s leaders would sincerely like to assure citizens of a “fair” health insurance system.

But what would be “fair”?

Would it be “fair” that the healthy individuals of cohort A pay a pure insurance premium of only $2,450 a year, while the sicker citizens in cohort B must pay $6,600? This is, after all, how health insurance now is priced in most states for individuals.

Or does “fairness” require that the two groups be merged into one large national risk pool A & B, whose risk profile is shown in the right-most column of the table. If each member of this merged pool is to pay the same pure premium, then the latter will have to be $4,525 to break even. Such a premium would be said to be “community rated” over these two distinct risk pools.

With a community-rated premium for the two risk pools, it would be predictable ex ante that, on average, members of cohort A would be subsidizing members in cohort B. We can infer the degree of subsidy from the premiums. Relative to their premium in a perfectly risk-segregated market, the community-rated premium of $4,525 will cost members of low-risk cohort A $2,075 more and the sicker members of cohort B $2,075 less than they would have paid in a risk-segregated market. Is that “fair”?

So what should the political leaders of this imaginary country do? It would be interesting to have your reaction. It is, after all, the very question our political leaders are tackling this moment.

Should you choose to respond, would you indicate your age?