Two Twisted Knees, Two Very Different Insurance Plans

To understand how the mix of public and private insurance affects the cost of health care in the United States, consider the hypothetical case of Mark and John, two 65-year-old friends who slip on the same muddy patch on the golf course and sprain their knee.

John relies entirely on public health insurance, and as he hasn’t yet fulfilled the annual deductible, the amount he must pay out of pocket before insurance kicks in. A doctor’s visit would cost him more than $100, or even hundreds of dollars more if the doctor orders an x-ray or MRI—which she will, because few injured knees can be definitively diagnosed without one. In fact, there’s no end to what John might owe, because the public plan he relies on, traditional Medicare, does not cap his out-of-pocket expenses. Knowing this, John applies ice to his knee, takes some pain medicine, and resigns himself to a temporary limp.

Mark also has public insurance, but in addition he holds a supplemental, private policy that covers his out-of-pocket expenses. The policy is great for Mark at times like this, because he can get his knee treated for free. Mark, not surprisingly, hobbles immediately to a doctor, who sends him to a radiologist. The end result: both men’s knees will be fine in a few weeks, but Mark’s knee will cost taxpayers hundreds, if not thousands of dollars more than John’s.

The US has a much-criticized system of health care—and some would call it systems. Many people rely entirely on private health insurance, often purchased through employers. Others, including veterans, low-income people, and seniors such as John, rely entirely on public insurance. And still others, such as Mark, rely on a combination of public and private insurance.

That combination is key to the future of US health care. The Patient Protection and Affordable Care Act, signed in 2010 and better known as Obamacare, provides a broad framework for universal health insurance, and its long-term success depends on a partnership between the government and private insurers. But is that a wise or a doomed compromise?

Neale Mahoney, assistant professor of economics and Neubauer Family Faculty Fellow at Chicago Booth, is analyzing and quantifying the effects of various mixtures of public health-care funding and private health-care markets. His findings offer reason for optimism but no silver bullet: the details are critical to building a national health-care system the country can afford and sustain.

Transforming an expensive system

The US, it is safe to say, runs the most inefficient health-care market in the developed world. The country spends the equivalent of almost 18 percent of its GDP on health care, more than 200 other countries for which the World Bank collects data. For example, the Netherlands and France, two of the biggest European health-care spenders, spent 12.4 percent and 11.7 percent, respectively. Avoidable emergency-room use, duplicated medical testing, and high administrative costs all inflate spending in the US, according to a 2014 report by the Commonwealth Fund, a private foundation whose mission is to promote a high-performing health-care system. Yet the same report ranks the US at the bottom of industrialized economies for quality of health care, lagging behind on measures including healthy life expectancy, and leading the list in infant mortality rates.

Some critics blame Americans’ distrust of big social-welfare programs. In stark contrast to the universal coverage seen in the rest of the developed world, some 47 million Americans had no health-care insurance in 2012. But for many decades the US government has provided well-loved public health care, in conjunction with private markets, for millions of citizens.

The most popular such program is Medicare, the program for US seniors that collects (or exempts) affordable premiums from roughly 54 million enrollees. Medicare pays private doctors and hospitals for the medical work, and it sometimes pays private insurance companies to assume the liabilities. Medicare is so beloved by seniors that most politicians in Washington consider it career suicide to endorse cuts in the program.

Obamacare, attempting to expand health-care collaboration between the public and private sectors, introduced government-run health-care exchanges that let any citizen buy private insurance, often with government subsidies for the premiums.

While Obamacare is a work in progress—and a contentious one at that—much of the rancor surrounding it lies in a fundamental disagreement over whether private markets can deliver health care more efficiently. Many people challenging the law want to offload more of the government’s work on to the private sector.

Representative Paul Ryan, for example, proposes a Medicare voucher program whereby Medicare would give seniors vouchers to buy private insurance instead of relying on Medicare to pay their bills. Other lawmakers want Obamacare replaced with incentives for more businesses and organizations to buy traditional private health insurance for employees and members. However, cost-saving measures that work in traditional markets can backfire at the junction of public and private health care.

“We spend a lot on health care and don’t get the best results,” Mahoney says. “It’s an interesting economic subject, because you realize that markets for health care don’t always work perfectly.”

Tax supplemental insurance

Mahoney has had a front-row seat in this debate throughout his career. As a graduate student at Stanford University, he joined a research project that addressed problems created when less healthy individuals flocked to higher-benefit insurance plans. He continued to study health-care markets as a Robert Wood Johnson Fellow in Health Policy Research at Harvard University and a consultant at McKinsey & Co. He worked in the Obama Administration to help create the Affordable Care Act.

Television advertising got him thinking about the havoc private competition could wreak on cost-saving efforts in the new system.

“I was watching television during the open-enrollment period, and every third ad was for Medigap,” he recalls.

Medigap is supplemental insurance offered by private insurers that Medicare enrollees can buy, and about 86 percent of traditional enrollees have Medigap or supplemental insurance from a former employer or union.

Unlike most private insurance policies, Medicare does not cap the amount a patient can owe. The most popular Medigap policies cover co-pays (payments made by someone receiving a medical service) and deductibles.

“The economist in me said, ‘Wait a minute, Medicare was supposed to include cost sharing,’” says Mahoney. “This basically defeats the purpose of cost sharing that was supposed to save the taxpayers money.”

Economists have long understood that lowering co-pays and deductibles increases health-care spending. And lawmakers often bounce around the idea of taxing the Marks of the system for their Medigap plans as a way of recouping these extra costs.

But tax proposals have been tricky, because for a long time, no one knew exactly how much Medigap plans raised costs. Research in the 1990s led by Susan Ettner, now of the University of California, Los Angeles, found that Medigap increased Medicare spending by about 25 percent. However, these studies compared people who bought Medigap policies to Medicare patients who didn’t.

The findings were complicated by questions of whether the typical buyer of Medigap coverage is less healthy—and therefore inherently a heavier user of services—than other Medicare recipients.

Mahoney and University of Texas at Austin economist Marika Cabral tackled this problem by looking at the overall spending of Medicare patients in health-care service areas that straddled state borders. On the borders, they found demographically similar populations who used the same doctors, clinics, and hospitals. But the rate of Medigap coverage was often vastly different on opposite sides of a border.

Medigap premiums are based on a state’s average health-care costs, and as a result, they vary widely from state to state. New York City’s notoriously high health-care costs, for example, drive up Medigap premiums for all the state’s residents. As a result, rural New Yorkers using the exact same health-care services as their neighbors in Vermont pay 40 percent more in monthly Medigap premiums. New Yorkers are, unsurprisingly, far less interested in buying Medigap than Vermonters.

The researchers find that areas with more Medigap coverage spent significantly more on health care than their cross-border counterparts. Medigap coverage increased physician claims by 33.7 percent and claims for hospital stays by 23.9 percent. Overall, Medigap coverage increased Medicare costs by 22.2 percent.

The differences in premiums and Medigap purchasing rates within single health-care service areas also allowed the researchers to estimate demand for the policies at various price points. They calculated that a 15 percent tax on Medigap premiums would generate combined tax revenue and cost savings of $12.9 billion annually.

Privatization works . . . in some places

Although Medigap plans utilize private health-care markets, they still require the US government to reimburse health-care providers for every service. The added “insurance” consists of cost protections solely for the patient. Medicare pays for any uptick in the utilization of medical services. Perhaps the government could avoid these consequences by farming out the insurance responsibility to the private sector—a popular idea in Washington, at least among Republicans.

But would privatized Medicare benefit seniors, whom it was designed to protect? And what about benefits to the government—would any efficiency gains simply convert to profits that a private system demands? According to Mahoney’s most recent research, it depends on where the patients live.

“This is one of the issues with using competitive markets to deliver health care: it works if there’s enough [population] density,” he says. “It doesn’t work in large areas of the country where there’s not.”

Mahoney, Cabral, and University of Texas at Austin economist Michael Geruso are studying the effects of certain payment reforms in Medicare Advantage, a form of privatized Medicare used by 15.7 million Americans. The researchers, by quantifying the benefits to patients and to insurers when government funding rises, offer insight into the type of markets needed to make a Medicare voucher plan worth the government’s money.

In Medicare Advantage plans, which cover roughly 30 percent of today’s Medicare enrollees, a private insurer collects a per-person fee from Medicare for a patient, as well as an additional premium from the patient.

Unlike Medigap, Medicare Advantage companies become the main insurer for the patient, assuming liability for all medical bills that Medicare would have paid. Many of these policies also offer benefits that traditional Medicare does not, such as vision and dental coverage. These companies usually contain costs by limiting the health-care providers for which patients can be reimbursed.

Mahoney and his colleagues looked at county-level Medicare Advantage data between 1997 and 2003, which covered four years before and three years after legislation dramatically raised per-patient payments in many counties. They studied rate books, contracts between Medicare and insurers, county-level enrollee summaries, and premium reports. They also analyzed trends in co-pay spending and the types of extra services covered, such as hearing, dental, and prescription-drug benefits. They assigned dollar amounts to the benefits patients received.

The researchers find that on average, insurers passed on to patients about half of the increased per-person fees they received. Most of the rest went to profits. The better benefits Medicare Advantage offered often led to lower premiums and co-pays, sometimes including additional coverage for things such as hearing aids.

However, the results varied greatly depending on the number of local Medicare Advantage insurers. Insurers in the least competitive markets passed on only 13 percent of the extra benefit to patients. Insurers in the most competitive markets passed on 74 percent.

Previous research concluded that Medicare spends more on enrollees in Medicare Advantage plans, and because of those findings, Obamacare dramatically cut payments to Advantage. Mahoney’s research suggests that the system can in fact be cost effective where there’s enough competition.

A model to help avoid ‘adverse selection’

One of the biggest worries about Obamacare is that only the most expensive patients will buy into the plans offered through health-care exchanges. Researchers call this situation, a serious concern, “adverse selection.” A lot of people with preexisting conditions could tank the entire system: the higher average health-care costs of this group would cause premiums to rise, which would cause even more young, healthy individuals to turn away from the plans, which would cause premiums to rise even more. It’s a vicious, well-documented cycle.

To prevent this, the government agreed to pay insurance companies risk-adjusted payments. These payments are supposed to give insurers the additional income they need to pay the bills of these higher-risk pools without collecting higher individual premiums. But do we really understand the effects these risk payments will have on the market?

Risk adjustments could create unintended consequences, Mahoney notes. For example, an insurer facing a pool of expensive beneficiaries has every incentive to keep premiums low to attract younger, healthier people. Risk adjustments could undermine that incentive, especially for an insurer who has little or no competition.

More generally, Mahoney realized that competition and adverse selection often interact: an insurer left with sicker patients because of adverse selection would presumably be unlikely to lower patient premiums or co-pays. But in a highly competitive market, it might be compelled to keep patient costs low in order to attract healthier customers to offset the spending of sicker ones.

Working with E. Glen Weyl, currently a researcher at Microsoft Research New England and on leave from the University of Chicago, Mahoney is conducting theoretical work that both economists hope will lay the groundwork for more empirical analysis in this area. The theoretical models allow researchers to see and analyze some of the counterintuitive effects of imperfect competition in health-care markets.

This gets us back to Mark’s knee: Could public and private insurance work together more optimally to save Medicare money on it? Mahoney’s research indicates that Medicare could tax his Medigap plan. Or if Mark lives in a competitive market, Medicare could subsidize a private insurer to take over his coverage. Future findings will have more suggestions, to address sprained knees and many other ailments