A Brief History of Public Health Insurance in the US

Any discussion of the health insurance policy debate will benefit from some historical context. Prior to the 1960’s, the U.S. government had very little impact on the provision of health insurance. Virtually all health insurance was provided through private companies.

For a private health insurance market to thrive, two conditions must exist.  The first condition is that a high degree of uncertainty must exist for both parties, the insurer and the insured. If one side of the transaction has a better understanding of the amount of risk, then adverse selection will occur.

The second condition is just as necessary but gets much less attention in public policy debates. The insured must be risk averse. This means that they are willing to pay additional money for the certainty of paying only the average cost of care. For example, suppose the average cost of caring for a group of people is $1,000 per month per person. If they are sufficiently risk averse, each person will be happy to pay a $1,000 monthly premium plus a little extra for the certainty of not having to pay a lot more than $1,000 if they incur medical bills. The little extra is the normal profit the private insurance company needs to receive in order to stay in business.

These two conditions together make it difficult for a purely private health insurance system to cover 100% of the population. People who know they are more likely to incur large health bills will pay the premium for health insurance and people who are relatively healthy and are not particularly risk averse with decline. The insurer will raise premiums to avoid losses. The end result is that premiums for people with pre-existing conditions including the elderly will be too high to afford and many healthy, risk-neutral people will choose to be uninsured.

Medicare Part A and B and Medicaid

This was, in fact, the situation in the 1960’s when Medicare Parts A (hospitalization) and B (physician services) were created to provide insurance for the elderly, disabled and people with kidney failure. Medicaid was created to provide health insurance for the poor.

These programs initially compensated hospitals and physicians on a per diem and percentage of billed charges basis. Providers quickly learned that by increasing their charge rates and hospital lengths of stay they could increase their profits. Consequently, charge rates skyrocketed. This led to a dramatic increase in the income of physicians and hospitals. So many new hospitals were constructed to cash in on this government-financed bonanza that an enormous number of unused hospital beds existed and a process to limit hospital construction (i.e. Certificate of Need) was created.

In the 1980’s Medicare Parts A and B and Medicaid reformed their provider compensation designs. For example, Medicare Part A adopted a “prospective” payment system. Instead of paying 80% of billed charges for a hospital stay, Medicare paid a fixed amount of money for each stay. The amount was determined by the diagnostic and procedure codes assigned by the hospital. This eliminated the incentive to keep the patient in the hospital longer than medically necessary. The excess number of hospital beds declined steadily for the following 20 years.

To compensate physicians, Medicare Part B now uses the Resource-Based Relative Value System (RBRVS). Like the prospective payment system for hospitals, this is a code-based system which assigns a dollar value for each Current Procedure Technology (CPT) code assigned to an office visit or surgical procedure.

Although these code-based compensation systems solved many perverse incentive problems of the old charges-based system, they have their own incentive problems. Upcoding, the illegal practice of systematically assigning more expensive codes than justified, was attempted by several hospital systems and physicians. Tenet, a large for-profit hospital chain, was found guilty of gaming the prospective payment system by rapidly increasing its cost-to-charges ratios on a yearly basis. They were assessed a large fine by Medicare and the system was reformed to prevent this type of fraud from happening again. But perhaps the biggest perverse incentive created by the prospective payment system is to encourage the early discharge of patients so that they can be readmitted a day later, thus doubling the hospital’s payment.

One thing in common that the provider compensation systems of Medicare A and B and Medicaid have is that they are calibrated to pay only the marginal operational costs of providing care. In other words, they do not cover providers’ capital costs. To cover capitals costs, providers must charge much higher rates to private insurers.

This cross subsidization is a type of indirect tax discussed in my previous posting. There are some advantages to an indirect tax that will be discussed in a future post.

Although Medicare and Medicaid are enormously expensive, they would be even more so if both systems had to cover a proportional share of capital costs incurred by providers. By shifting coverage of capital costs onto private insurers, the deadweight loss of the avoided taxes is itself avoided. Additionally, indirect taxation creates the illusion that the tax burden of these public systems is smaller than it actually is, thus making it more politically palatable.

The Clinton Administration and the Managed Care Revolution

Medicare and Medicaid addressed much of the insurance coverage gap problem, but not all of it. By the start of the first Clinton Administration in 1993, 15% of Americans were still without health insurance. These were mainly people with preexisting medical conditions and healthy, risk-neutral people who chose not to purchase health insurance.

To bridge this coverage gap, the Clinton Administration proposed a system of subsidies that ultimately failed to win approval by Congress. The media portrayed this political debacle as a victory by vested interests, but that was only part of the reason. Besides a desire to fill the coverage gap, another major motivation for this legislation was to slow the rapid increase in the cost of healthcare.

Prior to the first Clinton Administration, annual healthcare costs had been rising by 8% or greater. (See Figure 6). The adoption of Health Maintenance Organizations (HMOs) on a wide basis in the 1990’s led to a significant slowdown in healthcare costs. There was a consensus that the market, through HMOs, was fixing the problem. Therefore, the need for a costly and divisive government program was unnecessary.

Figure 6.

HMO’s slowed the growth rate of healthcare expenditures by imposing incentives on providers to better control costs. There was a focus on primary care physicians acting as gate keepers in order to decrease the use of expensive specialists. Other incentives, like capitated fees, also contributed to slower growth.

The slowdown in healthcare cost growth was only temporary, however.  By 2001, HMO enrollment had peaked and started a long decline. In 2017 according to the Medical Expenditure Panel Survey, fewer than 19% of the US population were enrolled in a private HMO and those still enrolled are confronted with far fewer restrictions than in the past.

Although the Clinton Administration’s efforts to expand public insurance coverage were unsuccessful, I included this section to illustrate a point about the American healthcare consumer. HMOs and their cost controlling restrictions proved to be effective in controlling the growth rate of costs, but were nonetheless, very unpopular. Americans do not like restrictions on their choice of provider. American employers were forced to offer less restrictive HMOs and alternative plans, such as Preferred Provider Organizations (PPO’s), in order to compete for employees.

European-style, single-payer systems share many characteristics with HMO’s. Without cost controls, these systems would experience unconstrained growth and quickly swamp their respective healthcare systems. Promising to expand Medicare coverage to all age groups while eliminating private health insurance can only work by adopting strict cost controls, the very same cost controls emphatically rejected by most Americans in the 1990’s. I do not think the politicians promising Medicare-For-All or public options that will crowd out private insurance understand the trade-off they are proposing.

Medicare Parts C and D

Medicare is popular with the public in general, but being a form of socialized medicine, has always been unpopular in conservative political circles. So, when it became clear that the lack of prescription drug coverage was a political liability, the George W. Bush administration decided to create a market-oriented system to fill this coverage gap. The result was Medicare Part C (aka Medicare Advantage) and Medicare Part D.

Medicare Part C purchases private insurance on behalf of beneficiaries. The premium paid is the average expected healthcare costs that would be spent on the beneficiary had she been a Medicare Parts A and B (i.e. Pay-For-Performance (PFP)) enrollee. To induce private insurers to participate, an extra amount is paid to provide a normal profit.

Part C has proven to be very popular and now comprises one third of all Medicare enrollees. There is evidence that Medicare Advantage plans cherry-pick relatively healthy beneficiaries and that the premiums paid by Medicare over-compensate plans. Because Part C pays more than the average cost per member, it has accelerated the annual growth rate of Medicare.

Medicare Part D allows enrollees to purchase prescription drug coverage from private insurers. Although it subsidizes the program by compensating insurers for very expensive or low-income beneficiaries, unlike Medicare Parts A and B, it does not use its market power to pay lower prices for prescription drugs. Consequently, Medicare Part D beneficiaries pay as much for prescription drugs as privately insured people.

Ironically, the market-oriented approach to Medicare Parts C and D has contributed to the acceleration of the cost of the Medicare program and especially the amount of direct taxation to fund it. These programs are particularly expensive for tax-payers and Medicare enrollees. There are two groups that unequivocally benefitted from the design of Medicare Parts C and D, however, pharmaceutical manufacturers and private insurance companies.

The Affordable Care Act

After several decades of political stalemate, the Democrats seized the opportunity to address the insurance coverage gap when they took over the presidency and both houses of Congress in 2009. Instead of exclusively using the government’s market power to provide health insurance at the provider’s marginal cost, like Medicare Parts A and B, the Obama Administration chose a combination of program types. They expanded Medicaid eligibility (i.e. the providers’ marginal cost approach) and created a health insurance exchange, a Republican-style market-oriented approach like Medicare Part D.

By subsidizing the purchase of private insurance rather than providing public insurance at the marginal cost of care, Obamacare resulted in higher payments to hospitals and physicians at a higher cost to taxpayers. In addition, healthy, risk-neutral people were penalized if they did not choose to purchase private health insurance (i.e. the individual mandate).

Despite this mandate, the number of uninsured people in the US remains far above zero. Like Medicare Part D, the benefits of the program are mixed. Many people with pre-existing conditions are able to obtain health insurance, but some are not. Taxpayers shoulder the full cost of the program, including those who feel the mandate is fundamentally unfair. The only groups that unequivocally benefit from Obamacare are healthcare providers (i.e. hospitals and physicians) and private insurers.

The Next Phase

The current status of Obamacare is the Trump Administration no longer enforces the individual mandate and the percentage of the population uninsured is now increasing after dropping significantly following its passage. Candidates for the Democratic party presidential nomination have authored competing proposals that can be generally summarized into two different categories: Medicare-For-All and a Public Option.

Like most sweeping legislative proposals, many details are left for future negotiations. The projected costs are debatable, but there are some features that can be described. Medicare-For-All is a relatively simple plan to expand Medicare (Parts A, B and prescription drug) coverage to all age groups. This simplicity is, I suspect, a major reason for its popularity in public opinion surveys.

A major flaw in this proposal is that Medicare has few constraints on costs or utilization, a feature all single-payer systems must have. With its strict limitations on costs and coverage, Medicaid is a much more realistic model for a single-payer system in the US than Medicare. Although a more accurate and honest appellation, I doubt “Medicaid-For-All” would poll nearly as well.

The Public Option has been marketed as a more moderate approach to closing the coverage gap. The basic idea is for the government to sell insurance to anybody who wishes to purchase it. This would guarantee that there would be at least one supplier of high-quality insurance at a reasonable price (i.e. premium). Private insurance companies that charge unreasonably high premiums would be forced to lower their premiums in order to compete or exit the insurance market.

The biggest problem I see with the Public Option proposals is that their premiums can be set arbitrarily low while still providing high-quality insurance. The premium the government charges need not cover the cost of capital nor operational costs for that matter. No private insurance company has the financial resources to compete with the federal government. Over time they will not be able to recoup their cost of capital and will exit the market, leaving it entirely to the government. Therefore, the Public Option is simply Medicare-For-All in sheep’s clothing, a less transparent method of achieving essentially the same end. The only difference being a premium, that even if set very low and with an enforced individual mandate, will leave many people uninsured.

The only way to provide health insurance to the entire population is to provide a public option with a zero premium. But it should not crowd out private insurance, otherwise moral hazard and runaway costs would ensue.

This might sound like a contradiction. How can a private profit-maximizing insurer compete with free public health insurance if it can’t compete with low-priced public insurance? It can’t, obviously. But it doesn’t need to. The Public Option need only solve the coverage gap problem while being less desirable than private health insurance for those who have access to it. I’ll explain more in a future posting.

Published by TheLoneEconomist

I am a PhD economist who studies just about anything and proudly specializes in nothing.

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