The Economics of Obamacare (Part 2): Analyzing the U.S. Health Insurance System

It’s impossible to evaluate the impact of the recently affirmed U.S. health care law without delving into the data. In this post, I’ll review the history of the U.S. health insurance market and analyze the cost pressures that have built up in the system over many decades. These factors inform my view that the impact of Obamacare on U.S. health care will unfold in three distinct phases, each with important implications for health care investors.

Let’s start the analysis by looking at the history of U.S. health care spending.

United States: Total Health Care Expenditures 1960–2010 ($ in Billions)

United States Total Health Care Expenditures 1960 2010 The Economics of Obamacare (Part 2): Analyzing the U.S. Health Insurance System

Sources: CMS, CFA Institute.

Relative to the rest of the economy, health care continues to grow faster, taking an ever greater share of GDP, as noted below.

United States: National Health Spending as a Percent of GDP

United States National Health Spending as a Percent of GDP The Economics of Obamacare (Part 2): Analyzing the U.S. Health Insurance System

Sources: CMS, CFA Institute.

What could explain this dramatic rise in health spending relative to other goods? Is it the growth in innovation and application of medical technology? Is it increased usage of health services? Do we as Americans overconsume health care as a group? If so, why? Is it the impact of frivolous lawsuits and claims of malpractice? Is it the aging population whose needs are greater than other cohorts? Or is it because of the existing and growing involvement of government in the system we currently have? I’m sure an honest answer involves all of these variables.

According to the U.S. National Institute for Health (NIH), the average lifetime expenditure per capita for health care in the U.S. is $ 316, 000 (in year 2000 constant dollars). But of course, this figure includes all spending by all age brackets. How much do people spend after the age of 65 through Medicare? According to the Urban Institute, lifetime Medicare benefits equate to $ 176,000 (in 2011 constant dollars) for a single, one-earner household. According to the same study, the average person contributes only $ 87,000 toward Medicare in taxes (also in 2011 constant dollars). For couples who have a one-income household, both spouses enjoy Medicare benefits from that single income. So, this couple can expect about $ 6 in benefits for each $ 1 paid to Medicare in taxes.

Do you sense a problem here? If Medicare were set up like an insurance company in which persons A, B, and C pay into a pool, which then turns around and pays claims to persons A, B, and C over time, perhaps they could invest the $ 87,000 over time and earn some return on the float and perhaps even pay for all these benefits. Alas, Medicare uses a socialized model where persons A, B, and C pay into a pool, which pays the claims of persons X and Y (not A, B, and C). Moreover, the Medicare trust fund has been sufficiently raided by irresponsible politicians who have used the money to fund other government programs. As a result, the trust fund is much smaller than it should be and must be invested for the short term, thereby compounding the funding problem.

The Changing Face of Health Insurance in America

Prior to 1942, health insurance was largely a product of risk management whereby families could protect themselves against an unexpected and costly health care expense due to a serious ailment. Back then, people would purchase their own policies to suit their own preferences for, perceptions of, and aversion to risk. Much like automobile insurance, or flood insurance, policyholders were protecting themselves from large, unusual costs that arose only on occasion, such as the major expense of treating cancer, a stroke, lupus, etc.

However, in 1942, in the heat of World War II and at the urging of President Franklin Delano Roosevelt, the U.S. Congress passed a law placing wage controls across the economy. Because companies could no longer compete for talent with monetary benefits, they began competing by offering such fringe benefits as health insurance, which had the advantage of being tax deductible as an expense for employers. In time, most companies began offering health insurance to their employees, and it became the de facto standard. This unintended consequence of the wage cap is the sole reason that there is any relationship at all between American employers and health insurance services today. So now, person E (for employer) buys health insurance for persons A, B, and C. Consequently, employers choose policies that, at best, reflect the preferences of groups of people, and at worst reflect the preferences of employers.  In any event, employer-purchased policies only indirectly reflect the trade-offs that these same individuals might buy for themselves. It was at this point that the relationship between the individual consumer and the insurance product was first broken.

The Uncoupling of Health Care Costs and Consumption Choices

Over time, many state legislatures continuously increased mandated coverages to be included in various group plans, forcing private insurers to lower out-of-pocket expenses and to cover routine care. In effect, 100 people pay premiums to cover the routine visits of 100 families in the plan. Is there really catastrophic risk in paying for your annual checkup? Why not just pay as you go? In essence, people with preferences to see their doctors and dentists only occasionally subsidize and pay for those who like to see the doctor frequently, say every three to six months. Moreover, as group insurance plans lower the out-of-pocket expenses for each visit, they encourage the consumption of ever greater health care services. So, now persons A, B, and C can use their health insurance to get claims paid on both unexpected health events as well as routine care. The point is that as these mandated benefits expanded and out-of-pocket amounts decreased, consumption of all manner of health care increased.

In fact, the linkage between out-of-pocket spending and usage of health care is well illustrated in a landmark study by RAND Corporation that shows the impact of out-of-pocket spending on actual medical care choices, and hence overall spending.

Between 1971 and 1982, RAND recruited 2,750 families (7,700 individuals) and randomly assigned them to one of five different insurance plans ranging from free medical care (an HMO-style plan) to 95% coinsurance (where the family pays 95% out of pocket). The difference in spending among the various people varied precisely with coinsurance amounts. Those with 25% coinsurance spent 20% less than participants with “free” care, while those with 95% coinsurance spent 30% less than those with “free” care. What is most fascinating is that the study found there were no differences in health outcomes among the people on the various insurance plans. Also important: the study purposely excluded people that were over 65 during any period of the study so as to avoid departures of participants from their chosen plan to Medicare, which, not coincidentally, offers important lessons about the impact of the Affordable Care Act. Clearly, the mere choice of plan dramatically affects health care choices and overall costs.

Nevertheless, we have increasingly moved toward lower and lower out-of-pocket expenses at the point of service, despite knowing that it leads to overconsumption of care. Moreover, people on private insurance plans have been increasingly been asked to bear the costs of care for other citizens in a variety of ad hoc ways, which gets baked into prices. However, as costly as these problems are, they pale in comparison to the impact of the bureaucratic black hole known as Medicare. And as we will see in part three of this series, Medicare was just the opening act to the galactic-scale black hole that is PPACA.

More articles from the Economics of Obamacare series:

  • Part 1: The Implications for Health Care Investing
  • Part 3: Understanding the Lessons of Medicare

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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