Free Market Medicare Reform Won't Work

Vice-Presidential candidate, Rep. Paul Ryan (R-WI)

Health care is not a free market; never has been and never will be. There are too many competing interests with asymmetric information. Doctors, pharmaceutical companies, medical device manufacturers, hospitals, outpatient facilities, etc. are paid according to necessarily complex formulae. Patients are simply not equipped to make reasonable decisions with any kind of expertise. They just aren't.

The reason Medicare functions is because it is heavily regulated to the point that market forces are expunged. Providers are paid according to a formula and are expected to deliver a product that conforms to a rigid set of standards. The patient is not expected to know if his/her medication is efficacious or his/her surgeon is competent, federal and state regulatory bodies ensure quality. Some decisions are left to the discretion of the physician, but most individuals would be surprised at the lack of freedom doctors have to perform tests or surgery. Strict criteria need to be met before Medicare will pay, and disciplinary action is meted out if the standard of care is not met. For a provider to lose the ability to bill Medicare is professional or business death.

The notion that patients, especially old and debilitated ones, can navigate a "free" health care market is delusional. And the notion that this would save money is downright insane. How do we know this? From the failure of Medicare Advantage, a tiny piece of free marketing, to cut costs or improve quality. On a larger scale, free markets in Medicare would be disastrous.

Peter Orzag summarizes how Paul Ryan's Medicare fix would work. Seniors would have a choice to enroll in a commercial insurance plan, or if too expensive, fall back to traditional Medicare. This is a boon for insurance companies. Like Medicare Advantage, the private carriers will select the healthiest and wealthiest and leave the poor and sick to the government-financed Medicare plan. Orzag:

In 2012, Medicare Advantage bids have come in on average a bit below traditional Medicare costs, analysis by the Medicare Payment Advisory Committee shows. Even more relevant to the revised Ryan plan is that, in 2009, the second-lowest bid in each U.S. county -- which is what the new plan would be based on -- was an average of 9 percent below traditional Medicare, a new analysis in the Journal of the American Medical Association shows.

As [National Review columnist Reihan] Salam wrote, “we have new research which finds that had competitive bidding been in place in 2009, it would have reduced Medicare expenditures by at least 9 percent while preserving access to the Medicare defined benefit for all beneficiaries.” The Wall Street Journal editorial page cited the same analysis and made the same point. Case closed?

No, because there’s very good reason to believe that the 9 percent differential is a mirage -- and that experience to date does not support claims that private plans in Medicare lower costs.To see why, imagine two beneficiaries. One has medical expenses amounting to $150 and the other, $50. The average cost is $100. Now imagine that a private plan bids $90 to cover beneficiaries, so it looks to be about 10 percent cheaper than traditional Medicare. That plan, however, while it is designed to be very attractive to the $50 beneficiary, isn’t appealing to the $150 one, so that person stays in traditional Medicare.

The result is that total costs rise from $200 ($150 for the expensive beneficiary plus $50 for the inexpensive one) to $240 ($150 for the expensive beneficiary plus $90 for the inexpensive one). So even though the plan “looks” like it saves money, it doesn’t. It overpays to cover the $50 beneficiary. (And that’s not even taking into account another factor: that if Medicare’s purchasing power is splintered, its negotiating leverage will be reduced. So the prices it must pay could rise. That would drive up the cost of covering the $150 beneficiary, pushing the total above $240.)

To counteract the selection effect on Medicare Advantage plans, a risk-adjustment process is used. The system has improved over time, but evidence suggests it still does not work very well. The models used to adjust payments can account for only about 10 percent of subsequent cost variation; even the most optimistic estimates suggest they could account for only 20 percent to 25 percent of the variation. This gap allows plans that can better predict beneficiary costs to game the system by selecting beneficiaries who are expected to cost much less than their risk-adjusted payments. (Plans do not always want the least-expensive beneficiaries, but rather those who are the least expensive compared with their risk-adjusted payment. The implication is the same, though: Plans can beat the risk adjustment, and be overpaid.)

How big is this selection effect in Medicare Advantage? The evidence suggests it’s huge. The most careful analysis was reported in a 2011 National Bureau of Economic Research paper by Jason Brown of the Treasury Department, Mark Duggan of the University of Pennsylvania, Ilyana Kuziemko of Princeton and William Woolston of Stanford University. In 2006, Medicare Advantage plans were overpaid by more than $3,000 per beneficiary because they were able to select beneficiaries who cost less than their risk-adjusted payments. About $1,000 of that overpayment reflects what the plans were paid, rather than what they bid. So relative to their bids, the plans were overpaid by $2,000 per beneficiary -- or roughly 25 percent of the bid, on average.

It's all about selection. Traditional Medicare today is actually run fairly efficiently, mainly because they have pricing power with providers and the administrative costs are lower than private insurers. Physicians accept 80% of their customary fee to see Medicare patients because to do otherwise would close their practices to a large swath of the patient population. Likewise for drug companies, hospitals, etc. Under Ryan's plan, the healthiest seniors would opt for a commercial plan-- at a higher cost-- and leave the sickest seniors to the traditional Medicare. With only the few sick seniors enrolled in traditional Medicare, the program will certainly lose money.

Furthermore, Ryan's plan changes Medicare from a defined benefit program to a defined contribution program. There is no guarantee that costs will be controlled, in fact there is pretty good evidence that costs will skyrocket as per the above example, with the difference made up by either patients paying more or the government funding the shortfall.

Investment tip: If Romney/Ryan win in November, buy United Healthcare (UNH) stock, especially if the GOP controls both houses of Congress. Cha-ching!