Private-Market Tooth Fairy Can’t Cut Medicare Cost

The vast bulk of health-care costs arise from an extremely small share of patients, whose insurance will inevitably bear a substantial share of their expenses.

That’s why competition in health care doesn’t work as well as in other sectors, and it’s also why the key to keeping costs to a minimum is to encourage providers to offer better, less costly care in complex cases.

Unfortunately, proponents of moving Medicare to a private “consumer-driven” system, including Republican vice presidential hopeful Paul Ryan, seem to instead believe in a health-care competition tooth fairy -- that if we just increase the patient’s share of costs and bolster competition among insurance companies, the expense will come down. As Karl Rove recently argued, “Competition will lower costs by using market forces to spur innovation and improvement.”

Someone might want to tell that to the Congressional Budget Office, which evaluated Ryan’s original 2011 proposal to gradually move all of Medicare to private insurance companies. (In all these comparisons, we must remember that the goal is to reduce total cost -- to the government and the beneficiary combined -- compared with current projections. Merely shifting costs across the two categories is not a particularly impressive accomplishment.)

What did the budget office conclude? “A private health insurance plan covering the standardized benefit would, CBO estimates, be more expensive currently than traditional Medicare.” The reason was that “both administrative costs (including profits) and payment rates to providers are higher for private plans than for Medicare.” And that effect was larger than any cost savings achieved by people getting less health care. In any Rove-versus-CBO debate that involves economic analysis, I’d put my money on the CBO.

When I pointed to this CBO analysis in last week’s column, critics charged that I was being misleading because Ryan has since updated his plan. I focused on the 2011 plan because that is the only one that CBO has evaluated in terms of total, not just federal, cost.

The difference in the new version of the Ryan plan is that traditional Medicare would coexist with private plans. To suggest that this would change everything is to make an odd argument: Moving entirely to private competition would not generate big savings, but moving partially would.

In any case, we already have a system similar in some ways to the revised Ryan proposal. Almost 30 percent of Medicare beneficiaries are covered by private insurers through the Medicare Advantage program, which exists alongside traditional Medicare. So what can we learn about the potential impact of the Ryan proposal from our experience to date with Medicare Advantage plans?

Reihan Salam, a commentator for the National Review, has correctly argued that in evaluating Medicare Advantage plans, we should look not at what the private insurers are actually paid (which is set by legislation) but rather at how much they are willing to be paid (in the form of the bids they submit to cover beneficiaries).

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 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.

That overpayment rate, furthermore, is likely to be higher for the second-lowest bid in each county, and it is therefore likely to be larger than the much-touted 9 percent discount, which doesn’t appropriately account for the selection effects.

The bottom line is that, if anything, Medicare Advantage bids are above, not below, traditional Medicare -- once you do the analysis correctly, on an apples-to-apples basis. So regardless of whether you use the CBO analysis of Ryan 1.0, or the evidence to date with Medicare Advantage to analyze Ryan 2.0, the conclusion is the same.

We don’t want to put all our chips down on the health-care competition tooth fairy.

(Peter Orszag is vice chairman of corporate and investment banking at Citigroup Inc. and a former director of the Office of Management and Budget in the Obama administration. The opinions expressed are his own.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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    Peter R. Orszag at

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