"Body Shop" Economics:
What's Good for Our Cars May Be Good for Our Health

Susan Feigenbaum

Susan Feigenbaum is an associate professor of economics at the University of Missouri-St. Louis and a visiting scholar at the Center for Study of Public Choice at George Mason University.

The existence of 35 million uninsured individuals, many of whom are children, gives ample testimony to the lamentable state of the U.S. health care system. Less than 40 percent of the below-poverty population is now covered by Medicaid, despite double-digit annual growth in program outlays--a clear indication that medical costs are the driving force behind the problem of access to care. Those costs must be contained if we are to address our medical care crisis.

"Solutions" that have preoccupied the public dialogue--preferred-provider plans, managed care, utilization review, fee schedules, copayments and deductibles, and national health insurance--typically assume that to successfully tame the medical cost leviathan requires increased cost-sharing and, more important, a curtailment of consumer and provider choices. Disguised as "efficiency" reforms that will reduce excessive provider reimbursement and "unnecessary" care, such initiatives have been rightly met with skepticism by such constituencies as labor and the elderly, who foresee the inevitable erosion of their medical coverage "entitlements."

In fact, I wish to argue that containing cost at minimum harm to beneficiaries requires an expansion, not diminution, of consumer choice. Whereas other approaches seek to assign providers, insurers, and government agencies the task of (re)directing health care dollars, it remains a basic economic principle that consumers are in the best position to assess the value of services rendered. Critics of a consumer-based system, who maintain that free choice has stoked the fires of medical cost inflation, ignore the central problem: consumers currently bear little of the cost of their utilization decisions. Indeed, the real culprit is medical insurance that, by tying reimbursement to services rendered, has insulated consumers from the opportunity cost of their health care choices and has created a situation where the marginal price of care approaches zero. Not surprisingly, as long as consumers and providers face a zero price, they will continue to demand a more than socially optimal amount of "the very best" care.

In a fashion perversely distinct from other insurance products, medical insurance has generally been unwilling to divorce payments for adverse health outcomes from services rendered; moreover, it has relied heavily on direct reimbursement of providers of care. How did such a "third-party payer" approach evolve? Why did medical insurance--insurance against medical care losses--arise and supplant earlier forms of health (sickness) insurance--insurance against adverse health events? The prominent role played by health care professionals in the design of our medical insurance system suggests that the resulting explosion in medical care outlays was an inevitable, if not intentional, consequence of the pursuit of private interests at public expense.


From "Sickness" Insurance to Medical Insurance

In the first decades of this century voluntary mutual societies underwrote large numbers of "sickness" policies, offering workers a means by which they could indemnify against income losses due to adverse health events (much like today's disability insurance). While some commercial insurers provided similar "sickness" coverage, the industry focussed primarily on lump-sum payment policies to underwrite the expense of terminal illness and subsequent burial. In any case, policy proceeds were fixed and paid independent of whether ill workers actually purchased medical services. In fact, only about 1 percent of the $97 million in sickness benefits paid out in 1914 went directly for medical care, a reflection of the primitive state of medicine in reducing morbidity and mortality. Thus, the original function of health insurance was solely "income stabilization"--pure insurance against uncertain, adverse health events.

As technological innovations led to medical interventions that would significantly improve the quality of life and longevity, the focus of health insurance shifted from illness-induced wage losses to medical treatment costs. By 1930 medical expenses generally outstripped wage losses due to sickness, yet only 10 percent of benefits paid under then-existing health insurance plans went to treatment costs. It was not until the late 1930s, when providers themselves introduced multihospital prepaid "service plans" (later known as Blue Cross), that the link between insurance benefits and services rendered was irrevocably forged. Such plans supplanted "sickness" insurance in favor of today's medical insurance product. The admitted goal of the plans was to stimulate demand for hospital services and, at the same time, reduce payment defaults through "first-day, first-dollar" prepaid coverage. Competition among plans was prohibited by American Hospital Association guidelines; instead, each plan was granted an exclusive territory. Because member hospitals agreed to provide services to subscribers regardless of renumeration, the plans successfully lobbied a majority of states for enabling acts that exempted them from reserve requirements. In addition, those acts often stipulated that a majority of plan directors be nominated by hospitals and that the plans be given tax-exempt status in recognition of their nonprofit hospital sponsorship.

Commercial insurers continued to be skeptical of the actuarial soundness of service plans. They worried about the lack of liability limits and the "blank check" they offered policyholders and providers. Nevertheless, motivated by World War II wage ceilings (fringe benefits were largely exempt) and lax tax treatment of employer insurance premium contributions, employers put increasing pressure on insurers to offer medical coverage as part of their portfolio of insurance products. With considerable reluctance those insurers finally opted to offer policies that indemnified subscribers for medical care losses via lump-sum reimbursement for specific services. Such indemnity policies carried fixed limits on insurer liability, required front-end deductibles and copayments, and excluded many elective treatments from coverage. Insurers paid insureds directly for reimbursable expenses (usually the lesser of billed charges or the payment limit) and left patients liable to medical providers for services rendered. While the benefits of indemnity coverage increased with the volume of services used, the fixed payment limits and cost-sharing requirements attempted to dampen demand for "unnecessary" and costly interventions. Thus, as far back as the 1940s, commercial insurers were grappling with mechanisms to overcome the dangers of overutilization inherent in "on-demand" medical coverage.

Still, the regulatory and tax advantages enjoyed by Blue Cross posed a formidable competitive threat to commercial insurers and led them to gradually broaden indemnity policy coverage to more closely resemble a Blue Cross product. While subscribers still received reimbursement directly from the insurer, payment limits were relaxed and cost-sharing caps put into place. At the same time, the federal Medicare program was likewise evolving into a Blue Cross clone, reimbursing "participating" providers directly on a usual and customary fee (physicians) or cost-plus (hospitals) basis and limiting their ability to balance bill enrollees. Indeed, it took a decade of double-digit medical care inflation to embolden Medicare to modify its program design, resulting in the 1982 adoption of fixed diagnosis-related payments for hospital care and the 1992 implementation of fee schedules for physicians' services. Still, providers receive direct payment and, in a clear effort to appease Medicare's political constituency, they are severely limited in their ability to charge patients beyond the deductible and copayment. Thus, subscribers remain largely insulated from the cost of medical care and receive little benefit from cost-effective utilization decisions. Moreover, the problem of "moral hazard" among providers has led to volume increases in the form of hospital readmissions and elective procedures as well as service redefinitions that substantially inflate reimbursement levels.


A Return to Sound Insurance Principles

As the dangers foreseen early on by the commercial insurance community become reality in the 1990s, it is time we reconsider the incestuous link between medical insurance and medical providers. While property insurers divorce insurance settlements from actual costs incurred--for example, automobile insurers pay claims independent of repair costs in any given instance--such a system has yet to be considered for medical insurance. The separation of insurance payments from services rendered would reintroduce into the medical care industry the most fundamental prerequisite for a well-functioning market: a price-sensitive consumer. To illustrate the point, consider the case of automobile insurance.

In the event of a collision, an insured receives an appraisal of damages, provided directly by insurance company appraisers or through submission of multiple repair estimates. Claims adjusters typically guarantee that settlements (less deductible) are sufficient to complete repair if an insurer-approved mechanic is used. Once the appraisal is accepted by both the insurer and insured, the claim is paid, which fulfills the insurance company's contractual obligation. Insurers compete for market share not only through premiums and coverage, but also through the ease, accuracy, and convenience of their appraisal systems. Once a claim has been settled, an automobile owner enjoys complete freedom of choice in selecting a repair shop. A savvy shopper of repair services may be able to repair his car and have money left over for other purposes. Thus, the insured party enjoys the full benefit of price-consciousness and, yet, bears the full opportunity cost of repair.

How could this scenario be extended to the medical insurance market? Currently, subscribers bear little cost of utilizing medical resources; even the existing cost-share components are often capped in any given policy year or are offset through supplemental major medical or "medigap" insurance. Since providers are reimbursed the lesser of billed charges or a fixed payment limit, patients are denied any benefit as "residual claimants" from lower cost utilization choices. In fact, to receive insurance benefits, one is often required to make cost-maximizing service choices; thus, for example, hospital services are reimbursable while lower-cost home health services and hospices often are not.

To create the same incentives in medical insurance as exist in property insurance requires the reintroduction of "sickness" insurance--conventional indemnity policies, with fixed payments made directly to subscribers per episode of illness (or per unit of care), independent of the resulting type or level of medical expenditure. Chronic illnesses could be indemnified on a "per unit of time" basis rather than per episode, thereby preserving the separation of payment from actual resources consumed. Identical cases would elicit identical payment, not necessarily identical medical care: given freedom of choice, individuals would now have the opportunity to supplement or use less than their full indemnity payment, thereby internalizing the full marginal cost of care. And, while the current system of copayments, deductibles, and allowable charges virtually assures "out-of-pocket" outlays, indemnity policies offer the real possibility of complete coverage for those who behave economically.

How might this new system be operationalized? Before seeking medical care, a subscriber's insurance company would conduct claims "appraisals" based on diagnostic and treatment cost information generated in-house or supplied by outside diagnosticians. In this way diagnosis would be separated from subsequent treatment. Insurers would guarantee that their settlement would be accepted as payment in full by contracted preferred providers. The ability of insurance companies to act as appraisers is not so far-fetched: currently, precertification and utilization review programs require that medical care needs be assessed before actual receipt of care, except in a medical emergency. Moreover, Medicare already "subcontracts" its appraisal work to the medical community, reimbursing hospital providers according to the diagnosis-related group category to which the patient is assigned, independent of actual treatment costs. Earlier studies have noted that the on-going development of sophisticated patient classification systems for prospective payment purposes provides a natural vehicle by which claims can be classified for the purposes of medical indemnification.

Indeed, the critical difference between the current system and what I propose here is that by paying insureds directly, diagnosis is divorced from the ensuing medical care, thereby reducing moral hazard on the part of providers and allowing subscribers to benefit from acting as prudent purchasers. Thus, policyholders and insurers become partners in their efforts to hold down medical costs through comparison shopping for price and quality and conserve health care dollars that can be redirected to coverage of the uninsured population. Other researchers have suggested that the Medicaid program would enjoy significant budget savings if beneficiaries were offered medical care vouchers that, when used to purchase care from low-cost providers, would entitle them to a share of the cost-savings accruing to the program.

Even the medical establishment could benefit from such an overhaul of medical insurance. Providers would be freed of burdensome price controls and could therefore provide a fuller range of services in response to patient demand. Thus, while one patient might opt for outpatient cataract surgery and home recuperation (the current Medicare standard of care), another might prefer to supplement his Medicare indemnity and stay overnight for observation, an option currently precluded by balance-billing rules. Consumers who chose to be treated at a higher-cost hospital closer to home could do so, albeit at higher out-of-pocket expense. Hospitals would no longer be forced to compete solely on service dimensions, such as elaborate birthing suites or private rooms, but could now compete in both price and lower-cost service options, such as inpatient spousal care. Finally, providers would be freed from the whims of public and private insurance monopsonies, which have engaged increasingly in price-cutting, quantity-limiting, and, arguably, quality-reducing activities to achieve short-term budget objectives. Mark Pauly has cogently argued that there is little assurance that the market power of medical insurers will be used to promote economic efficiency through cost containment rather than to impede efficiency through cost-shifting or limiting access.

Providers would now hold all patients directly liable for payment (in the form of indemnity vouchers or cash supplement) and would thereby reduce administrative costs associated with cumbersome and costly billing requirements of government and private insurers. Providers could choose to take "assignment" by adopting the insurer's fee schedule, forgive deductibles (currently prohibited by Medicare), or balance bill patients, waiving that right only upon mutual agreement with the insurer. Price-sensitive consumers would force higher-priced providers to justify their charges with information on quality of care and goodness of outcomes and would thereby improve market differentiation of more severe and complex cases. Obviously, the role of licensure becomes exceedingly important in assuring patients a "floor" of service quality, and insurers will likely continue to compete on the breadth and quality of services covered.

A recognized bias in the current medical insurance system is its implicit subsidy of risk-taking in lifestyle choices. Illness prevention activities such as exercise programs and health screenings (for example, mammography) are often excluded from insurance coverage. Moreover, the prevalence of uniform insurance premiums within employer groups results in individual premiums that do not reflect individual health risks. Yet, conservative estimates indicate that over 18 percent of employees' medical insurance claims can be directly attributable to controllable and measurable lifestyle risk factors. To encourage an optimal level of self-insurance, an indemnity plan could easily accommodate a contributory negligence standard, whereby settlements are adjusted to penalize policyholders for socially unacceptable lifestyle risks. Such an approach might be particularly attractive if the resulting savings in indemnity payments were used to expand coverage for cost-effective prevention activities such as health screenings. The introduction of a contributory negligence standard would also go far in dampening "moral hazard" among policyholders--discouraging self-induced and fraudulent claims, a problem that threatens virtually all insurance markets, including automobile and property. While the debate rages among medical ethicists over whether alcoholics ought to be discriminated against in the rationing of scarce kidneys for transplantation, perhaps that dialogue should be extended to the ethics of rationing scarce public and private insurance dollars on the basis of lifestyle choices.


Opting out of Medical Care: An Option?

Encouraging patients to become prudent purchasers would undoubtedly promote cost efficiency, reduce growth in medical care inflation, and free up financing for greater access to care. Unfortunately, however, any system that requires an individual to follow a prescribed course of care to receive insurance benefits continues to distort choice in favor of covered medical services and away from other consumption or investment alternatives. Recall the automobile insurance analogy. Subscribers there have the option of deciding not to purchase any repair services at all. A medical indemnity plan that divorces payment from services rendered has the potential for imposing upon insureds the full cost of not only utilizing high- versus low-cost care, but, perhaps more important, consuming medical versus nonmedical resources.

In reality, an indemnity plan that requires subscribers to purchase care for their illness with insurance proceeds can be difficult to monitor and enforce in many instances. How much care is enough? When does prudent purchasing give way to "insufficient" care? Obviously, when patients desire to purchase minimal or no medical care with their insurance settlement, competitive providers will have an incentive to exploit the "gains from trade" by reducing service quality or intensity along with price. Are there situations where society might see fit to permit patients to spend indemnity settlements on nonmedical pursuits? Are the ethical dimensions of allowing individuals to refuse care different from those arising when individuals are encouraged to opt out of medical insurance altogether (a route being pursued by a number of private and local government employers)? What are the implications for the level and mix of medical services utilized?

When one realizes that almost 30 percent of the Medicare budget is spent on acute care during an individual's last year of life and that an alarmingly high fraction of Medicaid outlays pays for nursing home care, one suspects that the same dollars put in the hands of the ill might be spent in a substantially different way. Quite likely, a legion of "prudent purchasers" would arise, each making a personal, and often painful, decision concerning the relative merits of medical services versus other "quality-of-life" needs (the education of their children and grandchildren, for example). Individuals would scrutinize the relative costs and benefits of medical care, thereby creating pressure on providers for more cost-effective treatments and consumer information. Palliative approaches to terminal illness (for example, through the hospice movement) would no longer be the stepchild to expensive, acute care interventions. Patients would be encouraged in their use of lower-cost treatment settings, which would lead to a long-belated recognition of the role of family care givers. Indeed, innovative long-term care insurance offered by the Golden Rule Company provides a "cash value" option that permits the policyholder's family to benefit monetarily when it chooses to provide home care (a choice greatly favored by the elderly).

To allow patients to opt out of care found warranted and reimbursable by insurers raises new administrative issues. Beneficiaries must bear the full cost of their decision to seek or reject medical treatment: the choice not to purchase care today cannot later be mitigated by appeal to public or private insurance or subsidy programs tomorrow. While the decision to refuse treatment may be revoked at any time, the individual must then bear the subsequent cost of medical care. Just as providers are currently required to obtain informed consent for recommended procedures, they would be required to obtain informed consent concerning the health implications of refusing recommended treatment. Thus, "downstream" hazards related to today's allocation of indemnity payments would be fully internalized in the decision process.

Clearly, there will be instances when it may be appropriate to demand that an insurance settlement be dedicated in its entirety to medical care. In such situations medical expense vouchers, redeemable by licensed service providers, will facilitate compliance. Thus, for example, public health needs require that treatment for infectious disease be mandatory. Moreover, concerns about the quality of parental decisions might lead to the requirement that all pediatric-related settlements take the form of vouchers. Terminally ill individuals may be permitted to "cash in" acute medical care benefits but be required to retain hospice coverage. (Indeed, Medicare already offers subscribers the option of substituting hospice services for acute care coverage.) Certainly, individuals unable to make choices in a competent fashion--children, the mentally ill, and terminally ill, unconscious patients--would require sufficient protections to avoid exploitation of their indemnity payments by legal guardians. "Living wills" provide an important vehicle by which one can "forward contract" future choices (or choice of guardian) to be enforced during any period of incompetency.

The biggest impediment to engineering such a radical departure from current insurance regimes is that it requires us to empower individuals rather than medical care providers to determine their medical care needs. Potentially, it could also grant individuals the freedom to trade medical services for other personal priorities. The moral dilemma implied here is little more than a red herring once one considers the looming alternative--government rationing through fee schedules, managed care, and national health insurance. While such approaches would reduce medical care coverage surreptitiously by limiting access and choice, a "cash-value" indemnity plan would require Congress to define explicitly the limits of publicly financed medical care rights--how much and for whom? Thus, even policymakers could be made to bear the cost of their life-and-health tragic decisions.

Selected Readings

Fuchs, V. Who Shall Live? New York: Basic Books, 1974.

Grannemann, T. and Pauly, M. Controlling Medicaid Costs. Washington, D.C: American Enterprise Institute, 1983.

Pauly, M. "Monopsony Power in Health Insurance: Thinking Straight While Standing on Your Head." Journal of Health Economics, Vol. 6 (1987).

Weisbrod, B.A. "The Health Care Quadrilemma: An Essay on Technological Change, Insurance, Quality of Care, and Cost Containment." Journal of Economic Literature, Vol. 29 (1991).

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