As we have seen, the Kerry plan calls for an enormous expansion of government-run health care programs. For those who remain in the private sector, most will participate in a nationwide system of managed competition, modeled after the Federal Employees Health Benefit Program (FEHBP). In fact, Ken Thorpe predicts that 75 percent of all employers will buy into the FEHBP-type system.

The idea of modeling the nation’s health care system on that available to federal employees is not new. Stanford University Professor Alain Enthoven made the proposal almost 25 years ago 44 and Hillary Clinton adopted it as the basis for her health care reform plan a decade ago. 45

Currently, federal employees choose among a dozen or more competing health plans each year. 46 However, the competition among these insurers is not the same as one would find in a free market. It takes place under artificial rules that seriously distort the incentives of buyers and sellers in the health insurance marketplace.

A. Managed Competition

Health insurance plans in the FEHBP do compete. But the competition is artificially constrained. Each health plan is required to charge the same premium to every applicant (community rating) and to accept all applicants regardless of health conditions (guaranteed issue). An 80-year-old retiree pays the same premium to join a health plan as a 20-year-old employee. 47 As a result, insurers do not compete on their ability to price and manage risk. Instead, they must compete on their ability to provide health care and manage its cost. This is not really competition among firms in the business of insurance. Rather, it is competition in the delivery of health care .

This artificial market changes the nature of the product both for buyers and sellers. Buyers are not purchasing protection against the loss of their assets when they select one of these health plans. The system as a whole provides protection against costs due to an expensive illness. Instead, when federal workers select a health plan they are choosing a set of particular health care services, such as access to one doctor network rather than another. This is comparable to requiring consumers to choose a specific auto insurer so they can have their cars repaired at particular auto repair shops; or to choose a specific homeowners’ insurer so they can get hail damage repair from a particular roofer.

The benefits of competition are easy to understand. These benefits flow principally from the fact that insurance companies find it in their self-interest to compete for the trade of potential customers. Thus, they make buyer-pleasing adjustments in their competitive strategies. However, none of the valuable benefits of competition will emerge if sellers find it in their self-interest not to sell to some buyers and if in fact, they compete with each other to avoid such customers. Yet managed competition creates these perverse incentives. People who know they need expensive medical treatment will use this knowledge to select a health plan. And since insurers understand this, they structure their products to discourage enrollment by the most expensive customers.

How Perverse Incentives Affect the Behavior of Buyers. Imagine a system in which health plans offer particular doctor and hospital networks in return for fixed premiums. People who are seriously ill and need specific, expensive medical treatment will select very differently from other people. Take a heart patient in need of cardiovascular surgery. This individual wants to find the best cardiologist and the best heart clinic. Therefore, this patient will look for the health plan that has a contract with that cardiologist and clinic. The premium matters little, since the value of receiving the best cardiovascular care far exceeds the patient’s premium payment.

The incentives facing healthy people are different. Because they are less likely to need any particular service in the near future, they are unlikely to spend much time investigating particular doctors and clinics. To the degree that they do investigate, they will probably inquire only about the primary care services they expect to receive. And if the need for heart surgery arises, odds are that patients will be able to switch insurers before the surgery is performed.

Thus the people who carefully compare the acute care services offered by competing health plans are likely to be the people who intend to use them. These are the very people health plans want to avoid. By contrast, those who choose a plan based on the quality and accessibility of nonacute services are more likely to be healthy.

How Perverse Incentives Affect the Behavior of Sellers. Imagine two competing HMOs. In the first, enrollees can see a primary care physician at any time, but there are cumbersome screening mechanisms and waiting periods for kidney dialysis, heart surgery and other expensive procedures. In the second, dialysis and heart surgery are available when needed, but primary care facilities are limited. Given a choice, most of us would enroll in the first HMO if we were healthy and switch to the second if afflicted with heart disease or kidney failure. But if everyone acted in this way, the second HMO would attract only expensive-to-treat patients. To cover its costs, it would have to charge a premium many times higher than the first HMO. The premium would need to approximate the cost of heart surgery or a kidney transplant. But most people can't afford that premium. Those who could afford it might be better off to simply buy their medical care directly. In any event, the HMO would face financial ruin. 48

It might seem that the second HMO could compete successfully by offering more primary care services. But to be truly competitive, it would have to change its strategy completely. The easiest way to keep costs down is to enroll only the healthy. And the easiest way to do that is not to have the doctors and facilities sick people want. As Alain Enthoven has noted (disapprovingly), “A good way to avoid enrolling diabetics is to have no endocrinologists on staff.... A good way to avoid cancer patients is to have a poor oncology department.” 49

To attract healthy enrollees, a health plan might offer inexpensive vaccinations, cancer screening and a health club membership. The plan also might offer services at convenient times and locations, and provide free parking and other amenities. Of course, these services might be attractive to all potential applicants, but they are more likely to be decisive for healthy people. Health plans also can attract the healthy by targeting their advertising to desirable demographics.

A survey by the Kaiser Family Foundation discovered how HMOs competed for seniors on Medicare. The HMO print and television ads showed seniors snorkeling, biking and swimming, but did not feature the sick or disabled. In addition, nearly one-third of HMO marketing seminars were held at sites that were not wheelchair accessible. 50 The following are just a few other examples of competition under managed competition uncovered by the Washington Post : 51

• When a Minnesota network offered direct access to an obstetrician while rivals required referrals from a gatekeeper, it attracted disproportionate numbers of pregnant women, lost millions of dollars and soon ended the practice.
• When Aetna U.S. Healthcare offered unusually generous coverage for in vitro fertilization, people with fertility problems flocked to the HMO and Aetna had to end the practice.
• In another case, a California health plan severed its relationship with a university hospital known for practicing high-tech medicine and tackling complicated cases.
• Other HMOs avoid contracting with doctors’ groups known for expertise with high-risk patients.

The term “medlining” is sometimes used to describe the practice of avoiding the sick. It is health care’s version of redlining — the banking and insurance practice of avoiding deteriorating neighborhoods. The other side of the coin, of course, is attracting the healthy. In addition to health club memberships, some health plans have also offered dental benefits and vision care. The theory is that anyone who will switch health plans to get a free pair of eyeglasses cannot be very sick. 52

B. The Results of Competition

In Figure IX, patients are arrayed along the horizontal axis from most to least costly (left to right). The cost-of-care line shows what would be spent on each patient, given current standards of medical practice. This line is highly skewed, reflecting the fact that in a typical pool about 2 percent of the group spends more than 40 percent of the health care dollars, 10 percent spends almost three-quarters and the majority have very small expenses. The premium (selected by the health plan) is based on the average cost of care for all patients under community rating. This is the premium that must be charged all plan members if the plan is to cover its costs. 53 The figure also illustrates how healthy people subsidize sick people, since most members have costs well below the premium they pay and a few have costs well above it. Clearly, this is what many proponents of managed competition believe the situation would look like for each health plan under their scheme. But a simple analysis shows that the diagram in Figure IX will give way to something else.

Roughly speaking, an equilibrium in a market exists if no health plan can adjust to become more profitable. 54 However, the plan represented in Figure IX can easily become more profitable if it can lower the cost of caring for its sicker members. As long as these members stay in the plan, it will have the same premium income and lower costs. If sicker members shift to another plan, this is even better — since by definition, the sick are unprofitable. On the other hand, healthier customers are overcharged, since their cost of care is below the premium they are paying. This means that other health plans can lure away these customers by providing higher benefits for the same premium. Thus in order to retain profitable customers and attract even more, the health plan represented in Figure IX should increase the amount it spends on healthy members.

In free markets, competition causes prices to change until they equal average cost. The same tendencies exist under artificial competition. Yet because community rating requires the same premiums for all members, competition will cause cost to change until it equals price. If premiums could rise for “unprofitable” members, health plans would compete them up to the level of the cost of those people’s care. But if the premiums are artificially constrained, the plans will compete the cost of care down to the level of the artificial premium. 55 The reverse pressures exist for “profitable” members. If the artificial premiums cannot be competed down to the level of average cost, the tendency will be to compete cost up to the level of the artificial premium. These conclusions follow from well-known principles of the economics of regulation. In the United States, we have had decades of experience with regulated markets. For most of the post-World War II period, the federal government has established minimum air fares higher than would have prevailed in a free market. Unable to compete on price, airlines have competed by offering more frequent flights, more convenient departures, more spacious seating and other inflight amenities. The reverse tendency emerges when prices are kept artificially low. For example, rent control laws prohibit landlords from raising their rents to the level of average cost. Since rents cannot rise, landlords tend to allow housing quality to deteriorate until housing costs equal the government-controlled rent. 56

Consider this result in terms of a basic economic theory: When firms are maximizing profits, marginal revenue must equal marginal cost. Under artificial competition, marginal revenue (the amount of premium each additional enrollee pays) must be the same for every enrollee. Thus if health plans are maximizing profits, marginal cost (the amount the plan spends on each additional enrollee) must also be the same for every enrollee.

Health plans, therefore, face competitive pressures to adjust the delivery of health care until the cost-of-care line coincides with the (community-rated) premium line. [See Figure X.] This means that health plans have a strong financial self-interest in underproviding services to the sick and overproviding services to the healthy. Left unchecked, the end result of this process is a condition under which each person receives health services whose cost is exactly equal to the premium he or she pays.

C. The Effect of Limited Open Seasons

The analysis presented here assumes that patients make choices among insurers based solely on the value of medical services they consume. This assumption would be justified to the degree that patients can easily shift back and forth among insurers as their health needs change. However, the federal employee program and most other managed competition programs allow plan changes only during “open season” once a year.

To the degree that people’s choices are constrained by limited open seasons, they must consider the insurance value of the plan they select as well as its direct consumption value. Consider an expectant mother choosing among competing health plans. She will need well-baby delivery services. However, she might experience complications in pregnancy or childbirth, or her child might be premature and require sophisticated medical treatment. In those cases, the woman would benefit from highly skilled medical personnel. Thus, she will be interested in purchasing real insurance as well as specific medical services.

For such potential problems as heart disease, cancer and AIDS, healthy people will be less likely to insure for expensive treatment — if they can switch insurers at least every 12 months. The tendency is to select a plan that is strong on preventive and diagnostic services, confident that one can eventually switch to a plan that is best at treating a particular disease should the need arise.

Therefore, periodic open seasons cause us to modify our prediction in recognition of an insurance component to people’s choices. Yet even with this modification we are left with the prediction that artificial competition will ultimately result in a radical deterioration in the quality of care sick people receive.

D. Barriers to Quality Deterioration

Just because health plans have an economic incentive to let treatment costs fall until they are no greater than the premium payments made on behalf of the sickest patients does not mean they will do so. Fear of tort liability lawsuits is one obstacle to quality deterioration. Doctors’ fear of censure or loss of a license to practice is another. But these obstacles are somewhat crude instruments for combating incentives that affect the decisions providers make.

E. Actual Experience of the FEHBP: Why Isn't It Worse?

Much of the behavior of the buyers and sellers within the FEHBP system is consistent with the theory of managed competition outlined here. But actual experience is nowhere near as bad as what theory would predict. Why not?

There are four apparent reasons.

Insurers and Providers Are a Small Part of a Large Private Market. In general, the doctors, hospital personnel and other providers who serve federal government employees are practicing in a very large private marketplace. Federal employees are a small fraction of their overall caseload. Similarly, the insurers for federal employees also compete in a much larger private marketplace. Undoubtedly, the practices and techniques that are the norm for the private market tend to shape and influence behavior within the FEHBP.

Put another way, managed competition within the FEHBP is a small subset of a much broader market where managed competition is absent. Behavior in the smaller market tends to reflect behavior in the larger one. But if it were the other way around — with managed competition being dominant and nonmanaged competition having a much smaller presence — we would expect the incentives of managed competition to exert a much greater impact on the practice of medicine.

There Is Very Little Movement of Enrollees among Plans. Despite the attractive idea that federal employees exercise choices among a dozen or so plans every year, the reality is that people tend to enroll in a plan and stay there. In fact, only about 5 percent of enrollees actually switch plans when they have the opportunity to do so. 57 With so little movement among plans, the system is far less competitive in practice than it appears to be in theory. The absence of vigorous competition undoubtedly ameliorates the harmful effects of the perverse incentives we have examined. However, efforts to encourage competition and choice would almost certainly put more pressure on the health plans to respond to the perverse incentives they face.

The Office of Personnel Management Actively Discourages Perverse Competitive Behavior. To most advocates of managed competition, the office of Personnel Management (OPM) impassively sets the rules of the game and allows the competitors to compete at will. In fact, OPM is a much more aggressive regulator. All plans and changes in plan design have to be approved by OPM and the agency uses this power to make the market far less competitive than it otherwise would be. What OPM does for a limited number of federal employees, however, is unlikely to be duplicated by an overseer of an insurance market that includes most of the people in the country.

No Alternative Market Exists. Federal employees essentially get health insurance through their employer, the federal government. They have few opportunities to go outside the FEHBP and buy insurance in another market. As noted above, employer premium payments escape income and payroll taxes. But if federal employees purchased health insurance on their own, they would have to do so with their own, aftertax dollars. The fact that federal employees are a captive market with no alternative market to turn to is another factor ameliorating competitive pressures within the FEHBP. Those pressures would certainly be much stronger (and their perverse outcomes more evident) if people could move in and out of a FEHBP system in the manner envisioned under Sen. Kerry’s health plan.

F. Kerry vs. the FEHBP.

In campaign speeches and campaign literature, Sen. Kerry has implied that ordinary citizens will be able to join the health system used by federal employees. These statements have shocked and alarmed many federal workers, however. They envision hordes of expensive uninsurables swamping the federal system and pushing up costs. 58 Anticipating this reaction, Kerry's team proposed a system that is essentially an FEHBP look-alike. The insurers who offer plans in the FEHBP will offer those same plans in the look-alike system. Same plans, same rules of competition, but formally separate systems.

Fewer Plans. How does Sen. Kerry know all the plans that participate in the FEHBP will choose to participate in the new look-alike? Many FEHBP plans are worker specific, such as the postal workers plan and the Panama Canal employees Plan. 59 One could require FEHBP insurers to participate in the look-alike system. But since this might cause some plans to leave both systems, federal employees would surely resist this idea.

Higher Costs. Even if the same plans were available in both systems, the premiums charged could not be the same for two reasons. First, adverse selection guarantees the look-alike pool will be sicker and more costly to insure. As noted above, healthy people will be able to leave this pool for low cost alternatives (at least initially), an option not available (or practical) for federal workers. Second, the look-alike system will be far more vulnerable to cost-increasing special interest mandates. (See the discussion below). The look-alike FEHBP system therefore will be more costly than the real FEHBP and this cost difference will grow through time.

G. Kerry vs. National Health Insurance.

Unlike the left wing of the Democratic party, Kerry rejects the idea of National Health Insurance. Yet because the managed competition system he proposes includes so many perverse incentives, we could experience the same drawbacks prevalent in the government-run health care schemes of other countries.

The most serious defect of national health insurance is the tendency to overprovide to the healthy and underprovide to the sick. This occurs because of the pressures inherent in allocating health care resources through the political system. Politicians cannot afford to spend most of the health care budget on the small number who need expensive care. Democratic politics forces them to take from the sick and give to the healthy instead. Take Britain, for example. Compared to health care in United States, the British National Health Service (NHS) is notorious for limiting access to modern medical technology: 60

• The per capita use of renal dialysis for kidney failure in the United States is more than three times that of Britain.
• Britain has less than one-half as many CT scanners per capita as the United States and only one-half as many MRI scanners.
• According to the World Health Organization (WHO), as many as 25,000 people in Britain die of cancer each year because they cannot obtain the latest cancer drugs.

Yet while the NHS routinely skimps on services for the seriously ill, it overprovides to patients with minor ailments. For example:

• There are more than 18 million ambulance rides in Britain every year, or about one ride for every three people in the country; 80 percent of the rides are for such nonemergency purposes as outpatient care and pharmacy visits and amount to little more than free taxi service.
• The NHS provides free day care services to more than 260,000, home care or home help services to 578,000, home alterations for 375,000 and occupational therapy for 300,000.

The British preference for “caring” over “curing” is a direct result of the political nature of national health insurance. In a typical U.S. private health care plan, 40 percent of health care dollars are spent on the sickest 2 percent of the population. In a government run system, politicians cannot afford to spend 40 percent of the budget on 2 percent of the voters, many of whom are probably too sick to vote anyway. The temptation is always to take from the few who are sick and spend instead on the many.

Managed competition, as we have seen, creates similar incentives. Whereas national health insurance overprovides to the healthy and underprovides to the sick for political reasons, managed competition encourages this same outcome because of perverse economic incentives.