Saving Medicare
Design, Timing and Pricing Issues
The prefunding of care will insure that future taxpayers are not responsible for the medical care expenses of retirees. As each age group retires, enough funds will have been accumulated to cover that group's total insured expenditures. Given that we have potentially solved the funding problem, however, a host of other questions remain. What type of health insurance should people be permitted (required) to buy? When should they be permitted to buy it? What premium should insurers be able to charge? What should be the duration of the insurance contract? How frequently should people be able to switch health plans?
These questions do not uniquely stem from the reform plan we are proposing. The same questions must be addressed under the current structure of Medicare. And the answers imbedded in the current system are not necessarily the best answers.
"At retirement, people could choose among competing health plans."
Health Insurance Options. Until recently, all beneficiaries under Medicare had essentially the same insurance coverage. For reasons discussed above, the design of Medicare is quite inefficient and private insurers surely could improve on it. The first ones given the opportunity to create an alternative were certain Health Maintenance Organizations (HMOs). Most seniors now have the option to join an HMO with most or all of the premium paid by Medicare and about 13 percent have done so. Beginning in 1999 seniors will have other options, including private fee-for-service plans, Medical Savings Account (MSA) plans and physician-run plans.
Since choices of this sort are already planned under the current Medicare system, it seems almost inevitable that they would also be a feature of any private, prefunded alternative. Choice has obvious potential benefits for the insured, giving them opportunities to select the most suitable plans. Encouraging insurers to find innovative new ways to meet consumer demand also can have benefits. But competition in health insurance can have drawbacks as well, especially when premiums are artificially constrained.
For example, under the current system HMOs receive the same Medicare payment, regardless of the expected health care costs of the enrollee, with some exceptions discussed below. This gives the HMOs a perverse incentive to avoid the sick, whose expected costs exceed the premium income they generate, and attract the healthy, whose premiums exceed their expected costs. Moreover, if people develop a health problem after they enroll, HMOs have an incentive to provide less than optimal care in an effort to encourage them to switch back to Medicare or to some other HMO. Whatever their resolutions, these problems must be confronted regardless of how Medicare is financed.
Timing Options. Given that people will be able to use their PRIME account funds to obtain insurance, at what age should they be able to exercise that option? Must they wait until they are 65? Or should they be able to select an insurer much earlier? (Note: even under the current system, people could be allowed to select a private insurer long before they reach age 65.)
"One question to be resolved: at what age should an insurer be selected?"
Either approach has advantages and disadvantages. The main problem with early commitment is that neither the insured nor the insurer has important information that will be revealed years after the choice is made. On the consumer side, someone entering the labor market today at age 22 will not know how the health plans are going to function 43 years later - when the chooser will actually need the services. On the supplier side, insurers may be unwilling to commit so many years in advance. If they do commit, they may be unwilling to promise the same benefits that they would at a later date. The reasons are obvious: uncertainty over the cost of medical care and uncertainty over the performance of capital markets.
Early choice would help solve the problem of varying health care risks, however. For example, if people choose their insurer in the prefunded system at age 22, when they presumably know little about what their medical care needs will be at age 65 and beyond, then each insurance pool will tend to have a cross-section of individuals - some of whom will be sick and some of whom will be healthy by the time they all reach age 65. On the other hand, if individuals choose their insurer at age 65, when they know more about their medical care risks, problems of adverse selection are likely to arise.
The problems that arise if health plans are required to accept all applicants are addressed above. And if they can reject applicants with high expected health costs, different problems arise. In any health insurance pool, the lower risks in the group are subsidizing the higher risks. This creates an incentive for lower risks to move to another pool with lower average risks and lower premiums - an option not available to high-risk members. As the low risks leave, premiums must be increased to cover the now-higher costs of the remaining members. Higher premiums, in turn, encourage even more departures. The result is a "death spiral" in which the plan is left with only the most expensive enrollees - who cannot afford to pay premiums that cover the cost of their care.
Pricing Options. One way to avoid the death spiral described above is to allow insurers to charge premiums that reflect expected costs for everyone who joins the pool. Thus, sick people would be charged higher premiums and healthy people lower ones. Under the current system, HMOs are not allowed to charge different out-of-pocket premiums to enrollees, based on their health status. However, Medicare's payment to the HMOs does vary depending upon certain indicators of expected costs, and more such risk adjustment of premiums is expected in the future.13 A similar kind of risk adjustment could be forced on the private system envisioned here by requiring pools that disproportionately attract healthy people to make payments to pools that disproportionately attract sicker people.
"Many problems would disappear if people had to choose a plan and remain in it for at least three or four years."
Still, no risk adjustment scheme works very well. Based on objective factors alone, health economists can predict no better than about 25 percent of the variation in future health care costs among individuals.14 Part of the problem is that information is often asymmetric. Enrollees have knowledge about their own health neither insurers nor risk adjusters possess. Perversely, insurers can sometimes take advantage of this asymmetry by making their health plans less attractive to sick people and more attractive to healthy people. The more freedom the plans have to differentiate their product, the more opportunities they have to encourage the healthy and discourage the sick.
Thus pricing restrictions exacerbate the trade-off described above: the more choices people have, the greater the problems of adverse selection. One way out of this problem may be to require lengthier insurance contracts.
Length of the Contract Options. How long should anyone be required to stay in his or her chosen health plan before switching to another? Most employers who give employees choices tend to allow switching only once a year. Although the new Medicare program will permit switching at will initially (except for the Medicare MSAs), eventually it also will revert to an annual enrollment. But is a one-year contract the best option? An alternative would be to require people to choose a health plan at age 65 and remain in that plan for the rest of their lives. A long-term insurance contract would reduce the problem of adverse selection in several ways. For the reasons given above, the longer the time horizon, the less information anyone has about future health care costs, and people who are sick today are not necessarily the most expensive patients over the long haul, since people who die soon do not generate more costs 10 or 20 years down the road.
Thus under long-term contracts insurers face both health care risks and longevity risks. Figure V shows the present value of annual Medicare payments (as of age 65) for individuals who die at different ages, using three discount rates: 3 percent, 5 percent and 7 percent. As the figure shows, individuals who die between ages 65 and 70 have lower health care costs than those who die later.
The conclusion is that many problems associated with annual movement among plans would disappear if people had to choose a plan and remain in it for at least three or four years.