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Rx for the U.S. health care crisis.

The nation is clearly at a crossroad in the financing of health care, an issue that will loom large in the forthcoming presidential elections. While most people welcome a long-overdue debate on this issue, there is a very real possibility that we will make serious mistakes in dealing with it. Since the business community will find itself front and center in the debate over who should pay for what, executives should understand the prerequisites for rationality and join forces with the medical community to press for policies that embody them. Failure to do so could be catastrophic both for companies' bottom lines and ultimately for U.S. global competitiveness.


At one level, insurance is just another commodity bought and sold on the market. Yet it is unlike any other commodity in several important respects. This was first appreciated in a systematic manner by Kenneth Arrow, the Stanford University Nobel laureate economist whose pioneering research on the economics of insurance in the 1960s remains state-of-the-art today.

One of Arrow's insights was that neither the market nor the government can ever provide a fully "efficient" (i.e., non-wasteful) allocation of risk throughout society. The principal reason is the so-called "moral hazards" problem endemic to insurance: The act of providing insurance changes the probabilities of occurrence of those very outcomes that are insured. We witness this phenomenon in everything from arson, on the one hand, to statistics of phantom back injuries in Holland, on the other. In Holland, the provision of overly generous health-care insurance caused a 400-percent increase in alleged back injuries.

Somewhat related to the moral hazards problem is the peculiar nature of the demand for insurance in health care. Evidence shows that if people receive blanket first-dollar coverage, the demand for coverage will explode. Each of us will think nothing of charging "the system" $200 for a visit to a doctor to remove a hang-nail. There is simply no incentive to weigh benefits against costs.

Yet demand drops off rapidly once people are charged a portion of the costs incurred by such visits, as studies carried out by the RAND Corporation have shown. This is taken as proof positive that first-dollar coverage needlessly inflates the demand for medical services, and thus gives rise to uncontrollable medical care inflation. So much so, in fact, that in many nationalized health care systems abroad that are touted as "successful," medical services are now being rationed according to "true need." This was hardly an objective of the original programs. And it is a denouement no one likes.

The principal lesson to be drawn from these observations is the need for a policy based upon cost-sharing. Cost-sharing serves both to reduce the moral-hazards incentive to cheat and to keep the demand for services in check. But this is only half the story. For, while the incentive to misrepresent one's condition or to demand excessive services characterizes the low end of the health care expense spectruM, it does not characterize the high end of the scale-catastrophic illness. Here, nothing argues for cost-sharing.

First, there is no evidence that people misrepresent their condition in these circumstances Indeed, rational people would do anything to avoid both being, and being perceived as being, extremely sick. Second, no question as to "true need" arises in these circumstances, where the magnitude of need is self-evident.

Accordingly, while the criterion of economic efficiency dictates cost-sharing at the low end of the spectrum, it does not do so at the high end. All in all, this suggests the need for some form of sliding-scale cost-sharing, whereby the proportion of costs born by the patient falls off sharply with the size of the total medical bill.

But what about equity? After all, public policies are not adopted on the grounds of efficiency alone. Is it fair to ask people to absorb some of the financial risks of illness? The answer is yes, and, interestingly, the perspective of fairness leads to precisely the same recommendation of sliding-scale cost-sharing as does the perspective of efficiency.

This point can be inferred from people's attitudes towards risk as revealed by their own behavior. Most people are relatively risk-neutral with small risks. Indeed, in certain instances-choosing to play Lotto, for example-they are actually risk-prone. It follows from the modern theory of rational decision-making under uncertainty that people should and do self-insure against small risks to the extent they are risk-neutral or only slightly risk-averse. On these grounds, policies that impose a portion of first-dollar costs upon individuals are fully consistent with our day-to-day behavior in life, and are thus fair.

But as the stakes increase, people evince a rapidly increasing degree of risk-aversion-and a corresponding increase in their appetite for insurance. So almost anyone who is able insures against loss of a home from fire-or against major medical expenses. Almost anyone who is asked reveals a preference for 100-percent coverage of catastrophic illness. This is particularly true when people learn that the premium for such coverage, when available, is not very large because the probability of catastrophe is definitionally very low.

All in all, rational people opt for sliding-scale insurance, whereby the proportion of their liability falls off rapidly as the magnitude of their risk increases. Yet curiously, genuine sliding-scale coverage is rarely offered by insurers, who prefer either fixed deductibles or fixed (e.g., 80/20) cost-sharing rules, regardless of the magnitude and probability of loss.


We have seen that sliding-scale cost-sharing policies offering full catastrophic coverage are consistent with the criteria of efficiency and equity. Yet, shortly after Arrow's pioneering work on this matter was published and widely disseminated, Congress enacted a U.S. Medicare program that was both inefficient and inequitable. Many corporate-sponsored benefit plans proffered in recent years were not much better.

The results have been predictable: At the low end of the scale, the demand for services exploded, precipitating extraordinary inflation; at the upper end, all but the already-broke live in dread of bankruptcy from serious illness. In response to this latter concern, Congress enacted the first catastrophic illness coverage several years ago, only to repeal it one year later-one of the most irrational performances by any government in recent memory.

Business executives would do well to keep all this in mind as they chart their positions in the coming battle over national health insurance. This is particularly true, given the two great developments that will alter the health care industry the most during the next 30 years: the explosion of new services due to the cracking of the genetic code and the aging of the baby-boomers. They should also keep in mind the implications of alternative policies for the competitiveness of U.S. industry. If irrational policies are once again adopted, and if business is stuck with 60 percent to 70 percent of the bill, as is now deemed reasonable," then the implicit medical cost for autos produced in Detroit could reach $2,150 per car by the year 2000.

The disastrous consequences of such an outcome will not be foremost in the minds of Congressmen playing electoral politics with this issue. It will be up to the business community to see that considerable pressure is brought to bear on the appropriate special-interest groups. Given the politics involved, it is most important that business leaders form an alliance with providers of health care-both small (independent clinics) and large (the Kaiser Permanentes) -and vigorously support the right set of policies. But which program should they back?

Only one conforms to the objectives of efficiency and equity and dovetails with the politics of the business and medical communities. This is known as the universal Major Risk Insurance (MRI) program. MRI was first proposed by Harvard economist Martin Feldstein back in 1971 during the early days of the Medicare debates, and it explicitly addressed the issues Arrow had raised at a theoretical level.

Regrettably, the program was not adopted, and the abject failure of the business community to get involved was one reason why. The program has been resurrected recently by Cornell economist Alfred Kahn, by University of Delaware economist Laurence Seidman, and others. This time the business community must see that it wins the day.

A brief review of the provisions of MRI will demonstrate how it conforms with the goals of efficiency and equity, and squares pretty well with the politics of the business and medical communities. MRI would be financed by general tax revenues; coverage would be universal and automatic. The required revenues would come from payroll taxes that would replace the patchwork of premiums currently paid by businesses and individuals. The payroll taxes could be split between the individual covered and his employer.

Each household would have a ceiling on its annual medical expenses. Before it reaches this ceiling, every household would pay a share of its annual bill. Moreover, that share would be a function of household income.

For example, a family with $50,000 in income might pay 30 percent of its annual medical bills, its cost-sharing rate, until its out-of-pocket bill reached, say, 7.5 percent of its income, or $3,750. The government would pay 100 percent of anything above this limit. The lower a family's income, the lower would be both its cost-sharing rate and its out-of-pocket ceiling. Finally, billing would be streamlined through use of an MRI credit card account integrated with a taxpayer's IRS account. Each family's medical account could be adjusted regularly for changes in income and would be settled annually.



It should be clear how such a program conforms with the objectives of efficiency and equity. Note in particular that everyone would have an immediate interest in cost-containment, since his out-of-pocket costs would rise with each additional dollar of services billed, at least until his designated ceiling is reached. So doctors will find patients asking whether this extra day in the hospital, or that extra test, is really needed. This is clearly not the case at present, notwithstanding the much-vaunted benefits of our private health care system.

But will MRI appeal to both the business and the health provider communities as it must if it is to have any political prospect of enactment? Yes, it should appeal to both groups.

The business community would be spared the fate now in store for it: being ordered to provide medical coverage for everyone regardless of the irrationality of the underlying system and the absence of meaningful cost-control incentives in particular. Moreover, to the extent businesses might voluntarily reimburse some portion of the uninsured expenses of each worker, they would have an incentive to institute preventive health care on premises. Finally, to the extent that they foot part of the underlying payroll tax, they would have a collective incentive to keep an eye on the rationality and rate of expansion of the overall system.

The providers of health care would benefit first and foremost by being able to remain the providers of the nation's health care. They could retain control of the prices they set and the quantity of services they prescribe. Of course, they can and should expect increasing pressure for cost control resulting from cost-sharing and from the bargaining policies of the large health care networks. Additionally, patients who are willing or able to pay more out-of-pocket could visit more expensive doctors and pay larger bills. Billing procedures and associated paperwork, currently a nightmare, would be streamlined. In short, health care providers would be spared the ultimate risk they face: micromanagement of their profession by government.

Micromanagement is the ultimate fate that befalls those nationalized health care systems that purport to offer free care. There is no free anything and, as demand and costs explode and public frustration mounts, government must inevitably step in to contain the disaster. The result is that very rationing and micromanagement of health care we now behold in other countries and are beginning to witness within our own Medicare program. Public frustration will rise, and the supply of able doctors will diminish.

In conclusion, a commonsensical Rx for one of the nation's foremost problems is MRI, or some variant thereof. The business community should join with health care providers and weigh in with their support. This support, by the way, must transcend traditional lobbying and include a large and expensive dose of public education. And it should start right now, while there is yet time.
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Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Viewpoint
Author:Brock, Horace W.
Publication:Financial Executive
Date:Jan 1, 1992
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