The 85% Solution

It almost goes without saying that the health care reform (HCR) bill that is about to pass the Senate is extraordinarily bad policy. The perceived problem we have with health care in this country is exploding cost. Health care expenditures continue to rise much faster than the rate of inflation.

Now this is not on its face an unacceptable situation. As a country becomes wealthier, it might make sense for a larger and larger fraction of its GDP to be spent on health care. There is an easily approachable limit to how much food, shelter, and I-Phones a person can consume, but given the fact that we all grow old, get sick, and die, the limit to how much health care we can consume over our lifetime is high enough that we won't be bumping against it for quite some time.

But I think most people agree (although perhaps for the wrong reasons) that there is something horribly awry with our current system. Costs are rising much faster than they should, and there are probably some simple adjustments that could be made to contain costs and make health care more affordable.

Anyway, rising health care costs are perceived to be the problem. So, what does the HCR bill do? It subsidizes consumers and taxes providers and producers. That's right, it artificially stimulates demand for health care, and enacts new taxes and fees which artificially suppresses the supply of health care resources.

Brilliant! This ranks right up there with Cash for Clunkers as a textbook case of fallacious reasoning in economics.

That said, I wanted to focus on just one small part of the HCR bill which highlights the lack of thought that goes into the crafting of such legislation. The provision to which I refer requires, in the words of Senator Al Franken, "... health insurance companies to spend 85% of premiums on actual health services -- not administrative costs, TV ads, or gargantuan CEO bonuses..."

No doubt Harry Reid and his pals have put a lot of thought into that number 85% (sorry if i dripped sarcasm on the page here), but isn't it amazing that a government bureaucrat could come up with a single number like that which works for the whole country and for all large group insurance plans (of course, the states will be given the freedom to raise the bar even higher, although one hopes that 100% will be understood as a natural limit)?

Now, one might expect a somewhat more precise and legalistic definition of the phrase "actual health services" in the "actual" bill, and here it is:

(1) on reimbursement for clinical services provided to enrollees under such coverage; [and]
(2) for activities that improve health care quality;

Well that clears it up. Let's do something novel and try to put ourselves in the shoes of a rational human being for a minute, one that responds to incentives and tries to game the wording of vague regulations.

You're the CEO of a health insurance company, and Congress tells you that you have to spend at least 85% of your premium revenue on health care services or activities that improve health care quality. You can do math, so you quickly determine that the amount of money available for other expenses, salaries, and profits is at most (100%-85%)*(total premiums) = (100%-85%)*(total expenditures for health care servides)/85% = 17.65% * (total expenditures for health care services).

The amount of money available scales linearly with total health care expenditures, which is interesting. Now if you can just find a way to spend more on health care, without increasing your administrative and marketing expenses, you can pay yourself, your employees, and your stockholders more money. Hmmm.

Suppose you cut co-pays and deductibles and encourage your customers to get more health care. You could pay doctors more too, and even fund all kinds of ridiculous perquisites for doctors under the category "activities that improve health care quality."

Of course you would have to raise health care premiums for all this to work, and normally you would be constrained by competition from other health care insurance providers. But under the new law, all of the other providers would be thinking the same way. All the incentives are now skewed towards increasing health care benefits and costs, with commensurately higher premiums to pay for it all.

The intent of this language, I guess, was to provide an incentive to insurance companies to cut administrative expenses. But that incentive was always there. All this provision will manage to do is remove any incentive to cut costs for "actual" health care services. Perversely, it does the opposite.