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July 6, 2010

Inside Value-Based Healthcare – Part 2: Who Pays for Health(care) Insurance

In my previous post, Value-Based Healthcare Part 1, I talked about the two primary business risks faced by insurers, Moral Hazard and Adverse Selection.  Recall that for health insurance markets to work effectively they must be structured to mitigate Adverse Selection (i.e., the reality that the very fact that someone is seeking insurance might make them uninsurable in the first place).  This means that the healthiest people must stay in the market as part of the risk pool, otherwise the underwriting will not work at affordable premium rates.  As such, employer-based Group Model health insurance has evolved as the prevalent distribution method.

So who pays for employer-based health insurance?

Today health insurance costs average about $4,800 per person per year.  While this expense is paid for by employers, it is essentially part of salary costs, and so it is really money that would otherwise be paid to employees were it not for the mandatory participation required in most Group Model plans.

Employers offer to buy the coverage on behalf of employees because they believe that having their employees insured improves productivity and it is viewed by prospective employees as a competitive perk.  This works out well from a risk pooling perspective, making Group Model insurance less expensive on average.  But what really drives the Group Model is its income tax subsidy.  The federal government does not assess income taxes on the value of Group Model health insurance (this subsidy does not exist for individual purchases of health insurance).

This tax subsidy is massive.  The average employee is in the 25% federal income tax bracket, making the subsidy worth about $1,200 per year (25% of the $4,800 average annual premium).  Approximately 180 million people participate in Group Model plans, meaning the total amount of this annual subsidy is about $216 billion per year.

So who pays for employer-based health insurance?

According to these calculations 180 million employees cost a total of approximately $864 billion, $648 billion is paid for by employees through payroll deductions and about $216 billion is paid for by the federal government through income tax subsidies.  These amounts exclude out-of-pocket expenses, which are by enlarge paid for by employees.

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Let’s get back to Moral Hazard.

Have you ever noticed that people are very hesitant to make claims on their automobile and property insurance?  Rarely do the costs of minor fender benders result in an insurance claim.  Why?  Because people fear that claims on their auto policies will result in either their premium increasing or their policy getting cancelled.  People tend to reserve that type of insurance for major catastrophes, paying the cost of minor accidents out of their own pockets.

Most people do not behave this way when it comes to health insurance.  A very high percentage of healthcare expenses become insurance claims.

Few people lose their insurance because of high insurance claims.  As claims increase, the burden of the higher premium is shared among the risk pool.  As a result, Moral Hazard (changing your ethics because you don’t pay for the consequences of your bad behavior) in Group Model plans is severe, and many believe it contributes significantly to the 8-12% average annual healthcare inflation rate.  Despite the reality that employees pay for more than 75% of the cost of their health insurance, they are fearless when making insurance claims.

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So, returning to the thread that ended Value-Based Healthcare Part 1.

Employer-based health insurance suffers from Moral Hazard.  Despite the fact that it seems obvious that employees pay the most of the tab, the cost is not individualized and the consequences of bad behavior are not perceived as even remotely severe.

Research backs the notion that when an insured party pays a higher percentage of the total cost of the service Moral Hazard reduces.

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption why not just increase the out-of-pocket payments and reduce Moral Hazard?

In some cases higher out-of-pocket costs can lead to Unintended Consequences, namely people forgoing necessary treatment.  For example, the medicines necessary to treat Type-2 diabetes are much less expensive than the costs associated with the side-effects of untreated diabetes like heart attack, stroke, amputations, blindness, etc.  A health insurer wants Type 2 diabetics to take their medications, however high out-of-pocket charges often impose barriers to compliance.

Medications like Glucophage, a treatment for Type 2 diabetes, have a high value.  The treatment costs about $400 per year, real money for an individual, but a small investment for a health insurer given that compliance with the drug should mitigate a number of side effects of Type 2 diabetes, saving money on hospitalizations and other forms of expensive healthcare.  Further, Type 2 diabetics should see podiatrists and ophthalmologists regularly.  Again, high co-pays for these services could mitigate compliance and increase adverse events within an insured diabetic population.

Value-Based Healthcare: Definition #2:

Value-Based Healthcare involves designing insurance benefits with economics that encourage (or remove the barriers to) the utilization of high-value healthcare services.

So why is Value-Based so new?  What are the barriers to implementing Value-Based?

These questions will be covered in future posts.

To leave you with something to think about, it was only until recently that the information technology necessary to begin experimenting with the implementation of Value-Based Healthcare became available.

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June 25, 2010

Inside Value-Based Healthcare – Part 1: Moral Hazard

Value-Based Healthcare.  There, I said it…

I had fun on Wednesday sitting on the healthcare reform panel at the Dow Jones Limited Partners Summit.   The conversation centered on investment trends in healthcare as updated for the passage of PPACA, during which I blurted out the concept of value-based healthcare, a pretty complex and to some extent novel concept, and a cornerstone to many of Psilos’ VC investment strategies.  This was subsequently reported, and to Jennifer Rossa’s credit, she provided enough detail around my comment to correctly convey the concept.

There are important nuances, however.  This post is the beginning of a series that will explore the ins-and-outs of Value-Based Healthcare.

Value-Based Healthcare: Definition #1:

Value-Based Healthcare, or more specifically, Value-Based Health Insurance Design, its sobriquet being simply, Value-Based, intends to mitigate the Moral Hazard inherent in low cost-sharing health insurance coverage.

If we were to take an insurance or advanced finance class together we would spend a lot of time talking about Moral Hazard and Adverse Selection, the two primary business risks that underpin managing financial institutions, insurance companies and banks included.  Failure to manage these risks properly can lead to disaster (in fact, recently Moral Hazard and Adverse Selection got the better of the mortgage banking business, a primary cause of the financial crisis).

Moral Hazard reflects the reality that a party insulated from a risk (like an insured or a borrower) will behave differently than if it were fully exposed to the risk.

Adverse Selection reflects the reality that the very nature of a party’s desire to seek insulation from risk reflects a greater risk of loss.  For example, parties that are either sick or expect to get sick have a higher demand for health insurance.  Similarly, parties in the market for a mortgage that have a concern that they may default are more attracted to low-down-payment mortgages.

Underwriting models are designed in part to set prices to countervail the risks of Moral Hazard and Adverse Selection.  This is more easily accomplished in an underwriting model where each policy gets priced individually, like automobile insurance.  In this model individuals are placed in broad price cohorts based on age, gender, style of car, etc., and then adjustments to the policy price are made based on individual attributes like historical driving record.  Moral Hazard and Adverse Selection are less prevalent in insurance markets where policies are individually underwritten and where the underwriter will be the party that ultimately pays the claims on any policy.  Absent these conditions the risks of Moral Hazard and Adverse Selection will always be lurking.

Such is the case in the current market for employer-based health insurance (also called Group Model health insurance).

Let’s start with Moral Hazard.  Today many employer-based health insurance models feature low cost-sharing, meaning that patients pay a very small amount of the health resources they consume.  Here the economic question is whether the value of a healthcare service exceeds the out-of-pocket cost to the patient, which is a small fraction of the actual costs.  Moral Hazard comes into play because the insurance insulates the patient from full payment, thus altering behavior toward increased healthcare consumption, a phenomenon some believe is encouraged by the fact that providers (doctors and hospitals) are generally not at risk either and are paid on a fee-for-service basis.

Consider what might happen if the out-of-pocket costs to the patient were raised.  In insurance markets where patients could opt out and choose not to buy insurance, an increase in out-of-pocket costs would certainly result in some people, probably the healthiest, declining coverage.  This would cause premiums to rise, because the insured pool would be sicker on average, causing more of the healthiest people to decline, increasing the risk of the pool, increasing the premiums, and so on, into an Adverse Selection spiral.

In health insurance markets we need the healthiest people to stay in the market in order for the underwriting to work at reasonable levels of insurance premium.  This is one of the reasons why health insurance is provided by employers.  Employers, or coalitions of employers, are able to deliver large enough populations of sick and healthy people for the underwriting to work.  The participation of large numbers of employees mitigates Adverse Selection and as a result many large employers choose to self-insure (tax incentives is another reason employer-based health insurance dominates – more on this another time).

Nonetheless, in employer-based health insurance we are still left with Moral Hazard, and research seems to back the notion that its degree is inversely correlated with the percentage out-of-pocket paid by patients (low out-of-pocket = high Moral Hazard = high healthcare consumption).

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption (and believe me, we are), why not just increase the out-of-pocket payments and reduce Moral Hazard?

It turns out not to be that simple.  Please give this some thought and we’ll dig a little deeper next time…

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