Healthcare and Insurance Reform: Innovation Zones, Vertically Integrated Mutuals, and Hybrid Policies

McKinsey & Co. was supposed to publish this in some forthcoming piece about mutuals and co-ops but just called to say that it isn't going to publish anything so controversial during a presidential race. So I append below my original draft. There is some chance that the edited version will eventually appear, presumably after the election, and quite a lot of their editing went into it, so I won't post the that version, just my original IP. I realize I haven't blogged in awhile but I'll have some investment-related stuff very soon.

The U.S. healthcare system is ill. Prices for medical services (and hence insurance premiums) have increased faster than inflation for decades and now comprise almost one fifth of aggregate economic output. No end to the trend appears in sight. Some American hospitals and doctors offer the best medical treatment in the world, bar none, but most Americans can afford access only to lower tier services that palpably lag global best practices. Tens of millions have no insurance whatsoever and suffer for it financially, psychologically, and biologically when they are sick or injured.

            In 2010, the U.S. federal government responded to those signs of illness by passing the Patient Protection and Affordable Care Act (PPACA). The mammoth law, much of which phases in incrementally with complete implementation coming in 2020, tries to address perceived problems by direct fiat. Millions of Americans are uninsured, so the law proclaims that they will be fined up to 2.5 percent of income (by 2016) if they do not acquire insurance (the so-called individual mandate). Pre-existing conditions raise insurance premiums or preclude coverage altogether so insurers will be forbidden to use them in underwriting decisions by 2014. Copayments reduce the number of scheduled appointments so they are to be banned for preventive care and checkups in 2018. And so forth.

            The U.S. Supreme Court (SCOTUS) may declare the individual mandate unconstitutional and could possibly strike down the entire law. Regardless of the court’s decision, which will likely come down to a single vote, America must face the reality that PPACA treats the healthcare system’s symptoms without doing much to cure its underlying disease, asymmetric information. Healthcare and its insurance is rife with adverse selection, moral hazard, and agency costs and until those problems are reduced the system will continue to perform in a suboptimal, if not dysfunctional, manner.

            In the context of healthcare, adverse selection is the greater propensity of people who are sick, or who are likely to become sick, to seek insurance. Insurers reduce it by increasing the premiums of people known to be sick or who have a history of illness and by declining to cover pre-existing ailments. They also mostly insure employed individuals, who unsurprisingly are on average healthier than people out of the labor force (other relevant factors like age and gender held constant).

            Moral hazard manifests itself in healthcare by the greater propensity of insured people to seek medical treatment for any given medical complaint. Insurers traditionally reduce it with copayments and deductibles. A copayment of $5 or $10 keeps insureds with the lowest incomes and most trivial ailments from utilizing scarce medical resources. Deductibles, healthcare expenses that insureds must pay out of pocket before insurance becomes effective, have a similar effect, at least until they are met.

            Agency problems occur when healthcare providers (HCPs) exploit the presence of insurance coverage to over-diagnose and over-treat patients. Doctors feel justified in breaking their Hippocratic Oath (the most widely used modern version of which enjoins doctors to avoid the “twin traps of overtreatment and therapeutic nihilism”) by pointing to the high costs of malpractice lawsuits: better to order yet another test lest the HCP be sued later on. To protect themselves from those agency costs, insurers limit what they will pay for specific procedures and refuse to pay for treatments that they believe are unwarranted. Unfortunately, most healthcare insurers today have incentives to behave in a short-sighted and niggardly fashion toward insureds, most of whom cannot change insurers, and whose deaths would benefit insurers’ shareholders.

            PPACA does not develop better ways of mitigating the costs associated with any of those three types of asymmetric information and in some instances, like abolishing the use of pre-existing conditions, even exacerbates them. (Some critics argue that its main purpose is to drive insurers out of business, thereby opening the door to a government-based healthcare system.) That PPACA does not address key economic issues is unsurprising given that it was clearly a political solution to what many took to be a largely, if not purely, political problem. A more economic, less hubristic approach would be to allow market participants to experiment to find ways of mitigating the problems of asymmetric information that plague the healthcare system. That might entail nationwide deregulation of healthcare and health insurance markets or, more conservatively, the establishment of one or more healthcare innovation zones (HCIZs) where such experimentation could lawfully take place. (Judging by reactions to PPACA in some parts of the nation, there would be no shortage of volunteer states or regions.)

            When free to look after their own interests, sellers and buyers of simple goods and services are so efficient at determining equilibrium price, quality, and quantity that only the most despotic governments intervene in the process, almost invariably with disastrous results. With more complex services, however, especially those involving a high degree of asymmetric information, governments become more heavily involved. The efficacy of government involvement varies depending on its exact nature but is often sufficiently uncertain to prevent a consensus from forming, at least among more empirically-driven (less ideologically-driven) policymakers and wonks. Moreover, the measuring rod against which the current healthcare system should be measured remains unclear. International comparisons with Canada, Netherlands, Switzerland, Cuba, and so forth are tricky, as are historical comparisons to earlier policy regimes.

            Given the obvious power of markets to solve difficult questions of production and distribution with the protection of, but without any guidance from, government, nations like the United States that purport to be dedicated to free market principles ought to compare the outcomes of regulated and unregulated markets. In other words, it should make its regulatory regimes compete with more market-based alternatives. (America’s failure to do this is one cause of otherwise outlandish claims that this policy or that politician are “socialist.”) Unregulated markets may not be perfect, but the nation would save tremendous resources, not to mention much angst, if they prove themselves superior to a regulated status quo. Based on my reading of the history of healthcare, insurance, and business in America, I believe that a relatively efficient private healthcare system would emerge if allowed to and can even speculate about what it might look like.

            First, HCPs and insurers would join forces in the same company, as many did before the Great Depression, because vertical integration reduces agency costs by uniting the interests of insurers and doctors and by reducing incentives to overcharge or over-treat. Throughout history, U.S. businesses have often merged in order to reduce dependency on market conditions and align the interests of suppliers and distributors. There is no obvious economic reason why HCPs and health insurers should not do likewise.

            Second, the most successful HCP-insurers (HCPIs) would be organized as mutuals, or in other words as for-profit corporations owned by their policyholders. Mutual accident, fire, life, and health insurers date to the nineteenth century, when elites anxious to help solve perplexing social problems lent their brains, energies, and expertise to mutual formation and operation. They acted not to enrich themselves directly – most were already well-off if not wealthy – but to improve the world in which they and their families lived by meeting the financial needs of the masses at the lowest possible cost.

Because non-bank corporations, including mutuals, were chartered by states, not the federal government, considerable variation reigned at first. The healthcare and insurance space was further enriched by the presence of numerous non-profit organizations ranging from free clinics to fraternal lodges. Even after an initial set of best practices emerged, ample room for innovators to test new organizational and policy forms against reality remained until the Great Depression. That great shock destroyed established institutions and practices and induced the federal government to favor joint-stock insurers and employer-based group policies, the flawed system left largely intact by PPACA.

Mutuals often dominated important segments of the insurance industry because their organizational form contains intrinsic incentives to provide safe, low-cost, long-term contracts. Mutual life insurers, for example, offer participating whole life policies that repay premiums to policyholders (in the form of so-called dividends) when mortality, expense, and/or investment returns prove better than expected. Lacking shareholders eager for short-term stock market gains, mutuals share profits with policyholders and invest safely for the long-term. Most mutual managers earn far less than their joint-stock peers and see themselves as stewards or risk managers rather than as risk-taking innovators.

For that very reason, mutuals are often criticized, sometimes accurately, for being unresponsive to changing market conditions. The most successful mutual insurers, like Guardian and MassMutual, stay energetic due to pressure from their sales agents, whose future commission streams depend upon appropriate policy innovations. The Guardian’s general agents (GAs), for example, play much the same role as large stockholders do in joint stock companies. Because their stakes in the mutual insurer cannot be sold nearly as easily as stocks, however, GAs have more incentive than stockholders do to encourage projects that maximize long-term value and minimize inappropriate short-term risks.

The most successful HCPIs would offer participating, non-cancelable (by the HCPI) policies providing both life and health insurance (hybrid). The actuarial problems involved in setting premiums for hybrid policies are non-trivial but not insurmountable (especially if participating policies are issued) and any additional cost is outweighed by the benefits hybrids would provide. The life insurance component effectively bonds the HCPI to provide a level of healthcare rationally consistent with the life insurance benefit. (No HCPI, for example, would deny a $50,000 surgery with a 95 percent chance of extending the life of a 40 year old patient for at least two decades if she was entitled to $1 million in life insurance because the investment returns on the $1 million and the continuation of premium payments would more than compensate.) In borderline cases, the HCPI could lower the death benefit in exchange for added medical care. Such policies would induce people to seek fewer heroic end-of-life treatments, which are currently a large portion of healthcare expenditures, because the costs would fall palpably and directly on their children and other life insurance beneficiaries.

Mutual HCPIs issuing hybrid policies would have strong incentives to minimize costs without endangering patient health. They would increase the number of qualified doctors and other providers, rationally allocate patients to the proper provider (e.g., nurse practitioner or physician’s assistant for simpler diagnoses), and provide policyholders with high levels of quality preventative care, rendering the government’s food pyramid, anti-smoking initiatives, and other preventative health programs unnecessary once again. Those incentives would be strengthened even further if patients received premium discounts during periods of illness.

            If left to their own devices, HCPIs would minimize adverse selection by issuing individual policies in utero, before any health screenings. Most parents would voluntarily purchase such policies for their unborn children because they would be cheaper than any issued thereafter, especially for children who turned out to have health problems. Abortion, contraception, gender reassignment, and other sensitive medical issues would all be left private, matters for policyholders and HCPIs to work out amongst themselves and not targets for politicians or pundits. 

Again, the conjectures proffered here are based on precedents from U.S. business history, especially the history of mutual life and health insurers. Healthcare and its insurance is humbling due to its complexity so HCPIs issuing hybrid policies in utero may or may not work. Under current policy, however, Americans will never know because nobody can lawfully test them, or any other healthcare-insurance innovations for that matter, in real markets. Without HCIZs, policymakers and their ostensible bosses, the American people, are effectively flying blind when it comes to healthcare reform. PPACA may not crash and burn; future court decisions, reforms, loopholes, or just plain luck may save it. Nobody should be surprised, however, if it fails to lower healthcare costs or improve outcomes. When costs reach 25 or 33 percent of GDP, will the federal government finally allow healthcare entrepreneurs to (re)introduce and test innovative policy and organizational forms or will it continue to pretend that it can solve major economic problems with politically-driven policies? Or will it nationalize and thus further politicize healthcare? Or will Americans continue to sink ever larger portions of their household budgets into an inefficient system grown too large and powerful to be reformed?