Politics & Policy

Free Lunch Eternal

The administrative costs of private health insurance.

The quest for the free lunch is eternal, and nowhere is that reality clearer than in the ongoing debate over reform of the U.S. health-care system. Many advocates of a single-payer (government) system of health insurance argue that “administrative” costs for private health insurance are much higher than those for such single-payer systems, such as Medicare. The adoption of a single-payer system for all Americans, they claim, would yield savings sufficient to cover all the uninsured.

And so the free lunch emerges yet again: We can have more “coverage” while losing nothing at all. New research published this week by the Manhattan Institute examines the data in detail, showing that it is highly problematic — a sharp understatement — to assert that the savings in administrative costs would be sufficient to “cover” the uninsured.

But there remains the implicit assumption, that the administrative costs borne by private insurers represent mere waste that can be eliminated without losing anything of value. If so, why do profit-seeking insurance companies continue to bear them? And why are the purchasers of health insurance services willing to pay for them? If important scale economies exist in administration, why do we not observe a long-term decline in the number of insurers accompanied by an increase in their average size?

The answer is rather simple: Insurers want to make money, while consumers want their benefits generous but their premiums low. And so a competitive market for private health insurance will be driven to eliminate cross-subsidies among classes of consumers, claims not included in agreed insurance contracts, and costs not justified by the services, savings, and efficiencies that they yield.

Consider first, cross-subsidies, that is, premiums for one group which are lower than the administrative and health-care costs that they impose upon the system. That gap, between premiums paid and costs imposed, must be financed in some way or the insurer will not be able to stay in business. One obvious approach might be to charge another group(s) premiums that are greater than the costs that they impose. But that would prove untenable in a competitive market, because competing insurers would offer lower premiums to the group(s) paying more than the costs that they generate. This of course, would abandon the provider with only the first group remaining under his provision.

And so market forces provide powerful incentives for insurers to invest resources in underwriting, that is, the evaluation of individuals and groups in terms of the costs that those consumers can be expected to impose upon the system. Unless regulations or other legal constraints prevent or impede such underwriting efforts, insurers will be forced by market pressures to align premiums with costs, because insurance cannot be a charitable endeavor in a world in which consumers predictably opt for premiums lower rather than higher.

Note that efforts by individuals and groups to avoid the costs of subsidizing others is not a phenomenon limited to the private sector. Such competition for lower costs is a prominent feature of public finance as well, as various interest groups struggle mightily to garner increases in their preferred programs as well as reductions in their tax burdens, both at the expense of others. Neither private, nor public health insurance is charity.

The alignment of premiums with costs is efficient economically, because the presence of cross-subsidies would mean that some consumers — essentially, the healthy — would purchase less insurance than would be observed otherwise. As the pooling of risks in insurance markets is productive, an artificial reduction in the size of that market means that there would be too much self insurance, and an inefficient allocation of risk for the economy as a whole, an outcome both adverse and not trivial.

Insurers also bear substantial administrative expenses in efforts to scrutinize claims, to ensure that the services for which insurance coverage is claimed actually are included in the insurance contract, and that the prices demanded by providers are within the limits specified in provider contracts. These efforts reduce costs, which otherwise would have to be spread among policyholders who would in turn shift to other insurers devoting greater effort to such administrative activity, and thus would be able to charge lower premiums.

Advertising and marketing often are criticized as wasteful or perverse. Apart from the provision of information about the availability and characteristics of products — one size actually does not fit all — advertising, by creating a stock of brand-name capital, provides market incentives for the delivery of promised product quality. If a private insurer systematically fails to live up to its promises, its market share—and the value of its brand name capital — will decline. If a government bureaucracy, on the other hand, attempts to save budget dollars by, say, forcing patients onto waiting lists, it loses little.

Government is an institution that exists explicitly for the purpose of engendering cross-subsidies among groups, whether through the tax/expenditure system or the regulatory mechanism. Single-payer health insurance, by its very nature (because it accepts all those eligible, and does not base taxes and fees on health status), must create such subsidies, and the tax system prevents competition on the basis of price.

Accordingly, the deeper issue inherent in the debate over relative administrative costs is a fundamental issue: Is the health-insurance system to be viewed as an institution with which to pool risks efficiently? Or is it a vehicle with which wealth is to be redistributed under political and regulatory processes? If the answer is the latter, there is no reason to expect the winners to be those most “deserving” by any defensible definition. Instead, it is the middle class that will be drawn into a politicized system, the middle class that will suffer the effects of an inexorable decline in health-care quality, and the middle class that will pay, with the Beltway taking a generous commission.

Benjamin Zycher is a senior fellow at the Manhattan Institute for Policy Research.


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