Fundamental Insurance Changes Needed to Reform American Healthcare

by Lesley Politi on December 15, 2008

As Americans debate healthcare policy, there seems to be bipartisan agreement that reform is long overdue. But the agreement stops there. Both presidential candidates have advanced reform  blueprints, and each claims that his plan will start us on the road to reform. Take such campaign talk with a huge grain of salt. Presidents Truman, Carter, Reagan, Clinton and Bush (G.W.) all saw Congress reject their reform plans. President Johnson won passage of Medicare and Medicaid in 1965, but these were new public programs for the aged, poor and the disabled, not a system wide overhaul.

Indeed, Medicare and Medicaid adopted the basic payment policies of private insurance, therebydecreasing chances for reform. As we have seen time and again, campaign promises do not guarantee change.


What type of reform do we want, and how do we get there? To answer these questions, let us divide our health care system into three basic parts–private insurance, Medicare and Medicaid All three systems use open-ended payment systems that encourage consumers and providers to use more resources than they would in a less-heavily insured market.

Private Health Insurance

In 2007, private health insurance and direct payments by individuals accounted for $1.04 trillion out of $2.3 trillion (46 percent) in total health expenditures. Modern private health insurance began in the 1930s, but grew swiftly after World War II. The number with hospital coverage increased from 10 percent (12.3 million) in 1940 to almost 90 percent (178 million) by 1975.

Modern drugs and new medical knowledge increased the effectiveness and the demand for medical care. But since it was expensive to only a small number of sick people, it became a service that could be covered through insurance. Population and income increases also boosted demand for health insurance.

Further, an unintended change in the tax code made it advantageous to acquire health insurance through employers rather than as individuals, as one might do with life, fire, or auto insurance. During World War II the National War Labor Board excluded the value of employer-provided health insurance from its war-time wage controls.

Thus, employers offered more health insurance to skirt wage limits. After the war, this setup effectively lowered taxes for American workers who got their health insurance from their employer. As a result, employees and unions had strong incentives to bargain for more extensive coverage (more coverage of physician care, drugs, mental health, etc) and less cost sharing.

Thus more people received more coverage and more medical services, but with little regard to the cost effectiveness or value of the services. The system remains largely unchanged, giving employers and insurers little reason to develop more cost-effective policies.


The second major sector of our health care system is Medicare, the government program providing health care for the aged and the disabled. In 2007, Medicare expenditures accounted for 20 percent ($444.7 billion) of total health expenditures.

Like private insurance, Medicare adopted the practice of paying the cost of the claims submitted by licensed physicians and hospitals. This fee-for-service system is still in place for about 82 percent of the Medicare population. The remaining 18 percent are in the Medicare version of managed care.

Like private health insurance, Medicare’s fee-for-service payment system creates incentives to submit more claims in order to receive more payment. The more the government clamps down on payment rates, the greater the incentive to submit more claims.

Thus, spending rises with little worry about either the medical or economic effectiveness of the services. The result is very high increases in the cost of the program and dire predictions of future failure.


The third major sector of our health care system is Medicaid, the joint federal and state program covering the poor and the disabled. In 2007, Medicaid expenditures were 15 percent ($336.5 billion) of total health expenditures. Federal rules grant the states a lot of flexibility in running their own programs: who they will cover, what benefits they will provide, and what payments they will make to providers. Compared to private insurance and Medicare, Medicaid programs in most states have the reputation of paying the lowest rates.

These frugal payment policies save some money but force many patients to seek care in hospital emergency rooms because they cannot find a physician who will accept Medicaid patients. The payment rules also encourage early and inappropriate admission of the aged and disabled to nursing homes.

Medicaid programs suffer from the same open-ended payment policies we have seen in the other two sectors–policies that encourage excessive use of services with little regard for their value.

Getting to Real Health Care Reform

Medical and health policy journals are now full of articles proposing needed reforms. These articles emphasize basing medical decisions on new knowledge about medical outcomes and cost effectiveness, on more attention to lifestyles and prevention, and the use of computers to improve efficiency.

While these are good ideas, consumers and providers must have incentives to adopt them before any real progress occurs. Instead, the present system continues to reward wasteful spending rather than careful consideration of costs and benefits.

To get to real reform we must change the open-ended payment policies of the three principal financing sources that now funnel money to physicians, hospitals, and other providers.

Perhaps the simplest way to reform employer-based health insurance is to cap the amount of tax-free health insurance that a firm can provide. This would encourage firms and insurance companies to redesign their health insurance policies to keep costs below the cap.

Thus everyone would have more reason to seriously consider the value of IT, prevention, and evidence on medical outcomes. More complicated proposals along these lines involve replacing the present tax exclusion with a standard deduction (as President Bush proposed) or adding a refundable tax credit for the purchase of health insurance (the McCain proposal).

Medicare reform proposals envision giving each eligible person a fixed voucher to purchase one of several federally-approved health plans. Each plan would have to cover a set of defined benefits and compete with other plans to provide quality service to Medicare beneficiaries.

Medicaid reform proposals also take a variety of approaches, all designed to provide a fixed payment to the individual or the state. The federal formula could be modified to allocate federal money to the states based on each state’s population of the poor and disabled.

The states could also receive encouragement to use managed-care plans with stronger incentives to effectively manage the care of the disabled and those with chronic conditions. State experiments have shown a lot of promise for programs that allow more of these beneficiaries to receive care in their homes rather than in nursing homes.

What we all seem to want from health reform is a better system that will provide us with higher quality care and more economic value. Achieving such reform will require us to replace the current open-ended payment systems with systems that reward quality and value. The longer we wait, the more difficult true change will be.

Robert B. Helms is a resident scholar at AEI.


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