Practical analysis for investment professionals
11 July 2012

The Economics of Obamacare (Part 3): Understanding the Lessons of Medicare

Posted In: Economics

This post explores Medicare, its role in the U.S. health insurance landscape and the lessons it holds for the future of health care and for investors in the wake of the U.S. Supreme Court’s historic decision to uphold the Patient Protection and Affordable Care Act (PPACA), more popularly known as ObamaCare.

What exactly is Medicare, and how does it work? Medicare is a government-run health insurance plan that provides coverage of medical-related costs for people over the age of 65. It is funded through income taxes on the tax-paying public. In contrast to the standard insurance model, Medicare is funded through taxes on persons A, B, and C, which are then used to pay the health care claims of other persons X and Y (i.e., the over-65 crowd). This is what makes Medicare a socialized model and not an insurance model per se. Moreover, an insurance model is able to estimate the cost of each policy reasonably well based on each person’s age, demographics, driving distance to work, and other factors — and hence prices its products accordingly. In the socialized model, the beneficiaries receive payments for claims, but do not pay for the policies themselves, so there is no practical way to link their contributions with their subsequent claims. As it stands now, persons A, B, and C pay into Medicare for many years through taxes and hope that the government will allow them to receive the unfettered coverage that their parents and grandparents received.

Medicare’s finances are further strained by the aging of the population. While the population has been aging steadily for some time, the population over age 65 is now exploding (see following exhibit of the increasing elderly population).

United States: Population Aged 65+ as a Percent of the Total Population

United States: Population Aged 65+ as a Percent of the Total Population

Sources: U.S. Administration on Aging, CFA Institute.

As illustrated in the estimate from U.S. Administration on Aging, people in the 65+ age cohort will grow from about 13% of the population in 2010 to about 20% of the population by 2030. This change is happening right now. Moreover, people in the age 65+ cohort spend about four times as much on health care as everyone else spends on average. As of 2004, those over age 65 spent $14,788 per year as compared to about $3,850 for everyone else. So, as the numbers of people in the 65+ age cohort swell, there will continue to be massive upward pressure on total costs.

Like any organization, Medicare tries to curtail its costs. And this is where it gets tricky: bureaucrats can only set limits on the prices they are willing to pay or limit the services they are willing to cover. While this does, in fact, help curtail costs to Medicare as a program, it doesn’t do much to curtail costs in the entire health care system. All of the underlying health care products and services must be produced by somebody — nurses, doctors, medical technology manufacturers, biologists, technicians, researchers, and so forth. Therefore, these things have their own costs for labor, materials, and research, to name just a few factors. So, doctors and hospitals treating Medicare patients are frequently left with partially unpaid bills. Consequently, doctors and hospitals raise their prices for everyone else (non-Medicare patients). Naturally, these more expensive price tags ultimately flow through to higher premiums on the private insurance policies covering these patients. In effect, the rest of the country picks up an increasing share of the tab for the Medicare crowd each year. So, persons A, B, and C pay for Medicare through taxes that pay claims for persons X and Y — and then these same persons A, B, and C simultaneously pay into a private insurance pool that pays claims for persons A, B, and C, as well as the disallowed portions of persons X and Y’s claims in Medicare. Got it?

Impact of the Insurance Mandate

As of today, the elderly comprise about 13% of the population in the United States (about 40 million people) and spend about 30% of all health care dollars. With 30 million additional people covered by PPACA, the role of government in health care will almost double overnight. The important lesson from Medicare is that this same exact framework of price mandates and cost shifting will also apply to the government-run plans that will become available on health care exchanges through PPACA. And by emulating the cost shifting of Medicare, the PPACA will see to it that more and more people migrate to government plans, only now it will apply to all age groups.

Private insurers like Aetna (AET), United Health Group (UNH), and WellPoint (WLP) receive the near-term trade-off of gaining millions of healthy, young, and currently uninsured customers to “join” their plans through the insurance mandate. The longer-term trade-off is that they must now compete with government-run insurance plans that can shift costs much like Medicare.

Looking at medical costs before and after the implementation of Medicare also helps to improve our perspective on the coming growth in bureaucracy from the PPACA. Medicare was passed in 1965 and implemented in 1966. The compound average growth rate in cost per patient day (adjusted for inflation) was 6% in the 10 years before Medicare and immediately and persistently escalated to 11% in the 10 years following implementation of Medicare — to the tune of a 5% premium to growth in real costs.

U.S. Hospitals: Real Cost per Patient Day (2005 Dollars)

U.S. Hospitals: Real Cost per Patient Day (2005 Dollars)

Sources: American Hospital Association, CFA Institute.

In fact, the real cost per patient day in 2010 is $187, nearly 29 times as much as the cost per patient day of $6.50 in 1965. In combination, Medicare suffers from the triple whammy of no coinsurance (which encourages overconsumption), cost shifting to the private sector, and strong growth in the elderly population. However, over the ten years ending in 2010 (before PPACA was passed), the compound annual growth in real costs per patient day were only 4.7% per year (despite ongoing advances in medical technology, downward movements in out-of-pocket spending, and other trends already well underway). At the time Medicare was implemented, it covered a maximum of only 9.5% of the population. In contrast, the PPACA will immediately take on 30 million new people — about 10% of today’s population and, through the insurance exchanges, will take on many, many more with the potential to take on 100% of the population. Under PPACA, it is likely to create an even greater premium in cost growth due to the accommodation of larger percentages of the population. My estimate is that real cost growth accelerates from 4.7% to about 11.7% (about a 7% premium in cost growth) for the foreseeable future due solely to the passage of Obamacare.

In response to all these cost pressures over the years, hospitals and physicians have continually adapted the ways they do business. Shorter hospital stays and greater at-home recovery are just two outcomes. Perhaps critics might argue that the trend toward outpatient programs is a trend toward greater bureaucratic efficiency. Shorter stays mean higher throughput in hospitals and more patients being cared for by a single hospital. If there are in fact fewer patients staying in a hospital while more patients are processed through that hospital, isn’t that a sign of efficiency? Sounds plausible, until you consider cost on a per patient basis. If it were true that greater outpatient numbers meant greater efficiency, shouldn’t we expect the bureaucratic cost in hospitals to decline on a per patient basis? In fact, the opposite is true. Bureaucratic costs per patient increase materially. Note how the number of staff per occupied bed is moving like a runaway train. Note well the pivotal moment in the data: 1966, the year Medicare was enacted. In the ten years ending in 1965, hospital staff grew at a rate of 3.8% per year. In the ten years following implementation of Medicare, hospital staff grew at a rate of 6.8% per year.

Gammon’s Law: U.S. Hospital Staff vs. Occupied Beds

Gammon's Law: U.S. Hospital Staff vs. Occupied Beds

Sources: American Hospital Association, CFA Institute.

The number of staff per bed in 2010 exhibits a more than 11-fold increase over the corresponding figure in 1946. Note also that this increase in staff occured while the number of occupied beds declined. As Milton Friedman explained, technological innovations typically drive unit costs downward. It’s true in every other industry, but not health care. Why? Innovation and efficiency may explain the decline in occupied beds, but it does not explain the explosion in costs.

Likewise, as we look forward from today, we should expect hospital staff per occupied bed to accelerate and occupied beds to decline at an accelerated pace. Using Medicare implementation as a benchmark, growth in hospital staff should accelerate from 1.9% to approximately 4.9% per year, while occupied beds should decelerate from –0.4% to –2.8% per year as illustrated below.

Gammon’s Law: Estimates for U.S. Hospital Staff vs. Occupied Beds

Gammon's Law: Estimates for U.S. Hospital Staff vs. Occupied Beds

Sources: American Hospital Association, CFA Institute.

Isn’t it also possible that a surge in innovation created new treatment regimens and new therapy classes including pharmaceutical products, medical devices, and diagnostic technologies? This can be a complex topic, to be sure. For example, even if a new therapy (A) is statistically proven to reduce costs when swapped out for a traditional therapy (B) in isolation, that savings can get lost across the entire system. For instance, many doctors may prescribe both therapy A and B, or they may prescribe therapy B to supplement therapies A, B, and C. In any event, in the aggregate, it is never clear just how much a new therapy is utilized as a substitute versus a supplement.

Another important driver of U.S. health spending is the fact that U.S. research effectively subsidizes the rest of the world. Because many other countries are already willing to limit access to care, they are also willing to demand lower prices from medical suppliers. So, if they don’t get the prices they want, they are willing to walk away from providing the product to their citizens at all. Moreover, because of the disincentives and difficulties of earning returns on R&D investments, many of these countries typically abstain from significant research, letting the U.S. market bear a disproportionate share of development. Consequently, health care manufacturers charge U.S. consumers higher prices than they charge in other markets for the very same products.

So, the U.S. health consumer has played a special role in the world by paying these higher prices. As other countries have increasingly socialized their health care systems, the United States has increasingly played the role of developer. Thus persons A, B, and C pay for the health claims of persons X and Y through Medicare AND pay for their own insurance (which person E buys for them), which pays claims for persons A, B, and C — as well as persons X and Y — and for persons H, I, J, and K, who live in foreign lands. And this, my friends, is how the cost of health insurance has become so expensive here in America. Unfortunately, the passage of PPACA will see to it that the government bureaucracy will be amplified many times over, greatly increasing the cost of US heath care and accelerating all current cost trends.  By design, the government can not match the program’s costs with corresponding revenues.  So, the great irony of Obamacare – whose advocates want free and equal access for all – is that the Government must eventually resort to its only real defense: limiting access to care in order to control costs.

But in the words of P.J. O’Rourke, “If you think it’s expensive now, just wait until it’s free!”

More articles from the Economics of Obamacare series:

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.


About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

9 thoughts on “The Economics of Obamacare (Part 3): Understanding the Lessons of Medicare”

  1. ja says:

    so who has the best idea to fix this problem? does it have to do with insurance companies competing across all state lines?

    1. Hi ja,

      Fixing the problem is complicated for many reasons, not the least of which are all the entrenched interests (including the private sector that makes money off of the current system). If – and this is a BIG if – the powers that be cooperated, we could shift health insurance toward Health Savings Accounts coupled with high deductible plans so that people take ownership of their health care dollars and pay for care at the point of service. As illustrated in the three articles, what we have today is NOT insurance, but rather semi-socialized health care. If we return to an insurance model and free markets, as described here, health costs would immediately come under control and health care productivity would blossom.

  2. Sandeep says:

    So the people above the 65 age braket not allowed to get the required health care ? and what about the money they have given to tax authorities ?This is the responsibility of the Government to see that every body gets treated. I would say that insurance companies are mainly responsible for the increased health care costs. Also, you should have included the cost of treatment in some other countries in which public health care exists like in Canada. (just for comparison purposes)

    1. Sandeep, you raise some excellent questions. I’m afraid that an adequate answer would require much more than I can give here. That said, I have looked at a number of other countries for comparison. Try reading Lives at Risk by Goodman, Musgrave and Herrick for a comprehensive comparison with single-payer systems around the world. The most important thing to note is that, like anything political, fallacies are abundant in any discussion of health care. For instance, comparing infant mortality rates across countries is foolishness – different countries have different definitions. Some countries exlude infant deaths if the baby is below a certain size, while others exclude infant deaths if the baby is below a certain weight, and yet other countries, like America, include all babies. I’ve also seen studies that compare Gammon’s Law at work in Saudi Arabia, Great Britain, Australia, etc. I will be blogging more on this topic in the future. Thanks for the questions!!!

  3. Ron this is a good article. The facts are correct. What Americans need to realize is that “Health Insurance” as we know of it… is NOT insurance at all. There is one very important element of the ecomomics that you left out. The fully insured health companies like UHC, Aetna, etc. don’t care if the cost of health care rises. They just make more money. They are nothing but a “cost plus” vendor for the 14% of the nation that they cover. In fact, Ron, they actually encourage hospitals to raise their fees so that the spread on their PPOs looks even better to potential customers. It’s true. I’ve been there and seen it happen. At the end of the 70’s health insurance as we knew it provided the gasoline for the conflagration that we now see. As long as there was a third party paying the freight then it didn’t matter what the hospitals charged and it didn’t matter to the covered member either. As long as the deductible was LOW no one cared. See my 14 part series on the History of Healthcare on You Tube under Simplicity Health Plans.

    Hence, the real surge in Self Funding brought on by the ERISA act of 1974. Now 45% of the nation is covered under self funding but that number of members pays only $480 billion a year for all of their care vs. the 14% covered by the main carriers at about $800 billion a year. One system is for profit and cost plus while the other is “not for profit” and run as efficiently as a company can run their own business except for the fact that they have to deal with hospital costs being driven up by the carriers.

    As a result the main health carriers have been able to move into the self funded field in a big way by extending their “discounts” to the happless self funded employer trying to control costs. This is niche where all the carriers will seek refuge. That is being administrators for self funded plans. It’s no wonder that the current administration in DC tried to get rid of self funding and it’s no wonder that state insurance commissioners are trying as well. Why? because states collect taxes on premiums but not self funded programs. So, the higher the premiums the more the states make in taxes helping to perpetuate buracratic inefficiency and deepen the black hole.

    As a physician I can tell you that Americans over use healthcare resources. In fact, we spend more per capita on care and are only ranked 17th in the world. It’s not about the quantity. It’s about our responsibility to stay healthy and plan with real “Insurance” for the bad day.

    It’s not a surprise that increasing the deductible causes people utilize healthcare in a more consumer orientated way. The data on high deductible consumer driven health plans bears that out. Those covered under these plans save money, utilize healthcare less and maintain their health.

    Here is the answer Ron to much of our problems:
    Allow all business to self fund and use real “stop loss insurance” since stop loss acts and functions as true insurance. Then make policies with minimum deductibles of $2000/$5000 that cover ONLY a select few screening tests. Those same policies would not allow 100% covrage after the deductible but at most only 80%. The total coverage per member per year would be no more than $1 million and $2 million in a life time.

    Then make it law that the insurance has to reimburse the member NOT the hospital or doctor.

    Then key premiums to biometrics of BMI, Blood Pressure and Smoking like any other insurace does for risk factors.

    If you’re healthy and want to gamble and not get insurance then that’s your right.

    Let Americans buy prescription drugs from anywhere in the world. (80% cost savings)

    Enable self funding to make it easier at all levels.

    Gregory Hummer, MD
    Simplicity Health Plans

    1. Hi Greg,

      Now that’s a comment! I will take a look at your piece on YouTube…sounds most interesting.

  4. It is all rather easy to understand………. There are simply two different kinds of folks in the world: Socialists who care more about helping those in need than they do about their own pocketbook, and capitalists who seem to care more about their own pocketbook than helping those in need.
    [email protected]

    1. Hi Doug,

      I can see why you say that. While that is a common perception, I do not share your view. No system will ever be perfect or be able to pay for every conceivable need. Given that, we can then turn to the issue you raise: capitalism vs. socialism. Socialism in health care fails for the very same reasons it fails everywhere else – there is no relationship between cost and revenues…and there is no incentive to create one. To be sure, there are capitalists that are greedy and self-serving. But that should not discourage us from weighing the costs and benefits of each system on balance. In my view, a free market system – a truly free market system – is both noble and benevolent, despite its imperfections. People make choices and trade-offs according to his or her own value systems and charities and the vast majority of Americans could afford it. If government stepped in to fill the void, they should do it with a private market voucher system. It would save countless GOBS of money.

  5. Sandeep Purohit says:

    Hello Ron,

    Your article is getting more interesting by comments and questions of other people. Thanks for answering my questions.

    I liked the Idea of Mr. Gregory Hummer about “Let Americans buy prescription drugs from anywhere in the world” and I am pretty sure Americans can save more than 80 %. I buy a strip of antibiotic tablets for $ 1 (after converting in Indian Rupees) in India compared to $90 I paid for the same medicine in US.
    I know it is not a good Idea to compare any other country’s health system with other countries because of so many different parameters and factors as Mr. Ron rightly explained but countries like India where most of the population don’t have health insurance, the health cost is very less and affordable. Now things are changing as multinational companies started giving insurance to their employees, resulting in higher medical costs in PPOs.
    Mr. Ron excellently expressed this situation in American Corporate culture in early nineties to attracting new employees. So by looking at developing world we can find some solutions as they are dealing with same situations now as developed world did in early nineties.

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