Commentary: Hard look at the economics of health care needed

By Kevin Schulman

For all of the debate coming out of Washington on health-care reform, there seems to be a lack of a fundamental understanding of the functioning of the health-care market, and how and why it has stopped working for consumers.

A major misunderstanding is the concept of health insurance. Health insurance is a simple idea - we all agree to pay into a pool and to share the resources we collect for appropriate medical needs. In this manner, the healthy subsidize the sick, in the hopes that resources will be available for them should they ever be in need.

Health-insurance companies are simply the keeper of the funds in this simplistic model (and their costs are actually regulated under the Affordable Care Act to be no more than 15 percent for group policies and 20 percent for individual policies).

So, why are costs for Obamacare increasing so rapidly? Here is the conceptual model:

Imagine a world where we have healthy people who will require $1,000 per year in health-care services, and sick people who will require $10,000 per year in services. The insurance company has to set a price for our policies.

The key question is what proportion of the population who sign up for insurance will be healthy. In this model, if 80 percent of the population is healthy, the costs of health-care services will be $2,800. However, if 70 percent of the population is healthy, the cost will be $3,700.

The key task of insurance companies was to estimate this proportion in advance of the opening of the exchange markets, with no prior knowledge of what consumers would likely do.

There was a lot of energy in the Obama administration to get out the message and to recruit healthy people into the insurance market. As a result, the insurance companies chose 80 percent. Well, they chose wrong. With all of the politicization of this program, and the demonization of the concept of health insurance, we ended up with 70 percent. With this incorrect estimate, the insurance companies lost $900 per person in our simple analysis, and needed a 32 percent rate increase to come up to market. It's not very complicated.

While much focus is on how to make the individual health-insurance markets more predictable, we're missing the more important question of why health-care prices are so high for the sick in the first place.

We keep hearing about competition among insurance companies leading to lower prices. However, we have just seen unprecedented moves by four major health-insurance companies in the United States to merge. Their argument - they lack market power over health-care providers to negotiate for better prices.

You see, the real weakness of Obamacare was a conceptual model asserting that doctors and hospitals will work together to drive down the cost of health care. However, doctors and hospitals negotiating as a unit have tremendous market power, and no incentive to drive down prices. In fact, in California, one study showed that if you go to a physician that owns his own practice, you cost your health plan $3,066. If you go to a physician employed by a multihospital system, you cost your health plan $4,776. This difference is a dramatic illustration of the power of local market monopolies on prices in health care.

No flavor of insurance currently under consideration will do anything to affect this dynamic. If health-insurance providers with large local market shares can't influence prices, then how will insurance with less market share influence prices? And how will powerless individuals fare in such markets as they "shop" for services from the only provider in town (which doesn't post its prices)?

Of course, we also have an issue with other health-care suppliers, such as pharmaceutical manufacturers. We have seen massive increases in the prices for new pharmaceutical products, with $100,000 drugs, once almost unheard of, now increasingly common. These prices impact people with severe illness, but simultaneously also impact the rest of us paying into the insurance pool. For a commercial health plan, almost 20 percent of their costs are for pharmaceuticals.

Of course, it's too much to ask these days for a reasoned discussion of the underlying economics of health care in Washington. However, without such a discussion, the most likely result will increase the cost of health care to you and your family.

Real reform will require a hard look at the economics of our health-care system - its strengths and its failings.

Kevin Schulman, M.D., is a professor of medicine at Duke University and a visiting scholar at Harvard Business School. kevin.schulman@duke.edu