A common justification for Medicare is that the public health insurance system has an overhead cost which is about 2% of claims, while the private sector has administrative costs between 20%-25% of claims. This tells us that Medicare is the best system for America…right?
Merrill Mathew’s of the Council for Affordable Health Insurance (CAFI) summarizes the findings of Mark Litow’s paper “Medicare’s Hidden Administrative Costs.” Litow finds that taking into account extra legal costs from Medicare adjudication and CMS salaries, the administrative cost ratio increases to 5.2%.
Private Insurance on average has administrative costs of 16.7% (varying between 30% for individual policies to 12.5% for large group policies). Yet these figures are inflated. If we exclude taxes and profits, as well as sales commissions, then the total administrative costs decrease to 8.9% overall and 8.0% for large group policies. I do not agree that commissions should be deducted from this this figure but profits and taxes certainly should. Medicare does not pay taxes and does not make a profit so any fair comparison should exclude these items. Further, tax revenue from insurance companies adds to the public’s coffers; profits should be seen as a cost of capital.
Even with Litow’s manipulation of the numbers, Medicare seems like a better deal. Let’s see why:
- Economies of scale: There are large economies of scale in the insurance business; however ,large insurance companies can certainly replicate the majority of the scale economies Medicare enjoys.
- Cost of Capital: Medicare incorrectly counts its cost of capital as 0. The true cost would take into account the direct cost of hiring IRS workers to collect the taxes which pay for Medicare as well as taking into account the distortionary effects of income taxation on workers labor supply decisions. For the private sector, the costs of capital is transparent: it is simply the interest rate.
- Demographics: Medicare serves the elderly population and thus has a high cost per enrollee. In 2003, the average medical cost for Medicare was $6,600 per person per year, while the same figure for private insurance was $2,700. Thus, if public and private health insurance had the same administrative cost per person, Medicare would still be seen as ‘more efficient’ since Medicare’s administrative cost ratio would be less than half the size of the private insurance’s cost ratio.
Finally, we need to realize that administrative costs are like people: some are good, and some are bad. What if a private insurance company raised its administrative costs by 1% , but was able to reduce fraudulent claims by 10% and reduce the premium charged to customers by 8%. This is an example of how an increase in the administrative cost ratio can add value. It is likely that private companies try to avoid paying for unnecessary medical treatment and are more vigilant to detect fraudulent claims then Medicare.