Monday, September 21, 2009

Thinking About Health-Care Profitability

I have a short piece up over at National Review Online:

The Obama administration and the congressional Democratic leadership have made a tactical decision to demonize health-insurance profits as part of their drive to promote health-care reform. Specifically, they are using this tactic to sell a "public option," through which the government would provide health insurance directly to the public. The attack plays to Americans' distrust of insurance companies. It is also untrue.

In a recent press conference, President Obama said, "There have been reports just over the last couple of days of insurance companies making record profits, right now. At a time when everybody's getting hammered, they're making record profits, and premiums are going up." Likewise, President Obama told Congress that insurers cherry-pick the healthiest (and thus lowest-cost) individuals while dropping coverage for those who become sick. "Insurance executives don't do this because they are bad people," the president explained. "They do it because it's profitable." Summing up, House Speaker Nancy Pelosi simply says of insurance companies, "They are the villains in this."

If so, they're not very competent villains. Despite all the hype, the health-insurance industry's profit margins remain modest. On average, health insurers deliver a profit of less than 4 cents for each dollar of sales.

Health insurance's profit margin is lower than that of the soft-drink industry, which competes ferociously through advertising. It is lower than that of the fast-food industry, which lures customers with dollar menus and supersized meals. It is far lower than that of the beer industry, with its profit margin of 18 percent. And it's not just foodstuffs that earn higher profits than health insurance: Some 85 industries have higher profit margins.

Democrats point out that insurers' profits approached $13 billion last year. "I mean, they are making so much money it is just ridiculous," said Sen. Jay Rockefeller (D., W. Va.). But Rockefeller, who owes his own substantial fortune and — let's face it — his seat in Congress to his great-grandfather, the oil magnate John D. Rockefeller, should know that any large industry will generate significant profits simply by virtue of its size, even if its profit margin is small. Yet the margin is what matters. Large industries divide profit among millions of investors, each of whom is seeking a decent return on his money. 

The problem with health care isn't excessive profits; it's excessive costs. The U.S. health system encourages overconsumption, with some experts estimating that up to 30 percent of health spending is wasted. But the question of profits remains important for two reasons.

First, you can often judge politicians' intentions on issues you don't understand — which, for most of us, includes the vast majority of health-care policy — by their truthfulness on issues you do understand. If their strategy is based on a claim that is so easily disproved, what will they do in areas you can't check? Second, the profit margins in private health insurance should give us pause regarding the public option, which would ostensibly be run as a non-profit.

Assuming that the only difference between the public option and private insurance is the need to deliver a profit, the public option would cost only about 4 percent less than private-sector coverage. And even this is an overstatement. Private health insurers produce a profit to pay the return demanded by their investors. The public option, instead of having investors, would receive its capital from the government. Those funds will be borrowed, of course, and the taxpayer must pay interest. When interest costs are included, the total costs of the public option are about the same as those of private insurance.

While demonizing health-insurance profits is a central part of the Democratic leadership's strategy, it is a red herring: health insurance is no more profitable than dozens of other industry sectors. And it's the free market that keeps it so. That's something to be remembered as the health debate progresses.

Andrew Biggs is a resident scholar at the American Enterprise Institute.

4 comments:

Arne said...

Isn't the complaint regarding health insurance more about administrative costs than about profits?

Andrew said...

Interesting post. Though it seems to be the normal thing to do (as with the energy debate last year), I think you are mistaken in looking at margins. Return on investment is a much better measure of whether an industry is getting abnormally high returns.

Andrew G. Biggs said...

Arne, you are right that many people argue that Medicare has lower administrative costs than private health insurance, but I'm not sure those claims really hold up to scrutiny. For instance, Medicare patients have much higher per patient spending so expressing administrative costs as a percentage of total costs will be skewed low. Likewise, Medicare forces doctors to bear some of its administrative burdens, hereby lowering Medicare's measured administrative costs. This paper (http://www.cahi.org/cahi_contents/resources/pdf/CAHI_Medicare_Admin_Final_Publication.pdf) discusses some of these issues.

Andrew G. Biggs said...

Andrew, you may be right that return on equity is a better measure, but health insurance's ranking relative to other industries is around the same whether measured by return on equity or net profit margin. Ranked by return on equity, health insurance is the eighty-seventh most profitable industry in the US.