Catastrophic Insurance and HSAs Can Control Costs

Published on March 20, 2010

Note to Readers:  This article is part of an occasional series of editorials on public policy issues not directly related to The Rational Walk’s typical focus on finance and investment topics.

This weekend, the House of Representatives will cast votes that could transform the nature of health care in America for decades to come.  The debate has been long and contentious and the political “sausage making” has been particularly ugly.  Progressives believe that the current proposals do not go far enough while conservatives are concerned that more government involvement in health care will lead to spiraling costs followed by rationing decisions made by government bureaucrats.  Is there any common ground that both sides can agree on?

Current System is Dysfunctional

The United States currently spends in excess of 17 percent of Gross Domestic Product on health care yet  over 15 percent of the population lacks any form of health insurance.  Furthermore, Americans spend far more than other industrialized nations on health care.  While excellent medical care is available in the United States, clearly the high cost of care and the fact that so many remain uninsured indicates that there are serious problems which must be addressed.

There are many problems that have led to the current dysfunctional system but one factor that seems undeniable is the fact that normal cost controls that apply to nearly every other market are absent from health care because consumers with insurance typically have little reason to care about costs.  While insurance companies obviously negotiate reimbursement rates with providers, the end consumer often has no idea how much his or her health care costs and has no incentive to really care.  Typical insurance policies have relatively low deductibles and modest co-payments for office visits.  Doctors have incentives to order extra procedures and tests both to hedge against medical liability lawsuits and to recover costs of expensive equipment such as MRI machines.

Our current system of employer provided health insurance stems from the wage and price controls imposed by the government during World War II in an attempt to control inflation.  Companies that needed to attract workers but could not offer higher cash wages offered fringe benefits such as health insurance instead.  After the war, efforts to treat fringe benefits  as  taxable income failed and insurance became tied to employment in a way that was not the case previously.  A “payment wedge” was created between the providers and ultimate consumers of health care which the late Milton Friedman discussed in a 1996 editorial.

While today’s system has many problems other than incentives to hold costs down (such as pre-existing condition clauses  and lifetime benefit caps), it seems clear that downward pressure on costs could be achieved by placing the consumer closer to the provider in terms of making actual payment for services.

Health Savings Accounts Offer a Solution

Most “comprehensive” health insurance policies offer relatively low deductibles and co-payments in exchange for high premiums that are getting more expensive every year.  Co-payments and other out of pocket costs are designed to provide the consumer with some incentive to control costs.  However, even with slightly higher co-payments that have become common in recent years, consumers have few reasons to seriously question or even ask about the cost of care.

Health Savings Accounts (HSA) coupled with high deductible “catastrophic” insurance offers a solution that can create downward pressure on health care costs.  In a typical arrangement, a consumer will purchase a policy that offers coverage once costs for a year exceed a relatively high level such as $3,000.  At the same time, the consumer will set up a HSA funded with pre-tax dollars that will fully cover costs up to the deductible.  In many cases, the combined cost of the catastrophic plan and funding the HSA is similar to the cost of a traditional plan.

Let us take a look at a current example.  The website offers individual and family policies and is popular among those who are not covered by an employer’s plan (although the offered plans are restricted by pre-existing conditions, a problem which requires a separate discussion).  This morning, two potential choices (among many others) were offered for a non-smoking male in his late 30s living in a mid-Atlantic state:

A consumer who selects the catastrophic plan will pay $1,548 in annual premiums while the traditional plan will cost $4,596.  However, in order to fund a HSA account to ensure that care below the deductible can be paid for, the individual should also deposit the maximum $3,050 in an HSA using pre-tax dollars.  This can be accomplished through monthly payments of $254.  The total cost for the individual for the catastrophic plan plus the HSA deposit would be $4,598 which is nearly identical to the cost of the traditional plan alone.  On an after-tax basis, the catastrophic/HSA option is superior because the HSA deposit is tax deductible for most taxpayers.

During the course of the year, medical care that falls below the deductible will be paid for using the funds in the HSA account.  The exception, which is critical, is that most catastrophic plans provide for an annual physical that is exempt from the deductible and available at a relatively low co-payment cost ($30 in this example).  This removes the potential incentive for the individual to avoid preventative care in order to avoid spending funds in the HSA.

Once the deductible on the catastrophic policy is reached, it will work much like the traditional plan but has a slightly higher annual out of pocket maximum.  In extreme situations, the traditional plan would be better because it lacks the $3 million lifetime cap. For the majority of individuals, HSA funds will build up over time and eventually the power of compounding will result in a significant nest egg that can be used for health care or other purposes in retirement.

Not a Complete Solution

No one is suggesting that broader use of health savings accounts and catastrophic policies will solve all of the health care problems in America.  However, placing the consumer in a position where he or she cares about health care spending will naturally dampen efforts of providers to sell more services.

Many critics object that consumers are not going to negotiate fees when gravely ill.  This is obviously accurate.  The idea of someone negotiating for the most cost effective heart surgery en route to the hospital is obviously absurd.  In such cases, the traditional insurance model works reasonably well and a catastrophic policy would kick in.  However, during normal times, there is no reason for consumers to regard health spending as something beyond the rules of normal economics.  Health savings accounts provide some incentives that can help lower costs.  Combined with other necessary reforms, particularly related to pre-existing conditions, significant progress could be made in a manner that keeps the consumer in control.

Catastrophic Insurance and HSAs Can Control Costs