It is time to propose something different: real reform with Medicare indemnities. This article will introduce the concept of an indemnity and explain why medical indemnities would correct the perverse incentives created by the prevailing payment methods in health insurance. After describing how indemnities have been used for long-term care and the Republic of Korea to pay for medical care, I will offer a plan for designing a medical indemnity for Medicare.
An indemnity is a fixed amount of money paid to an individual after the occurrence of a well-defined event. Indemnities are common in automobile and homeowners' insurance, which pay on the basis of damages to the policyholder's automobile or house. In the case of automobile insurance, the policyholder typically receives an appraisal of the damage from the insurance company in an amount sufficient to complete the repair if a company-approved repair shop is used. Sometimes the appraisal can be obtained by the policyholder him- or herself by submitting several estimates from approved repair shops to the company. After they agree on the appraisal, the company writes a check to the policyholder, and then withdraws entirely from oversight of the actual repair. The policyholder is free to obtain the repair from one of the approved repair shops, from someone else, or to make no repair at all. Through these choices, the policyholder reveals how much the repair is worth to him.
In the case of medical insurance, indemnity payments would be made after a particular illness was diagnosed. Patients would then be free to use the money to select the optimal course of treatment. The payment could be limited to the care obtained from physicians, or services obtained from multiple providers could be bundled into a single payment. The merits of indemnity insurance for health care were discovered by a small number of policy analysts, including Mark Pauly, Frank Gianfrancesco, and Jack Hadley. Their early explorations were followed by Susan Feigenbaum's proposal to model health insurance on auto collision insurance. To my knowledge, Feigenbaum's 1992 proposal is the most recent for medical indemnities.
Mark Pauly described the perverse incentives created by the prevailing payment methods in health insurance. In contrast, a "pure" indemnity would specify the payment of a particular number of dollars to an individual with a given physical condition. Except for minor effects resulting from an increase in his income, the individual would consume the same amount of medical care as he would when paying with his own money. As a consequence, he would have an incentive to use the right amount of medical care and to shop for the best prices and types of care offered by alternative providers. Providers in turn would have incentives to become more efficient in order to gain business from indemnified consumers.
Frank Gianfrancesco was the second economist to analyze indemnity insurance for medical care. He added several more advantages of indemnities to Pauly's argument that they would create incentives for patients to use the right amount of medical care. First, he said, indemnities would make it easier for the insurer to predict its expenses because the variation in outlays "is unaffected by the variability of individual expenditures within each claim category". This would lead to lower administrative costs. Second, indemnities would lead to a more equitable distribution of insurance benefits among similarly insured individuals because each would be paid the same amount. In contrast, most conventional insurance makes larger payments to physicians who treat patients more intensively. This is a variation of Pauly's criticism of traditional medical insurance. Jack Hadley was the third economist to analyze indemnity insurance for medical care. His definition of an indemnity was different from Pauly's. Hadley viewed the indemnity as a fixed payment for each service, not a fixed payment triggered by the onset of a medical condition. He saw three advantages of per-service indemnities over a Medicare fee schedule. First, indemnities would reward patients for seeking care from lower-priced physicians; second, indemnities would not eliminate price competition among physicians; and third, indemnities would leave physicians free to change their fees when practice costs changed. The third point was particularly important because the difference between indemnity payments and physicians' actual charges could be a "barometer of how much access and quality beneficiaries are receiving". Hadley also thought that an indemnity payment system would be easier to administer than the "customary, prevailing, and reasonable" reimbursement method, in which insurers had to perform complicated administrative calculations for every physician and claim. Physicians would set their own prices (and possibly be required to post them for customers to inspect), and billing arrangements would be left up to the physician.
Susan Feigenbaum argued that the "central problem" facing our medical care system is that "consumers currently bear little of the cost of their utilization decisions". She attributed this problem to a medical insurance system that reduces the consumer's out-of-pocket price and increases the demand for medical care. To remedy it, she proposed replacing medical reimbursement insurance with a system of pure indemnities similar to auto collision insurance. In her ideal system, the subscriber's insurance company would conduct "claims appraisals" similar to those performed by an auto insurer. Upon determining that the patient's diagnosis was valid, the insurer would issue a lump-sum payment that would be accepted by contracting providers as payment in full for treatment.
Feigenbaum was aware that recipients of auto collision indemnities do not have to purchase any repair services, and she asked if there were any situations where patients might be able to spend their medical indemnities on nonmedical goods and services. One such case might be end-of-life medical care, where "one suspects that the same dollars put in the hands of the ill might be spent in a substantially different way" . Feigenbaum suggested that the individual would have to obtain "informed consent" before opting out of medical care. This would reduce the chance that he or she could later appeal to public or private subsidy programs to cover the cost of treatment. After introducing my proposal for indemnities, I will turn Feigenbaum's question around and ask if there are any conditions under which insured individuals might be compelled to buy medical care. I will also discuss the problem of enforcing indemnity contracts.
Several studies investigated the properties of an "ideal" insurance policy - that is, one that would equate the marginal utility of a dollar paid at the point of purchasing medical care to that of a dollar paid at the point of purchasing insurance. Some asked if the ideal policy would have a deductible if there were an upper limit on coverage. One had shown that if the insurer charges a "loading fee" (a cost to process each claim), the optimal policy would have a deductible to discourage small claims, followed by full insurance above the deductible. Others showed that an ideal insurance policy with a limit on coverage would include a deductible and then full coverage up to the cap. But, unlike in Arrow's analysis, the policy would have a deductible even in the absence of administrative expenses.
One reviewed the potential for indemnity insurance. Assuming only one disease and an exogenous cure rate that varies in the population, he showed that it is never socially or privately optimal to offer an indemnity larger than the cost of treatment.
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