The man who watered down the public option explains what government economists got wrong.

How to fix health policy.
Nov. 19 2009 1:02 PM

Mr. Level Playing Field

Len Nichols explains why his "level playing field" is misunderstood by the Congressional Budget Office.

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Len Nichols.
Len Nichols, director of health policy for the New America Foundation

Washington is a place where politics and economics often aren't on speaking terms. Nowhere is this more apparent than in the twilight struggle to create a "public option" government health-insurance program. After protracted negotiation with conservative "blue dog" Democrats, House Speaker Nancy Pelosi passed a health care bill that included a watered-down public option that would not be permitted to align physician and doctor fees with Medicare rates, which typically are below the rates paid by private insurers. Even so, public-option advocates like me argued, the advantages inherent in government health insurance would price public-option premiums lower than premiums for private insurance, exerting downward competitive pressure on the private market. This was health care reform's most effective tool for curbing medical inflation.

We were wrong. Not in any cosmic sense, mind you, but, rather, in the narrow sense that this particular version of the public option, known to the cognoscenti as the "level playing field" option because it would operate identically in most respects to its private competitors, would not, in fact, price its premiums below the private market. That, at any rate, is what the Congressional Budget Office concluded and what it is likely also to conclude with respect to the "opt-out" version of the public option that Senate Majority Leader Harry Reid has submitted to the CBO for scoring. It's also the conclusion of Richard Foster, chief actuary of the Centers for Medicare and Medicaid Services, in a Nov. 13 memo on the House bill.

How did we not see this coming? Seeking an answer, I paid a visit to Len Nichols, director of health policy at the New America Foundation.

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The public option was invented by Jacob Hacker, a political scientist at Yale (and former New America fellow), but the level-playing-field variation was dreamed up partly by Nichols, an economist. There's some irony here, because Hacker's original vision was shrewder economically than it's proven to be in the political realm, while Nichols's variation (since endorsed, I suspect reluctantly, by Hacker) turned out to be sharper about politics than economics. Possibly, the greater real-world pungency of Nichols' version can be attributed to his collaborator on the March 2009 paper  that first proposed the idea: John M. Bertko, former chief actuary for Humana Inc., a major health insurer. *

In reviewing Nichols and Bertko's paper, I was reminded that that they never made any great claims to extravagant cost savings. In comparison with "price-control centered strategies"—e.g., Medicare—"our approach to cost containment relies on a more market-oriented approach to value-based purchasing, which admittedly could take some time to materialize." The paper continues:

Yet, this kind of policy is also more likely than the buying power of one public payer to find a politically sustainable balance between access, quality, and affordability over time. In addition, there is widespread agreement that the main source of health care cost growth in the long run is not provider price inflation, but rather inappropriate use of new technology. … We think payment reform and best-practice information is more likely to enable sustainable cost growth reduction than price controls from public plan market power alone.

If you're gonna squeeze somebody, Nichols and Bertko were saying, don't squeeze insurers. Squeeze doctors and hospitals gently over time. I didn't like this approach when they first suggested it (I called it "lemon capitalism"), but over time, I came to recognize that the level playing field was the only version of the public option that had much chance of becoming law. And, anyway, it would still be cheaper than private insurance, right?

Wrong, said the CBO on the accursed sixth page of its analysis of the Pelosi bill. The CBO had earlier said that a public plan tied to Medicare reimbursement rates "would be about 10 percent cheaper than a typical private plan offered in the exchanges." Not so with the level playing field: Roughly one-fifth of the people purchasing coverage through the exchanges would enroll in the public plan, meaning that total enrollment in that plan would be about 6 million. According to the CBO report:

That estimate of enrollment reflects CBO's assessment that a public plan paying negotiated rates would attract a broad network of providers but would typically have premiums that are somewhat higher [italics mine] than the average premiums for the private plans in the exchanges. The rates the public plan pays to providers would, on average, probably be comparable to the rates paid by private insurers participating in the exchanges. The public plan would have lower administrative costs than those private plans but would probably engage in less management of utilization by its enrollees [including "cherry picking" healthy customers and "lemon dropping" sick ones, which would be reduced but not eliminated by health reform's new regulations] and attract a less healthy pool of enrollees.

The analysis of the House bill by the chief actuary of the Centers for Medicare and Medicaid Services said much the same thing, estimating premiums for the public option would cost 4 percent more than those for private plans. Were adverse selection not a factor, it said, premiums for the public plan would be 5 percent cheaper than for private plans.

The adverse-selection problem hadn't even been mentioned in Nichols' and Bertko's original paper. It had, however, been discussed by Princeton sociologist and Hillarycare veteran Paul Starr in a rather prescient June essay for the American Prospect ("Perils of the Public Plan"):

Here's the delicate political problem: Depending on the rules, the entire system could tip one way or the other. Unconstrained, the public plan could drive private insurers out of business, setting off a political backlash not just from the industry but from much of the public. Over-constrained, the public plan could go into a death spiral itself as it becomes a dumping ground for high-risk enrollees, its rates rise, and it loses its appeal to the public at large. Creating a fair system of public-private competition—giving the public plan just enough power to offset its likely higher risks—wouldn't be easy even if it were up to neutral experts, which it isn't.

Starr elaborated in an August essay for the American Prospect ("Sacrificing the Public Option"):

Private insurers have spent decades perfecting the art of attracting the well and avoiding the sick. As the annual open enrollment approaches, for example, insurers will strive to re-enroll their current healthy low-cost members, while letting the sicker ones migrate to other plans. The public option, however, would likely refrain from using practices of this kind, and its costs would be correspondingly higher. Instead of being outcompeted, the private insurers could use the public plan as a dumping ground for the sick.

Some provisions in reform legislation attempt to mitigate this risk. The most important of these calls for "risk adjusting" payments by the exchanges to the plans—that is, providing a bonus to plans that enroll a sicker population and paying proportionately less to plans that enroll a healthier group. But it would be a mistake to think that such methods can completely avert the danger that the public plan will experience higher costs. As a result, just to break even, the public plan might require higher premiums than private insurers charge.

When I mentioned Starr's pieces to Nichols, he said he hadn't read them. But he's well familiar with utilization management, and he thinks it's a red herring. Yes, he said, of course private health insurers engage in it—and so would the level-playing-field public option. A level playing field means that if Aetna is cherry-picking and lemon-dropping, Uncle Sam must do so, too. CBO and the Centers for Medicare and Medicaid Services, Nichols told me, "are presuming public option managers will be passive." But they won't be.

Vigorous utilization management, Nichols explained, is already standard practice in the public plans that more than 30 states currently offer to state employees as an alternative to private health insurance. But what about people with chronic medical conditions, I asked. "Most people who have the most serious chronic conditions already have coverage," Nichols answered. And, anyway, Nichols said, by requiring guaranteed issue (i.e., insurers must take all comers), health reform will give private insurers a financial interest in their customers' continued good health that they didn't have before. The same would be true for the public option.

OK, I said. Then why have a public option at all?

Nichols' answer surprised me. In many places, he said, it isn't necessary. In Seattle, in Denver, and in Northern California, he said, there's already a lot of aggressive competition among health insurers.

But in other, typically more rural places, he said, it is necessary—in Arkansas, for instance, where Nichols is from, and North Dakota and Maine—because these places are much more likely to be dominated by a single insurer (typically "the Blues"—i.e., BlueCross BlueShield, which, since their origins in the 1930s as community-minded nonprofits, have largely evolved into aggressive for-profit companies). In Little Rock, Ark., Nichols told the Senate commerce committee in July, BlueCross BlueShield has a 75 percent market share. The Blues maintain their dominance, especially in the small-group market, by paying doctors "at very high levels," Nichols testified, driving up prices so high that potential competitors like Aetna or Cigna can't sign them up.

The head-splitting irony is that these rural places are the very ones most opposed to health reform generally and a public option in particular. Sen. Blanche Lincoln, D-Ark.; Sen. Olympia Snowe, R-Me.; and Sen. Kent Conrad, D-N.D., all voted against the public option in the Senate finance committee. The political resistance in such places to the public option has turned Nichols against Reid's opt-out provision. Why offer an opt-out, Nichols says, when the likeliest places to opt out are the ones that need the public option the most? Instead, Nichols favors Snowe's trigger. If health reform brings in enough private competition to get the rural monopolists to clean up their act, he says, mission accomplished. If not, their continued dominance will trigger competition.

That assumes, of course, that a Congress that rejected a public option on the first go-round would allow the trigger mechanism to be activated. I have pretty strong doubts  that it would.

In general, I don't find Nichols' vision of a public option very cheering. It either wouldn't keep costs down or would keep them down very little—and would do so by manhandling those most in need of health care to roughly the same extent that private plans do. But perhaps it would provide something to build on. I don't honestly believe the government would allow the manhandling—or, if it did, I don't believe it would allow that treatment for very long. Nor do I think it would allow the public option to sustain the "death spiral" described by Starr any more than it allowed the theoretically independent FannieMae to go broke.

Still, I could be wrong. I'd never have guessed that, six years after Medicare introduced a drug benefit, it would still be forbidden to negotiate prices with pharmaceutical companies. Health reform might fix that, but it probably won't.

E-mail Timothy Noah at chatterbox@slate.com.

Correction, Nov. 18, 2009: An earlier version of this column misspelled Bertko's last name. ( Return to the corrected sentence.)

Timothy Noah is a former Slate staffer. His  book about income inequality is The Great Divergence.

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