Copyright © 2007 by Regina E. Herzlinger. Click here for terms of use.
A few years ago, I went food shopping with a new immigrant from the Caribbean. We went to a supermarket in the middle-income, blue-collar community of Waltham, Massachusetts. I had liked the place since my first visit there. When I asked a young man who was stocking shelves where I could find bulgur wheat, he not only knew what it was, he actually accompanied me to its location. But more startling was the beauty and variety of the food displays: gorgeous, crisp red-leaf lettuces nestled in pristine crushed-ice beds; orange carrots arranged in a sunburst pattern, cleverly reflected in an angled overhead mirror; pyramids of polished apples radiating light. The fish and meat counters too were mosaics of color and texture, displaying their firm-fleshed and obviously fresh wares. Even the prepared food line was stunning.
Because this supermarket was located in the People's Republic of Massachusetts, we went prepared to laugh at the veggie burgers, and yes, they were there. But so were glistening, crisp roasted chickens; wonderful melted-cheese-oozing pizzas , quiches, and pasta; and dozens of delicious salads and fragrant spiced ethnic foods. There was fresh-brewed dark roasted coffee too, along with the chicory and carob drinks. My friend marveled at the beauty, choice, and quality of the merchandise. "What a difference, " she said, "compared to the limited choice and sullen service of the markets back home. You have to beg for everything, even for a bag to put your groceries in. And the prices here are much less too."
The American consumer experience is about choices—a dizzying array of choices is available to us nearly everywhere we shop. Go to a supermarket and you will find shelves that groan with choices. You buy what suits your tastes, your dietary needs, your pocketbook. And you can choose from a large variety of markets too, ranging from your local convenience store to your metro high-end purveyor of gourmet foods. Shop for a car and you can select from hundreds of foreign or domestic makes, fuel-efficient or gas-challenged models, large or midsized or small, sports cars or family vans. Four-wheel drive? Sure, if you want it. Colors? Accessories? Options? You buy a car based on your desires, your needs, and the amount of money you are willing to spend. And you can buy your car from many different car dealers.
Yet all this consumer choice does not come at an increased price. To the contrary, the prices for consumer goods, such as cars and food, have steadily decreased as a percentage of income, while their quality has steadily improved.1The reason is that choice enables competition, and competition fuels innovation, and innovation increases productivity. In other words, we all get more for our money because of choice.
But when it comes to health insurance, there is little choice and few options. You take what your employer gives you and you go away. Want your human resources department to reward you with lower insurance premiums for not smoking and for working hard to stay fit? Want to increase your deductible and pay less for your health insurance? Want to strengthen the dental coverage in recognition of your lousy teeth and gums? "I'm a diabetic. Could my coverage include this specialized facility for diabetes…?" Forget it.
Even if your employer offers a "choice" of more than one policy, the choice is often illusory. Current insurance plans are overwhelmingly identical. If you are willing to pay a little more, you get to choose from a wider array of doctors and hospitals. If you want to pay less, you get an HMO, as Jack did, or a narrow group of doctors and hospitals. That's choice, health insurance style. What a contrast to the choice we have in items that are not so central to life or death as health care, like food or cars.
After all, "We're paying, " your employer will tell you. But, in fact, they're not. You are.
Your employer uses your money to pay for your health insurance. In a global competitive economy, your employer can pay you only some total sum in salary and benefits, say, $50, 000, and remain competitive. You can receive that $50, 000 totally in salary, or you can receive it in some combination of salary and benefits. To receive health insurance, your employers likely commandeered a lot of what would otherwise be your salary, up to $15, 000, and then used it to give you what they claim is an insurance "benefit."
Employers do not buy our clothes, our food, or our cars. We would not want them to. How can they possibly know our preferences and the prices we are willing to pay? So why in the world are we willing to give them our money to buy something much more important, our health insurance, for us?
Our employers have become our health insurance buyers because Congress willed it to be so. By jiggering the tax codes, Congress enabled corporations to buy health insurance with pretax money; but in the same breath and in the same tax codes it required that if you or I bought health insurance on our own, we could use only after-tax money.2A policy that costs us $7, 500 a year when purchased by our employer would cost us $15, 000 if we purchased it ourselves, assuming for simplicity that we are in a 50 percent tax bracket (including federal and state income tax and Social Security taxes). Not much of an option. (These and the other fatal contributions that the U.S. Congress provided to speed along Jack's death will be explored further in Chapter 5.) Some estimate the 2006 value of this tax subsidy at hundreds of billions of dollars.3
Employers have a business to run. Senior managers cannot spend a lot of time in selecting health insurance. So they have turned the job over to their human resources (HR) staffers—a really bad decision. HR personnel have many good qualities—they are well-meaning, able people—but they are not trained as business managers with numbers to meet and markets to conquer. Their motivations are paternalistic and bureaucratic rather than competitive and entrepreneurial.
HR staffers were mandated to cut costs, and they felt they could accomplish that only by limiting options, not by expanding them. They thought that by giving all their health insurance business to only a few firms, they would receive volume discounts on the price. Thus, HR staffers that were involved in purchasing health insurance for employees decided to narrow the health insurance choices the company would offer. Like typical corporate bureaucrats, they did not believe in competition, choice, and entrepreneurialism. They also mistrusted their employees' ability to choose among many options that might have been offered.
The paternalistic HR types also advocated managed care plans. You don't have to spend much time in an HR department before they tell you how irrational employees are and what terrible choices they make. Many in the HR community believed that insurance firms would do a better job of managing medical care than incompetent employees and their greedy doctors.
By limiting choice and making the health insurance policies virtually identical, HR simplified the job of comparing their costs. Their decision to limit the choice of insurance vendors and insurance plans so that their jobs would be simpler, once again demonstrated the truism that when agents serve your interests, they frequently also pay considerable attention to their own needs.
Most big businesses do not really buy insurance. They are large enough to insure themselves against the high odds of a few of their employees' becoming really sick. Instead, they self-insure; that is, they pay all of their insured employees' health care expenses. They hire insurance firms solely to administer their health insurance plans. But small businesses, like Jack's, cannot self-insure. They have to buy an insurance policy from an insurance plan. As an owner of a small business, Jack's average annual health insurance cost per employee was $4, 000, while a large business's cost per employee was $3, 300—nearly 20 percent less.4Jack was discriminated against. But this is only the beginning of the problems of small businesses in the health insurance market.
Many states mandate the benefits that health insurance policies must contain, thus increasing their cost. State governments have the power to regulate health insurance; but self-insured employers are free from this regulation because they do not buy health insurance. New York state legislators, for example, require that all insurance policies contain benefits for chiropractic therapy and in vitro fertilization. Whether enrollees want these benefits or not, all New York state insurance policies must contain them. State governments also license and regulate the insurers who are permitted to do business in the state, thus potentially limiting competition. In massive New York state, in 2006, there were only 29 such firms while the much smaller, but less regulated, state of Indiana had 77.5Some state governments force health insurance firms to charge the same prices for everyone, sick or healthy, causing many insurers to avoid doing business in them. Last, some states prohibit the sale of cheap, high-deductible health insurance policies.
Because Jack's state government actively regulated the benefits, pricing, and coverage of the insurance policies made available to small businesses, he could not find anything other than an HMO policy. Although Jack was a benevolent owner, his employees, most of whom earned less than $40, 000 a year, could not afford the $10, 000 price tag of the HMO policy for a family, and he could not afford to subsidize them.
So, as the owner of a small business, Jack wound up with only one HMO option. In theory, if Jack had worked for a large corporation, his employers could have offered him considerable choice; for example, they could have offered him a health insurance policy that would have enabled him to choose his health care provider from a broad range of doctors and hospitals, including some that specialized in the treatment of kidney disease patients like Jack. But the HR staff in the large firms would likely have forced him to accept only managed care options for his health insurance. They too would have contributed to his death.
My former boss, Harvard University's President Lawrence Summers, is a brilliant economist (despite occasional gaffes, such as questioning women's innate scientific ability and the worthiness of collegiate departments for African-American studies). But, although Summers is a great economist, and economists study financial resource allocation, I would not allow him to select my house, my car, my refrigerator, or my children's education.
As brilliant an economist as Lawrence Summers is, how could he possibly know what I want, need, and am willing to pay for in my health insurance coverage? After all, I am only one of Harvard University's thousands of employees. As a result, he did not offer me what I want in health insurance. Worse yet, I do not even know how much of my salary he commandeered to buy this health insurance, although I too am an economist.
Yet I allowed him to choose my health insurance. A historical accident explains why people like you and me sit back while our employers misuse our money to choose and buy our health insurance coverage. File it under the heading of "be careful what you wish for."
Employer-sponsored health benefits grew rapidly in the 1930s and 1940s, in part because several attempts to provide government-sponsored health insurance failed—Theodore Roosevelt's 1912 election platform included national health insurance. Private-sector insurance companies preferred to sell insurance to employed people because they were thought to be healthier than the unemployed, and it was easier to sell to one large company that represented thousands of employees than to sell to each of its many employees. In those early days, employees paid the full premium. Employers offered support for the purchase of health insurance only in the form of payroll deductions.
All this changed when, after World War II, the government froze wages and prices to control inflation. Meanwhile, the economy was booming, fueled by pent-up demand for goods and services from long-deprived returning soldiers and their families. Employers searching for a way to recruit workers hit on a great idea: exempt the money they used to purchase health insurance benefits from income taxes so it could be purchased with pre-income-tax money. GI Joe could buy his health insurance on his own with after-tax income or let his boss buy it for him with money that would not be taxed.
Clearly, the corporate promise to provide tax-free health insurance benefits could be a great lure to perspective employees. Another tax benefit loomed: corporations could (and still can) deduct the money they used to purchase health insurance from their income when they computed the amount of income taxes they owed, thus lowering their taxes—but consumers who purchased health insurance could not.
In the mid-1950s, only 45 percent of the population had hospital insurance.6But the number insured through their employers grew explosively, peaking at nearly 170 million in 2000.7In 2004, 64 percent of the insured got insurance through their employers.8
As time went on, employees tended to forget that their income was being used to buy their health insurance. Increasingly their perception was that health insurance was a freebie. But it was not and it is not.
Insured employees are effectively paying for their health insurance by accepting lower salaries than they would earn if their employer were not offering this "benefit."9After all, there is a market for labor. Employers whose total labor costs are way out of line cannot survive in globally competitive markets. Employers examine the total amount they pay for labor, including salary and benefits, such as health insurance. When the total sum becomes uncompetitive for employers who pay for their employees' health insurance, they must lower either employees' salaries or employees' benefits or outsource the work to an uninsured third party. But because of the tax preference for income that comes in the form of health insurance benefits, both employers and employees would rather cut some other components of the total compensation bucket.
For example, suppose an employer in the ferociously competitive global automobile industry who pays average employees a total of $90, 000 in salary and benefits feels compelled to reduce this total in some way to remain competitive. If the employer cuts the employees' health insurance benefits, they will have to use after-tax income to pay for the costs of additional insurance. An employee in a 50 percent tax bracket will need to earn $2 for every $1 of health insurance he or she buys for himself or herself. On the other hand, if the employer continues to buy the employee's health insurance, the employer needs only $1 of salary to buy $1 of health insurance.
The increase in the total number of people with health insurance was not totally good news either: the very fact of being insured causes people to pay less attention to the value they receive for the money. When I gave birth to my first child, I noticed a huge charge for a room on the surgery floor on my bill; but I never made it to surgery. The hospital had put me on this floor because it had run out of regular rooms. When I called the hospital to correct the bill, the clerk said, "What do you care? Your insurer, not you, is paying for this." No wonder health care costs were soaring.
Employers are increasingly trapped between a rock and a hard place. They find it difficult to reduce significantly their role in the selection of health insurance because of the tax preference attached to employers' purchase; but employees who perceive that they are using somebody else's money do not exercise their normal shopping muscles when it comes to health care.
The rise in health insurance premiums gravely injures U.S. competitiveness. Especially hurt are old-line sickies like General Motors. GM spent $5.2 billion in 2004 on health care for employees, retirees, and their families. They claim that adds up to $1, 600 for every car they made last year, more than they spent for steel. These costs, they tell us, had a "tremendous impact" on GM's billions of dollars in losses. Add lackluster sales of their products to the picture, and we can see why the auto giant is hemorrhaging money. In contrast, GM's global rivals, like Toyota, spend only $110 per car.10 (These figures are unlikely to be exactly correct, says your author, an old accounting teacher; but they, nevertheless, illustrate the magnitude of the problem. GM is likely overstating its current costs by throwing in the unfunded expenses for its retirees' health care. Toyota, on the other hand, may be understating its costs by ignoring the increased taxes paid to fund the Japanese government's substantial role in health care. But because Japan spends about half as much as the United States spends on health care, the differences in spending between GM and Toyota are likely significant.)
Don't get me wrong. I'm not pleading the case of the poor multinational corporation here, nor am I offering to pass the hat for GM. But I am concerned about the workers who are being hurt as GM lays off employees and contemplates cutbacks on benefits, including, of course, workers' health care.
What to do? Well, one HR solution, not a great one, was to require employees to pay more of their health insurance premiums. They did that. General Motors, for example, newly required its retirees to pay $752 per family per year in 2006.11The second was to reduce the payment for the benefits in the insurance policies. They did that too. From 1999 to 2006, the amount that employees spent on health care out of their own pocket increased substantially. Annual spending for family coverage doubled to $3, 000, while the percentage of insured workers whose plans had deductibles less than $500 halved.12
But these changes have not accomplished much response to the inflation in costs. Employers, still searching for new ways to control their health care costs, turned to their human resources staffs, who have come up with the ideas that many companies have tried in recent years. The results have been awful. In a bad imitation of Corporate Purchasing 101, they reduced the number of their suppliers and turned to a new breed of managed care vendors—not Kaiser, but tough businesspeople who scrutinized every health care dollar, especially those aimed at the sick.
I can choose from 240 models of cars; 500 types of chocolate bars; 50 million blogs;13but my boss offers me a "choice" of one or only a few virtually identical health insurance policies. Why do corporations limit plan choice?
Employers know that, in the long run, employees will not put up with paying more and more for less and less, so they have hit on a different solution: limit the number of plans they offer employees. This idea is Corporate Purchasing 101, a strategy perfected by Wal-Mart, fabled for its supply chain management: that is, squeezing the hell out of its vendors on pricing, product, and delivery. They endure the purchaser's bear hug because it is buying so much volume. If GM applies it, for example, by offering only a handful of health insurers to its employees, it can squeeze those insurers to get greater value for the money.
But this strategy is deeply flawed when applied to health care. Remember Professor Harold Hill, the great rascal/salesman in The Music Man? He was teaching an important business lesson when he noted that "you gotta know the territory."
Same thing with corporate strategy: you gotta know the business environment. Corporate Purchasing 101 does not work in health care.
One reason is that people have some brand loyalty when it comes to health insurance, especially for older brands like Blue Cross and Blue Shield. The brand loyalty gives the vendor power because it is difficult to take away a trusted brand product from employees.
But an even worse obstacle to the vendor squeeze play in health insurance is the idiosyncratic history of partner-providers of insurers. U.S. health insurance programs were essentially created by health services providers who wanted assurance that they would get paid for their services. Consequently, a strong relationship existed between the providers and the insurers. Naturally, in these circumstances, insurers found it hard to press their partner-providers for price concessions. In other words, the middleman in health care—the insurer—has always had a lot to do with the doctors we could use.
In 1929, Baylor University Medical Center enrolled Dallas public school employees, many of them women of child-bearing age, in a plan that guaranteed 21 days of hospital care for a premium of $6 a year. Similar monthly payment plans to local hospitals soon became popular. Plans offered by individual hospitals eventually gave way to regional Blue Cross plans supported by the American Hospital Association. Begun in 1939, Blue Shield provided coverage for physician fees in hospitals.
The local Blue Cross Blue Shield insurers, which in many parts of the country are the largest health insurers, were thus founded by the doctors and hospitals who dominated the insurers' boards.14How much could the Blues squeeze the pay of their own board members?
So the dominant, trusted brand-name insurance firms could and did push back against the corporate HR demands.
Furthermore, the implementer of this Corporate Purchasing 101 strategy was no steely-eyed purchasing agent. Health care benefits are usually purchased by the human resources department. The "I don't get no respect" mantra could well be echoed by HR personnel. In most firms, their status is at the bottom of the corporate pecking order.
The managers who really run the corporations, the ones with profit and loss responsibility, view the HR focus on benefits and employee morale as peripheral to the main corporate missions of making goods, providing services, and maximizing the bottom line.15 It does not help that most HR managers are schooled in counseling or human relations rather than in finance or accounting.16Toss in a hefty amount of sexism—most HR personnel are women17—and you can see why HR personnel are generally viewed as softies. Their history in dreaming up the Corporate Purchasing 101 did little to dispel this image.
Although this failed cost-cutting strategy did succeed in robbing employees of a choice of carriers and coverage, companies were still faced with rising costs.
The academic health care public policy community has long been enthusiastic about the prospects of using your money to manage your health care, but the American public did not share its enthusiasm. Americans simply did not want to pay somebody else to interfere with something as personal and important as their health, thank you very much. They didn't want to be told what doctors they had to see or when they had to see them, nor did they want any of the other limitations placed on them by HMOs. The few HMOs that existed were stuck in the mud.
Along came an unlikely savior for the HMOs—a U.S. president, one with a distinctive voice and a big nose.
Who was this champion of HMO health insurance? Bill Clinton, promoting Hillary-care or another of his well-intended but failed health care initiatives?
Nope. It was the Prince of Darkness himself, Richard Milhous Nixon, our tormented former commander in chief.
Nixon, whose interests lay primarily in foreign policy, was instinctively interventionist when it came to domestic policy. After all, he introduced government control of wages and prices for the economy. But Nixon was enough of a political realist to understand that governmental control of health care was not going to fly with the American public. Instead of the government, he would get HMOs to effect cost controls, while the federal government would foot the bill.
What convinced the cynical Nixon to back HMOs was the idea that "the less care they give them, the more money they make, " as his aide, John Ehrlichman, informed him on February 17, 1971:
Nixon's 1973 HMO act not only required firms that offered health insurance to include a managed care product, in which the enrollee must obtain a gatekeeper's authorization for the use of medical care, among their choices, but it also subsidized their price with hundreds of millions of dollars of your tax money. With their then-limited volume, HMOs cost more because they incurred substantial fixed costs and "gatekeepers." Richard Nixon effectively lowered their price by subsidizing it. Federal subsidies enabled managed care plans to attract customers by offering benefits that other insurers could not. Last, in its cruelest aspect, the act enabled physicians to be paid for not providing health care. After all, the just-say-no version of managed care was all about convincing doctors not to provide medical care.
A few wily entrepreneurs saw a substantial opportunity in all of this. If the traditional insurers were not playing ball with HR and the federal government was subsidizing the purchase of HMOs, these sharpies were going to offer a new kind of health insurance—they called it "managed care." Their pitch was that they would not be merely paying health care providers whatever they charged for whatever they did; instead, they would oversee them to ensure that they did not give more health care services than needed or the wrong kind of care.
The managed care entrepreneurs promised the HR types that they would manage the prices the doctors and hospitals received. No more multimillionaire surgeons and hospital CEOs lounging away their Wednesdays at the golf club.
This new managed care strategy was supported by the academic community. The academics cited the example of Kaiser. They talked about the importance of prepayment and the emphasis it enabled on prevention. They lauded health service providers whose interests were squarely aligned with the insurers in integrated managed care groups. What they did not talk about, but what they knew, was that this version of managed care put their technocratic skills of evaluating medical treatments front and center.
After all, the managed care health insurance firms these new guys created were no Kaisers. OK, Kaiser's CEO earned $4 million in 2005, not a bad sum for a nonprofit CEO.19But his millions were a pittance when compared to the gobs of money earned by the managed care entrepreneurs. Unlike the missionary Henry Kaiser and Dr. Sidney Garfield, the new entrepreneurs were clearly out for the bucks. And they were good at extracting as much money for themselves as possible. Scoundrels or not, and you be the judge, you have to admire their sheer chutzpah.
Martin "Marty" Wygod provides one example of their financial acumen. Wygod, who got his start in life by managing horses, was a little late to the managed care land grab. Instead, he focused on managing one slice of health care, pharmaceuticals. He set up a pharmaceutical benefit manager (PBM) called "Medco" that would oversee pharmaceutical expenses for the managed care enrollees. The managed care insurers were glad to offload this tedious function: people take a lot of drugs, and the information technology required to manage their prices and volume is enormously complicated. From the perspective of the managed care insurers, in a market that exceeded $1 trillion, the game was not really worth the candle: pharmaceuticals accounted for less than 10 percent of U.S. health care expenses. Pretty soon, Wygod had a big public firm on his hands.
But Wygod knew something that many people did not: a substantial fraction of Medco's profits came not only from its dazzling skill in managing drug expenses, but also from rebates the manufacturers gave Medco for favoring their drugs. Marty Wygod, no HR softie, understood Corporate Purchasing 101 very well. He threw Medco's business to those pharmaceutical firms that gave him the best prices. Not all of these discounts were passed on to the managed care firms or to their enrollees; some of the rebates were kept by Medco.
What some call a "rebate" others might call a "kickback." And when it is called a "kickback, " the congressional and executive branches of government get interested. It was only a matter of time before the PBMs would be grilled by a member of Congress intent on grabbing the lead story of the 7 p.m. news.
Entrepreneurs generally sell at the top of the market. After all, they know so much more than the buyer about the enterprise. When Wygod was ready to sell, he found a really munificent buyer, a veritable fairy godmother—the pharmaceutical firm Merck.
Merck not only paid $6.5 billion for Medco, but—and here is the part that makes this whole story worth telling—it also paid Wygod, personally, a $60 million finder's fee. Get this: the guy is the chairman of Medco; it is his job to maximize shareholders' welfare; but he is so shrewd that he somehow convinces his board to allow him to pocket an additional $60 million for selling the outfit.20
How shrewd is shrewd? Merck ultimately offloaded Medco in an initial public offering (IPO) valued at $5.5 billion in 2003. Merck never fessed up to how much money it lost, or made, while it was running this acquisition; but Eli Lilly, another pharma that bought a PBM, lost about $3 billion when it finally dumped it.21Meanwhile, Medco had the dubious pleasure of explaining to the U.S. Justice Department why a rebate from a company for buying its drugs was not a kickback and against the interest of the public.22
Our income tax codes essentially force our employers to buy health insurance on our behalf. But the selection of health insurance is not an essential business function. Executives have a business to run. So they have turned the job over to the human resources personnel. The HR crowd is made up of staffers. Unlike most businesspeople who are charged with line, or operating, functions, HR does not design, manufacture, sell, or service products. Their experiences are thus not shaped by competition. And by education, and likely inclination, they are paternalistic; they study benefit design, not supply chain management or competitive strategy.
As an examination of HR magazines and their own journals will confirm, HR professionals do not present the idea that competition among different vendors of health insurance would reduce costs and improve quality. Nor do they trust employees to make good choices. Instead, they limit health insurance choices. Faced with rising health care costs and with federal requirements and subsidies, encouraged by the academics about Kaiser, and influenced by the HR crowd, companies began to restrict these policies to ones that managed care. But the new versions of managed care that they selected bore scant resemblance to the early incarnation of Kaiser. These new versions were managed by tough businesspeople who understood that a good way to make a buck was to tightly manage the use of health care services by the sick and disabled.
We know the rest of this story. Since 1996, many employers have narrowed choice. By 2005, virtually all employers were offering only one plan, typically a managed care one.23
But HR staffs were not the only entity on the side of the HMOs. The U.S. Congress helped too by subsidizing the HMOs' prices with our tax money and passing legislation that enabled doctors not to provide medical care. Congressional munificence was not limited to HMOs; it also helped hospitals, as we saw in Chapter 3, and it really opened the coffers for some drug companies. Sadly, doctors are not on Congress's gift list. To the contrary, the U.S. Congress is encouraging Uncle Sam to become Dr. Sam, encroaching on the practice of medicine, and it has also limited the ability of doctors to manage the organizations in which they work.
As we will see, Congress has gotten powerfully involved in various aspects of health care. How would it behave if it had full control?
We can answer the question by examining congressional oversight of kidney care, the only disease that is almost fully paid for by the U.S. federal government.