Category Archives: Health

On Administrative Costs in Health Insurance

In a recent post, Garett Jones asks, “Will ACA’s cost-cutters outcut private insurers?” The post was inspired by a new paper in the New England Journal of Medicine presents an argument in favor of the ACA. I would like to offer some corresponding comments.

One thing that the paper emphasizes is the role of administrative costs. One argument often made in favor of a single payer system is that there are lower administrative costs with one insurer. This is thought to be true of both the insurers and the providers who would only have to negotiate payment rates with one insurer rather than many. Typically, single payer advocates use this to argue that more administrative costs imply that there is a waste of resources. Nonetheless, there are important reasons to question these claims.

First, the game is rigged. Estimates of administrative costs for government-provided insurance never include any estimate of the deadweight loss from taxation that would result from switching individuals on private insurance plans to a public plan.

Second, and substantially more important, is that this argument treats the problem as static rather than dynamic. Insurance companies have an incentive to reduce these costs. If these firms innovate in eliminating some of these costs, these innovations will also leak over into other areas of the economy. To the extent to which insurance companies are marginalized, such innovations will be less likely, which can potentially reduce the benefits of positive externalities that result from innovation.

Third, there seems to be either a misunderstanding or a lack of curiosity with respect to the issue of administrative costs on the insurer side. For example, if the government exhibits economies of scale and the private sector doesn’t then the government can provide the service more efficiently. However, the observation of lower administrative costs on the part of the government does NOT imply greater efficiency. Suppose that administrative costs are predominantly variable costs (the more claims, the higher the cost). It is possible that each individual firm’s variable cost curve lies below the government’s variable cost curve, but that the sum of the variable costs of all private firms is above that of the government. Since we are generally looking at aggregate costs of the private sector versus the public sector, this is consistent with the observation that administrative costs in the private sector are above the public sector, but does not imply any gain in efficiency by switching to the government.

Finally, on the provider sign, the claim is that providers are wasting resources by negotiating with multiple insurers. But, this argument begs the question. Why don’t providers simply negotiate rates multilaterally with insurers? Why do they choose to negotiate individually with insurers with different characteristics like size? To the extent that we believe that health care providers are profit-seeking, why wouldn’t they explore other arrangements? The observation that providers voluntarily choose to negotiate different rates with different insurers suggests not that these negotiations are a waste of resources, but rather that they are beneficial. Thus, in this instance, “waste of resources” seems to imply “not using resources the way we want them to.”