By Robert Laszewski

I have been struck by the optimism regarding private Medicare presented by health plan executives during the recent earnings season and the analysts failure to press them on just how their numbers will add-up to sustain the long-term viability of a private Medicare strategy.

The typical private Medicare health plan operates on a medical cost ratio in the mid-80s. Let’s assume 86% for medical costs and the remaining 14% for overhead, profit, and taxes.

Government-run Medicare operates on about 3% overhead. One can argue that many federal Medicare costs are paid for elsewhere but that is the number the private plans have to compete against. So private Medicare plans spend 14% on overhead and Medicare charges
itself 3% — that’s an 11% disadvantage for the private market right
out of the box.

Private plans have to offer better benefits in order for seniors to want to buy the private plans. Let’s use 6% as the amount health plans spend for the extra benefits needed to attract seniors to their plans.

So, in this example, the disadvantage for private Medicare is not only the 11% overhead shortfall but another 6% for the benefits needed to keep selling the plans to seniors–or a total burden of about 17%.

Today, the government pays private Medicare plans an average of 13% more than it does the government-run plan–17% more for the private fee-for-service (PFFS) version that will sunset in 2011.

These extra payments are what make private Medicare so attractive to seniors and HMOs today.

Let’s say our HMO has half of its private Medicare growth in PFFS. Their average payment above what standard Medicare gets would be about 15%. So this hypothetical HMO gets 115% of what Medicare pays itself for the same senior population. Take the 11% overhead disadvantage from that as well as the extra 6% they spend on attracting seniors with better benefits and the HMO would have a medical care cost of 98% of what Medicare spends (115%-11%-6%=98%) in order to balance the books today.

So, today my hypothetical HMO is managing its medical costs at about 98% of what Medicare spends for the same senior population.

But what happens if the extra Medicare payments to private Medicare go away? It is almost certain that is going to happen–presuming the Democrats increase their majorities in the fall.

Private Medicare will always need to offer seniors something extra to get and keep their business–that extra 6% our hypothetical HMO spends today. Why would seniors buy it if there wasn’t an incentive to do so?

The whole private Medicare experiment is about the notion that the market can manage Medicare costs better than government-run Medicare. If the private market cannot get a better long-term cost outcome the whole strategy simply is not viable.

The day private Medicare gets the same payments as public Medicare the private sector is going to have to make up for that higher overhead level (11%) and better benefits (6%) by managing to a lower medical cost outcome than government-run Medicare.

Instead of private Medicare operating at 98% of the medical cost level of public Medicare, as our hypothetical HMO does today, my HMO will need to have medical costs at 83% of public Medicare in order to sustain a medical cost ratio 11 points higher than Medicare and 6% in better benefits (100%-11%-6%=83%).

For any private Medicare strategy to be viable post-excess payments to the private plans, the private plans have to beat Medicare’s costs. In my example, which I will suggest is a pretty fair approximation of the market reality, no health plan can sustain its private Medicare business plan unless it can ultimately get its medical costs to about 83% of the government-run Medicare plan. And, that would just be a tie with the public program’s costs. To prove the private market is better than government-run Medicare the result would have to be even better than that.

Most private plans are in the 95% to 100% range today. And, some of the markets they are in have much better payments than the average extra government payment of 13% and 17%.

During this past earnings season about every health plan manager has boasted that Medicare is in their future and they can achieve their earnings objectives while competing head-to-head with the public program.

But for that to happen, the typical HMO needs to reduce its Medicare benefits ratio from 95% to 100% today to about 83% to just match the performance of the government-run plan.

Not a single investment analyst challenged HMO managers on any conference call I heard on how they are going to get from here to there before the Democrats zap the extra payments private Medicare plans now get.

It would seem to me that would be at the crux of whether their private Medicare strategy had any long-term viability.