07/23/2010 04:40 pm ET | Updated May 25, 2011

The Paradox of Medicare Overhead

A great deal of misinformation, spin, and overheated hype came out of last year's debate on health care. Of the modicum of real information that managed to get through the enormous buzz of noise and confusion, the most startling was the stark comparison between the overhead of private health insurance and Medicare. Private health insurance spends 20% or more of every premium dollar on overhead: processing costs, administration, and profit. The corresponding number for Medicare is 1%.

The numbers defy belief. To conservatives, it is inconceivable that a government program could be more efficient than private industry, much less 20 times more efficient. To liberals, the contrast is welcome, because it strongly makes the case for caps on health insurance overhead, and even more so for a real public option, such as extension of Medicare to other age groups. Even liberals, however, scratch their heads as to why this could or should be so.

After pondering the question for many months, a simple explanation occurred to me. It is based on two observations. First, what we call health insurance has actually evolved from medical insurance to health care funding. Second, Medicare, as part of the Social Security Administration, is organized as a funds transfer agency, not as an insurer. Let's see what these observations mean.

Health insurance was modeled on other forms of property and casualty insurance -- the kind you buy to insure your car in case of a crash or your house in case of fire. Many, actually most, policy holders pay premiums for years on end and never make a claim, because they never suffer a loss larger than the deductable. Insurance of this type covers catastrophes: losses so large that they would threaten the solvency of a family.

Cigna corporate headquarters, Philadelphia

It seems perfectly natural that insurance companies would carefully investigate claims and rule out fraud. Any claim would be very large compared to the monthly premium -- or even compared to a lifetime of premiums. If the company spends staff hours, or even staff days, on each investigation, it is still a miniscule overhead compared to the tens or hundreds of thousands of dollars they will pay to settle the claim.

This same model carried over into health insurance. Not so many years ago, health insurance was truly "major medical" insurance. It would kick in if you had a major operation, but you wouldn't bother with it for a routine doctor's office visit.

But over years, health costs went up as the expectation for what was covered went up. Medicare partially drove the increase in expectations, as it covered both major and routine expenses. It reached the point in recent years where people expect health insurance to cover just about all of their health care expenses, except for co-pays and deductables. Further, people came to expect that private insurance would, like Medicare, pay the provider directly.

Private insurance responded to the demands, but did not fundamentally change its business structure. Claims processing remains very labor-intense, just like in any casualty insurance organization. But claims, which had been large compared to monthly premiums and once every few years became small compared to premiums and several per month. Even though the companies tried to increase their capacity and reduce their cost through automation, the fundamental model still resulted in a very expensive operation.

Social security is often misunderstood as a retirement savings plan. The way the Social Security Administration shows individual benefits contributes to this misperception. In actuality, Social Security is a money transfer mechanism. Workers and employers make deposits into the system with every paycheck. Retirees receive automatic withdrawals from the system in the form of e-checks or electronic funds transfers every month.

Social Security Administration headquarters, Baltimore

Social Security was, from its inception, a very efficient operation, devoted to doing its job at the least extra cost to the taxpayers. Their offices are spartan in the extreme: a Marines barrack looks like a Ritz-Carlton by comparison. Their procedures are what they are: remorseless, inflexible, and highly efficient.

When Medicare was created in 1965, the Johnson administration realized that there was only one government agency that would be up to the immense administrative burden: Social Security. Medicare made the rules rigid and uniform, so that the discipline learned from Social Security of handling a high volume of relatively low value transactions could apply.

So there is the root of the paradox. Medicare was, almost by historical accident, designed to be efficient at the business of health care funding. Driven both by competition within the industry and comparison to Medicare, private health insurance evolved into a condition where its overhead became ever higher.

You don't use your auto insurance to buy gas for your car, but you expect the equivalent from your health insurance. It doesn't make sense. The private insurance industry knows it doesn't make sense. They know they run like an insurance company, not like the check processing department of a bank. They can't change, and they don't really know what to do about it.

The health care bill called on private insurance to cut its overhead modestly. I expect that will prove to be a struggle, which could have unintended, and mostly bad, consequences for policy holders.

When debate ended this winter, the 111th Congress could not bring itself to dispassionately discuss the pros and cons of extending Medicare to more age groups on an opt-in basis. As we contemplate future deficits and the incomplete job done on health care financing, the opportunity to utilize the low overhead of Medicare is still on the table for the 112th and 113th Congresses to consider. Hopefully with better arithmetic and less vitriol.