Explaining Premium Support:  How Medicare Reform Could Work
Jeff Lemieux
Revised November 6, 2003 (to correct a typographical error in the text).

Abstract:
The premium support concept is both loved and vilified, but it is not very well understood.  This report outlines the structure of a national (federal employees-style) premium support system in Medicare.  It includes the basic rationale for premium support and a step-by-step example of how premiums would be calculated.  Ideally, a premium support system would create a competitive process under which (1) Medicare benefits could evolve more rapidly toward national norms, and (2) spending growth could be expected to slow, creating better value for beneficiaries and taxpayers.  The Congressional role in Medicare would gradually shift from micromanagement to oversight and outcomes evaluation.

There are two ways to implement a premium support system:  a national premium schedule with geographic adjustment, or a set of local premium schedules.  There are advantages and disadvantages to both approaches.  A local premium schedule approach would have no effect on beneficiary premiums in areas where no private health plan options existed.  However, a local system could have premiums that changed by larger amounts from year to year, and would lead to differing prices for the government-run fee-for-service plan (or plans) in different locations around the country.  A national system would be more likely to spur the creation of private nationwide or regional health plan options.  It would be a larger political leap in some ways, but a national system would be simpler and easier to explain to senior citizens.

Outline:
Introduction -- Premium Support as a Potential Alternative to Benefit Cuts, Tax Increases
A Federal Employees-Style Premium Schedule
  Premium Support Vs. Defined Contribution
A National Premium Support Approach -- The Original Breaux-Frist Model
  National Premiums, Geographic Adjustment and Risk Adjustment
  Sensitivity Testing
Local Premium Support Proposal in the House-Passed Medicare Rx Bill
Commentary

Introduction -- Premium Support as a Potential Alternative to Benefit Cuts, Tax Increases:  The National Bipartisan Commission on the Future of Medicare, co-chaired by Sen. John Breaux and Rep. Bill Thomas, was a byproduct of Congressional dissatisfaction with the deep Medicare budget cuts enacted in the Balanced Budget Act (BBA) of 1997, and with the legislative process that created them.

The Medicare Commission's main worry was the projection of unsustainable Medicare spending growth.  Congress knew the BBA cuts were only a temporary fix. 

The secondary concern was with process.  The BBA was a prime example of Congressional micromanagement -- hundreds of provisions setting Medicare's payments and rules, which would require thousands of pages of regulations to implement.  In some cases, BBA rules had to be modified or even reversed in subsequent legislation.  The process was fraught with problems and errors. 

The third objective of the Medicare Commission was benefit evolution and modernization.  Medicare's benefits have largely remained stuck on the original 1960s model because changing them requires an act of Congress, which rarely occurs.  By contrast, private insurance systems, like the federal employees' program, have allowed health plans to gradually adapt benefits to changes in health care, without Congressional action.

Slowing the Growth of Medicare Spending.  Figure 1 shows current projections of Medicare spending to 2030 as a percent of Gross Domestic Product (GDP), with and without the addition of the modestly sized drug benefit being debated in Congress.

Figure 1.


Medicare spending is projected to begin growing rapidly as a share of the economy (and the federal budget) when the baby boom generation begins to retire in large numbers after 2010. 

There are five unpalatable ways to deal with rising Medicare costs:  (1) Raise taxes, (2) Cut Medicare benefits, (3) Cut payments to health providers, (4) Cut federal spending elsewhere in the budget, and (5) Tolerate potentially ruinous deficits.  Tax increases, spending cuts, or additional deficits in the range of 3 or more percent of GDP would be very difficult to enact and tough to endure.  Cuts in benefits or provider payments would have to be dramatic, and might not be consistent with a reasonable level of health care for senior citizens.

The Medicare Commission sought out alternative, less disruptive ways to ease Medicare's budget problems.  

Process Improvements.  Ideally, any Medicare reform should begin the process of ending Congressional micromanagement of all the details of Medicare payments, benefits, and rules.  Medicare administrators should be accountable for the program's results -- improvements in seniors' health and well-being -- and should have flexibility to achieve better results.  They should not be consumed with writing rules to implement exceedingly complex and prescriptive laws passed by Congress.

The original Medicare proposals by Senators Breaux and Bill Frist included a process that would give a strong measure of flexibility to the traditional government-run program -- including a high-option plan with a prescription drug benefit -- in exchange for putting the government-run plan (or plans) under the umbrella of a competitive system.  

Benefit Modernization.  At the time of the Medicare Commission, prescription drugs were the main benefit modernization considered.  (Commissioners also recommended some smaller-scale benefit rationalizations, such as a combined deductible and cost sharing for some outpatient services.) 

Now, health experts are encouraging Medicare to implement programs or processes that would lead to better care for people with long-term or chronic health conditions.

Chronic care takes place between regular physician or hospital visits.  It can include between-visit monitoring or educational services. 

It may not be worthwhile for health insurers to make investments in chronic care services unless they would receive a financial payoff via reductions in the number of hospitalizations or other expensive health services.  This is another reason why Medicare beneficiaries should receive care from comprehensive health plans (which cover the full range of health services, not just one service or another).  A premium support system is designed for comprehensive health plans with the full scope of benefits.

Direct Competition Under A Federal Employees-Style Premium Schedule:  The Medicare Commission recommended directing the program toward the premium support system used by federal employees, in an attempt to slow the growth of spending, reduce Congressional micromanagement, and improve Medicare benefits.

The essence of a premium support system is the premium schedule, the formulas that determine beneficiaries' premiums depending on which health plan they choose.  The premium schedule is based on a national (or local) benchmark or reference premium.

A motivating idea behind premium support is that public-sector and private-sector health plans will react to one another's progress or failings eventually, through both legislative and market processes.  Why not make those reactions and counter-reactions more direct and efficient?

For example, when Medicare launched new price controls for hospitals in the 1980s, the program's cost growth slowed dramatically.  After a while, employers realized that private health plans were paying much more for hospital care than the government.  They demanded cost reductions from private health plans.

Private plans could not control hospital prices -- they generally didn't have sufficient market power.  However, over time they developed managed care techniques to help enrollees avoid hospitalization, which, in turn, increased their ability to bargain for favorable hospital rates.

When managed care dramatically reduced the growth of private plan premiums in the mid-1990s, Congress reacted by legislating new payments cuts in Medicare, via the BBA.

The goal of a premium support system is to allow private and public health plans to compete side by side.  Enrollees would be given a choice of plans each year, and would be allowed to save money on their premiums by switching to less expensive plans.  This process would force private and public health plans to mimic each other's successes (and avoid failures) directly -- consumer preferences would be revealed quickly through the enrollment process.  Seniors and taxpayers would not have to wait for Congress to decide on changes in their health insurance.

Premium Support Vs. Defined Contribution.  A premium support system can be confused with a defined contribution approach. 

Under premium support, the government pays a fixed percentage of the average premium in the system.  Therefore, the government's costs would rise or fall at the same rate as enrollees' health premiums (in the aggregate).  The government would share in the cost or (sometimes) savings when health costs rose or fell.  In a sense, the government would share with enrollees the "risk" of rising health costs and the "reward" from falling health costs.

Under a defined contribution, the government would pay a fixed amount, which would be indexed higher over time by some outside measure, such as some multiple of the Consumer Price Index (CPI), or a formula based on growth of nominal (not inflation-adjusted) Gross Domestic Product (GDP).  Therefore, the government's cost would not rise or fall with changes in health spending or premiums.  If health premiums rose faster than the index measure, the enrollees' share of health premiums would rise.  Likewise, if health premiums grew slower than the index measure, the percentage of the premium paid by enrollees would fall.  Therefore, enrollees would take the risk of rapidly rising health costs, and would receive the reward if health costs fell.

Of course, under either a defined contribution or a premium support system, enrollees could affect the rate of growth of health costs by choosing more or less expensive health plans.  Health costs are not exogenous in this sense -- people's choices of richer or more spartan benefits, or more or less restrictive health plans, would actually change the rate of growth of health spending.

A National Premium Support Approach -- The Original Breaux-Frist Model:  Under a national premium support system in Medicare, the government would pay about 90 percent of the "weighted average" premium for standard benefits.  In addition, the government would pay an extra amount toward the cost of certain "high option" plans.

The average premium would be weighted by the number of enrollees in each plan.  In the Breaux-Frist model, the average premium would not include certain optional benefits.  (Health plans -- including the government-run plans -- would have to separate out the cost of optional benefits when they made their annual premium bids.)

For example, the table marked Step 1, Plan Premiums (below) shows a simplified example of a national premium support system with three government-run plans and 4 private plans.  In this example, the government-run plans would account for 80 percent of the total enrollment.

Plans would submit their bids for the following year, as shown.

Step 1, Plan Premiums
(Example)
Plan	Last Year's Enrollment	Total Premium
Gov't std	60%	6,500
Gov't high1	10%	7,300
Gov't high2	10%	7,500
Priv A std	5%	6,700
Priv A high	5%	7,500
Priv B high	5%	7,300
Priv C high	5%	6,300
Total	100%

If the plan was a "high-option" plan with optional benefits, it would also submit a separate premium for standard or "core" benefits, as shown in Step 2, National Weighted Average Premium (below).

The national weighted average premium would be computed from these adjusted premiums for core benefits.

Step 2, National Weighted Average Premium
(Example)
		Premium for
Plan	Last Year's Enrollment	Core Benefits
Gov't std	60%	6,500
Gov't high1	10%	6,500
Gov't high2	10%	6,500
Priv A std	5%	6,400
Priv A high	5%	6,700
Priv B high	5%	6,400
Priv C high	5%	5,500
National Weighted Average		6,450

In this example, the national weighted average premium would be $6,450.  This number is very important, because it would be the reference premium or "benchmark" for the national premium schedule, the set of formulas that computes the enrollee premium for each plan.

Step 3, Computation of National Premium Schedule (below) shows an example of how such a premium schedule would work.  This premium schedule sets the final amount a beneficiary would pay for standard (not high option) plans.  Under the Breaux-Frist model, enrollees selecting a high option plan would receive an additional premium reduction or discount (to encourage seniors to enroll in high-option plans).

This premium schedule is set so that the enrollee would pay 10 percent of a plan's premium if that premium equaled the national weighted average for standard benefits.  In general, the enrollees' share would decline rapidly toward zero for plans with premiums below the national weighed average.  However, enrollees would pay the full amount by which a standard plan's premium exceeded the national weighted average.  (Again, enrollees would get an additional discount from these amounts if the plan they selected was a high-option plan, as discussed below).

For example, consider an enrollee in the government run standard plan.  The premium for that plan is $6,500, as shown in Step 1.  Based on the National Premium Schedule in Step 3, the enrollee's annual share of the premium would be $700, or about 11 percent of the national weighted average premium for standard benefits.  (Because the government-run standard plan enrolls more than half of all Medicare beneficiaries in this example, it makes sense that the premium for this plan would be very near the national weighted average premium, and that the enrollees' share of the premium would be very close to 10 percent.)

Step 3, Computation of National Premium Schedule
(Before Extra Discount for High Option Plans)
Plan	Enrollee	Enrollee
Premium	Premium	Premium
		(percent)
5,300	0	0%
5,400	0	0%
5,500	10	0%
5,600	80	1%
5,700	150	2%
5,800	210	3%
5,900	280	4%
6,000	350	5%
6,100	410	6%
6,200	480	7%
6,300	550	9%
6,400	610	9%
6,500	700	11%
6,600	800	12%
6,700	900	14%
6,800	1,000	16%
6,900	1,100	17%
7,000	1,200	19%
7,100	1,300	20%
7,200	1,400	22%
7,300	1,500	23%
7,400	1,600	25%
7,500	1,700	26%
7,600	1,800	28%

Step 4, Open Enrollment (below) shows enrollee premiums as computed from the national premium schedule, but with an extra $200 annual premium discount for high option plans.  This is the final premium schedule that would be sent to Medicare beneficiaries each year, representing the choices they could make.  

For example, the government-run high option plan #1 bid a total premium of $7,300 (from Step 1).  According to the main premium schedule, the enrollee premium for that plan would be $1,500 a year.  However, enrollees in high-option plans qualify for an additional $200 discount.  So the total premium due from an enrollee in the government-run high-option plan #1 would be $1,300.

Under a premium support system, this is the "price" a Medicare beneficiary would see on his or her annual menu of choices.  It would be deducted from the Social Security check, as Part B premiums (standard for most Medicare beneficiaries) are deducted under current law.  (Note, these are annual figures -- beneficiaries would probably be quoted a monthly price or premium.)

Step 4, Open Enrollment
	Enrollee Premium	Enrollee Premium After
Plan	Before Discount	High Option Discount
Gov't std	700	700
Gov't high1	1,500	1,300
Gov't high2	1,700	1,500
Priv A std	900	900
Priv A high	1,700	1,500
Priv B high	1,500	1,300
Priv C high	550	350

National Premiums, Geographic Adjustment and Risk Adjustment.  One of the advantages of a national premium support system is that the national, government-run plans would have the same premium nationwide.  Another key advantage is that a national system could encourage private plans to create nationwide, or at least regional options.

Geographic Adjustment.  A national premium support system would require a geographic adjustment to properly compensate plans whose service areas were in higher- or lower-cost areas.

At first, the geographic adjustment would mimic the current location-based differentials paid to private health plans in Medicare.  These adjustments include the effects of local input prices and also service levels or local practice patterns.  Starting with the current adjustment would avoid any disruption to current service. 

Over time, however, the Breaux-Frist plan would reduce those differentials to the point where they only represented input costs, not differing levels of services.

The following illustration gives an example of how two plans would adjust their premium bids to account for differing geographic adjustments they would receive for enrollees within their respective service areas.  (For this process to work, plans would have to know the geographic adjustment levels in advance.)

Illustration--Plan Premiums in Higher- and Lower-Cost Areas
	Plan X	Plan Y
Geographic Factor	1.10	0.90
Amount Plan Needs for Patient Care	7,150	5,850
Plan Submits Premium	6,500	6,500
Plan Payment from Medicare	7,150	5,850
Beneficiary Premium	700	700
Note: Plan X is a standard plan in a higher-cost area; Plan Y
is a standard plan in a lower-cost area.

In this example, both plans are equally efficient, but one plan is in a higher-cost area.  The geographic adjustment allows their final premium bids to be identical -- an enrollee would pay the same premium in either plan.

Geographic adjustment has both advantages and disadvantages.  On the one hand, it adds complexity and the potential for political interference (legislators in low-cost areas frequently complain that the current geographic adjustment formula used for payments to Medicare HMOs fail to reimburse plans equitably in their districts).  On the other hand, geographic adjustment would encourage private health plans to operate nationwide, or at least in large regions of the country.  They would be assured of adequate reimbursement even if most of their enrollees lived in high-cost areas.

Risk Adjustment.  Plans would also adjust their bids if they knew they would receive significant payment adjustments based on the health status or "risk" of their enrollees.  The adjustment for risk could include proxy measures such as age and sex, which are correlated with expected health costs.  The adjustment would also include direct measures, such as diagnosis at previous hospitalization, drug prescriptions (if available), or other medical encounter data.

Like geographic adjusters, risk adjustment methods would be known to plans prior to when they submitted bids.  If a plan knew it would likely have disproportionately older or sicker enrollees, and would receive extra payments due to the risk adjuster, it could adjust its bid accordingly to remain competitive.

Sensitivity Testing.  A national premium support schedule would be quite stable.  Under virtually any scenario over next 10 or 15 years, the government-run plan (or plans) would remain the most common choice of seniors, with a market share well above 50 percent.  Therefore, the national weighted average would be dominated by the cost of the government-run plans.

Suppose, for example, in the above example that the cost of core benefits in all three government-run plans was $500 higher (and that the cost of the private plans remained the same).  This scenario is a proxy for the fears of many Democrats that the government-run plans would not be able to compete with private plans, or that the risk or geographic adjusters would be biased against the government-run plans. 

Under that unfavorable scenario, therefore, the cost of each government-run plan would be $7,000 instead of $6,500 in Step 2.  The national weighted average would jump from $6,450 to $6,850.  Recomputing the national premium schedule (Step 3) based on the new national weighted average premium of $6,850 would cause the premium for enrollees in the government-run standard plan to rise by about $100 a year, from 11 percent to 12 percent of the total cost.  That is significant, but it would hardly be devastating.

Even assuming a bad scenario, therefore, the enrollee premium in the government-run plan would not rapidly rise to levels that threatened its viability.  Moreover, we could be sure that if the government-run plans truly had difficulty competing with private plans, Congress would enact laws to grant them more flexibility.  Likewise, if the risk adjusters or geographic adjusters were somehow biased against the government-run plans, Congress would quickly fix them.

To be sure, if the government-run plans failed to compete in the long run, they could gradually lose market share and their premiums could rise more significantly.  Still, it seems likely that Medicare's government run-plans would find ways to keep their costs under control in ways that benefited both enrollees and taxpayers.  That, obviously, is a key goal of premium support.

Local Premium Support Program in the House-Passed Medicare Rx Bill:  The House-passed Medicare bill would create a rudimentary local premium support system, which would be phased-in very slowly beginning in 2010.  

It's not possible to know whether the House-passed local premium support system will emerge from the House-Senate Medicare negotiations, or to say exactly what its characteristics would be.  But here are some basics. 

A local premium support system would be limited to designated "high-competition" areas.  All health plans serving the area -- including the government-run plan -- would submit bids, and beneficiaries' premiums would be computed based on a local premium schedule.

One advantage of a local premium support system is that the premium for the government-run plan (or plans) would only be affected by competition in areas where people had choices of alternative private plans.  For example, if competition drove the premium for the government-run plan up in an area, that would automatically indicate that there must be some low-cost private options available.  Similarly, if there were no private plans available, or if the available private plans were expensive, the cost of the government-run plans would either be unchanged or would be driven down, not up.

The biggest disadvantage of a local premium support system would be that seniors living in different areas of the country would face different premiums for the government-run plan.  The government-run plan would "bid" on its costs within the locality, and its premium would be determined locally, based on that bid and the bids of private health plans.  People living outside the area, with different local costs and health plan options, could end up paying different amounts for the same government-run plan.  Seniors might have an advantage to move to get a better price for the government-run plan, or to register for the plan from the most favorable location.

Another disadvantage is premium variability.  In areas where private health plans have significant market share, the local premium schedule would not necessarily be dominated by the premium for the government-run plan.  Thus if private health plan premiums changed rapidly, of if large numbers of enrollees switched to different plans, the premium for the government-run plan could rise of fall by a substantial amount.  This is one reason why the House-passed proposal would phase-in the local premium support schedules gradually.

Geographic adjustment would not necessarily be needed under a local premium support approach. Beneficiary premiums would be based on local premiums and costs that already reflected local input price and service levels.  (Risk adjustment would remain essential.)

Commentary:  Premium support would probably not dramatically change Medicare at first, under either a national system or a local system.  However, it does hold the potential to slow the growth of Medicare's costs and spark improvements in benefits in the decades after 2010. 

To make premium support work, the market share of private health plans in Medicare would probably have to grow to perhaps 20 or 30 percent.  There would have to be enough real competition to persuade the managers of the government-run fee-for-service plan to take greater responsibility for that plan's operations, and to persuade Congress to keep its hands off and allow the government-run plan to compete.

To some degree, the potential for competition could be as helpful in modernizing the benefits and reining in the costs of the government-run plan as the reality.  The goals are to give beneficiaries real, stable private plan options, and to change the operational mindset of the government-run plan(s).

To get started toward the goal of a functioning premium support system in Medicare, it is very important that health plans begin to submit real bids, even if at first those bids don't have much impact on their reimbursements from the government.  It is also very important that beneficiaries see government-provided menus of options, with the convenience of having their premiums deducted from Social Security checks.  That would legitimize the new choices in many seniors' minds.

At its best, premium support in Medicare should change the working relationship between private health plans and Medicare officials, so that plans feel as though Medicare is a solid business partner.  For too long, private health plans have been viewed through the same adversarial lens that Medicare administrators use for hospitals, doctors, and other health providers. 

Finally, it is very important to establish an oversight process that allows the Medicare's government-run plans to gain the flexibility they will need to create innovative new benefits. 

Chronic care might be a good first step in this process.  The government-run plans should be given more flexibility to develop local or regional programs to help beneficiaries with chronic or long-term health problems, in exchange for greater transparency and oversight.  This would allow the Medicare administrators to improve their internal management capability and reporting at the local and regional level.  If those efforts were successful, it would give Congress more confidence that the Medicare program should be granted additional operational discretion.

Over time, the government-run plan should be allowed to offer "high option" coverage with modernized benefit packages, as the original Medicare reform proposals envisioned.

Links:
Breaux-Thomas Medicare Commission Homepage
Breaux-Frist I Premium Support Proposal
Centrists.Org Issue Summary:  Medicare Reform and Prescription Drugs
CentristPolicyNetwork.Org 2003 Medicare and Prescription Drug Resource Page
Medicare Actuary's Charts on Premium Variability in a Local Premium Support System