healthcare costs outsourcingBy Chad Sandstedt of Value Investing Lab

The press and politicians love to point fingers at the evil empire of healthcare providers and insurance companies. Headlines with shock value that read something like “Acme Health Insurance Raises Premiums 39%” seem to be a weekly occurrence. What these articles fail to tell the reader more times than not is the real reason behind these premium increases. Here it is.

There has been a brutal tug of war occurring in healthcare between private pay and public pay which is starting to get ugly, real ugly. Private pay is comprised of private health insurance companies like United Healthcare, Wellpoint, Aetna and Humana. Public pay consists primarily of federal programs for the elderly (Medicare) and state-run programs for low income households (Medicaid).

The numbers in this example are for illustration only. For easy math let’s start our tug of war with a mix of 70% private pay and 30% public pay with each paying the hospital the same rates for the same procedure. In this example let’s use a broken leg which starts at $1,000 regardless of the type of coverage. The hospital is indifferent to the patient’s source of payment because they will receive $1,000 either way.

Fast forward 10 years where a couple of recessions has shifted 20% of the population to public healthcare due to higher unemployment and more part time jobs that don’t pay full benefits. Now you have 50% private pay and 50% public pay. Due to a weak economy tax revenue to the public payors is down just when it’s needed most. The result is that the public payors need lower rates so the hospital cuts the cost of treating a broken leg from $1,000 to $600. It’s not much of a negotiation because the hospital is required to treat almost everyone who walks into their emergency room so the hospital decides $600 is better than nothing. Because the hospital’s cost of keeping the doors open is not changing they must increase the rates on the private payors to offset the loss of revenue from the public payors. To maintain their total revenue at the same level the hospital must increase the cost of a broken leg to $1,400 for private payors.

Because the private payor needs to recover these increases they increased their insurance premiums. These increased premiums forced 20 percent of the population to the public payor so the mix is now 30% private pay and 70% public pay. The public payor needs another price cut because it cannot afford the current rates so the hospital drops the cost of a broken leg again, this time to $429 which is still better than receiving nothing. Since there has been no breakthrough in treating a broken leg the cost is still the same to the hospital so they need to recoup these lower rates with higher rates from the private payor, increasing them to $2,333. This equates to a tax of $1,333 for breaking your leg to subsidize the below cost rates charged to public payors.

The scary part is that the numbers are even worse in reality. In actuality, an emergency room I recently analyzed charges the private payor about $3,000 and the public payor only $500 for the same product. (Medicaid was $400 and Medicare was about $600). The real tax for breaking your leg is closer to $2,000.

The Healthcare Reform Act of 2010 (a/k/a ObamaCare) was marked as the socialization of healthcare by its opponents. News Flash: Healthcare has been in the process of being socialized for decades under both Democratic and Republican leadership.

The following chart illustrates the changes in the U.S. population from 1987 to 2009 as it relates to their source of insurance.

The number of Americans with private insurance has remained relatively flat for the last 23 years (that’s as far back as I could find data for). Over this time period the U.S. population has grown by 26% while the number of Americans with private insurance has only grown by 4%. The number of Americans with public insurance has grown by 66% while the number of uninsured Americans has increased 63% over the same period.

The following chart illustrates how the percentage of the U.S. population is quickly shifting to public insurance or no insurance at all.

Nobody knows where the tipping point is, but we are undoubtedly getting closer to it on a daily basis. As the cost of private health insurance gets more expensive, it forces more people into Medicaid and Medicare, it causing another round of increased rates. This is a vicious cycle if there ever was one. If this continues on the current path there will eventually be only one person remaining who can afford private health insurance meaning one day in the future Bill Gates will be paying billions for a broken leg to subsidize all of our broken legs.

The solution to this vicious healthcare cycle is twofold: (i) develop a network of healthcare providers that do not accept public payors; and (ii) promote health savings accounts. By not accepting public payors a hospital can drop their price for a broken leg back to $1,000 and make money. In addition to the government requiring hospitals to treat almost everyone, the other major problem is that the current system provides no immediate incentive to shop for lower prices. This is where the health savings accounts come into play. If people are spending their own money, not the insurance company’s money, they will drive right by the hospital charging $3,000 for a broken leg and drive the extra 10 minutes to visit the hospital that charges $1,000.

From an investment perspective this environment will present a serious headwind for hospitals and private insurance companies. Unless they are able to transition into providers of private-pay hospitals and health savings accounts they may not be around in another 20 years.

Disclosure: I do not own any shares of the companies mentioned in this article.

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