Health Sense:
When Spending Money Saves Money
Ian R. Harper
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It would cost the government more to allow private health insurance to dwindle than to continue to support it, reports Ian R. Harper

Australia has a mixed public and private health insurance system. All Australians enjoy public health insurance, in the sense that anyone can access treatment for illness in a public hospital at no cost. The cost of providing such treatment is met from general taxation revenue, to which all Australians contribute according to their means. By the same token, public health insurance is mandatory in that people cannot claim a rebate of tax paid should they choose to be treated in a private rather than a public hospital (or as a private patient in a public hospital).
Because publicly provided health care is funded through the tax system rather than explicit premiums, changes to the public health insurance system have fiscal implications for the government. If the government wished to improve the level of coverage and services provided by the public health system, this would involve raising additional taxation revenue, lowering expenditure on other government programmes and/or increasing the level of public debt. In such circumstances, it is unsurprising that debate on public health insurance has often been diverted into a debate about funding and fiscal priorities rather than addressing the fundamental issues of the nature and coverage of the Australian health insurance system.

Private health insurance in Australia is generally provided by not-for-profit institutions, including the government-owned health insurance company, Medibank Private Limited. The policy benefits and premiums charged by these institutions are regulated by the Federal government. Private health insurance provides an individual (and his or her dependants) with a variety of benefits, some of which substitute for those available in the public system and some of which are additional or ancillary. The particular benefits depend on the exact nature of the insurance policy purchased.
A privately insured patient can access the services of private hospitals with zero or reduced out-of-pocket expenses compared to someone without private insurance cover. In particular, a privately insured patient can choose to be treated in either a public or a private facility and can also exercise some choice over the specialist medical staff involved.

A privately insured individual can often receive more timely care by avoiding the waiting lists associated with treatment as a public patient in a public hospital. This is true of anyone who opts to pay for private treatment, whether or not they are privately insured. The element of insurance creates options that would otherwise depend upon a patient's financial circumstances at the time. Insurance also replaces uncertainty surrounding a person's financial outlays on private health care with relative certainty, something many people value.

Private health insurance (PHI) is more comprehensive in its coverage than public insurance but also overlaps with the public insurance system. Apart from the additional choice available to privately insured patients, they may also access a range of services, including dental and optical services, which are available only on a limited basis in public facilities. But the two systems also overlap in that many procedures undertaken by private hospitals are identical to those available in public hospitals (or may even be exactly the same if the insured person is treated as a private patient in a public hospital).

When a privately insured patient opts for treatment in a private hospital for a procedure that would otherwise have been performed at public expense in a public hospital, there is no rebate of taxes paid by the private patient. The private patient pays twice for hospital treatment-once through taxes paid to support the public system and once again to access private treatment. This is true even if the privately insured patient chooses to be treated in a public hospital and fails to declare his or her status as privately insured. In this case, the premiums paid to secure a place in a private hospital are not rebated and the patient effectively pays twice for the procedure.

Private insurance cover can also be obtained for ancillary services such as dental treatment, ambulance, chiropractic treatment, home nursing, podiatry, physiotherapy, occupational, speech and eye therapy, glasses and contact lenses, prostheses and the like. Such services are not covered by Medicare and hence there is no overlap between public and private insurance. The decision to take out PHI for ancillaries is not about choice, since there is no public alternative, but about the desire to lay off the risk of unforeseen expense. Those without PHI for ancillaries choose to self-insure, either because they are less risk averse than the privately insured or because they cannot afford to pay an insurer to bear the risk on their behalf.

Private health insurers offer ancillary cover to attract the young and healthy into private health insurance, those for whom the option of private hospital treatment does not by itself rank highly.

The fall and rise of private health insurance
The willingness of some Australians to pay twice for hospital care in the private sector has helped to keep the cost of the public hospital system down and also to free up access to public hospital treatment. When Australians began to drop private health insurance during the late 1980s and into the 1990s, the effect on public hospital costs was predictable. As the proportion of the population with private health cover fell from 50% to 30% by 1997-98, the real cost of funding public hospitals rose by more than 75% over the same period.

Figure 1 shows clearly the trend decline in the take-up of PHI from the mid-1980s until late 1999. The trend decline was driven by:

• the impact of universal health care available through Medicare (that is, 'free' public health insurance);
• regulations setting minimum benefit levels for private health funds and obliging them to cover good and bad health risks alike; and
• inevitable increases in PHI premiums as better health risks abandoned private insurance in favour of the public alternative.

Figure 1 also shows the trend increase in real public hospital expenditure that accompanied the decline in PHI. As people abandoned private health insurance, they fell back onto the public hospital system, increasing its cost to the public revenue.

Beginning in 1997, the Federal government introduced a series of reforms designed to reverse the decline in PHI and relieve the pressure on public hospital outlays. These included:

• an income tax surcharge of 1% on high-income earners who do not have private health insurance-effective from July 1997;
• a non-means-tested 30% rebate on private health insurance premiums-effective from January 1999; and
• a form of lifetime community rating-effective from July 2000-which imposes higher premiums on those who join a private health fund after the age of 30 (or, for those already over 30 years of age, who join after 30 June 2000).

The combined effect of these changes was to produce a dramatic reversal of the trend decline in PHI, beginning in late 1999. Since that time, the proportion of the Australian population covered by PHI has increased from 30% to around 45%. Much of the increase occurred around the implementation date for lifetime health cover (although Access Economics1 regards the general 'price' of PHI as the primary driver of the amount demanded). Ted Frech, Sandra Hopkins, and Gary MacDonald2 attribute the response primarily to the second and third of the policy changes, noting that a high proportion of high-income earners already subscribed to PHI when the 1% surcharge was introduced.

Sources: Private Health Insurance Administrative Council (PHIAC), Australian Institute of Health and Welfare.

There is emerging evidence that the reforms have relieved pressure on the public hospital system. Outlays on public hospital treatment have stabilised at around $14 billion per annum in real terms since the introduction of the reform initiatives. Had the trend rate of increase in public hospital outlays prior to that time continued, annual expenditure would today be in excess of $17 billion in real terms.

Public expenditure on hospitals is but a share of total health expenditure by the public sector but, given the nature of PHI in Australia, involves services most likely to be relieved by an increased take-up of private health insurance. While the 30% rebate costs the Federal government around $2 billion per annum, had previous trends in public hospital outlays alone continued, the increase in that expenditure (around $3 billion in 2001-02) would easily have outweighed the annual cost of the rebate.

Sustaining public health
It is unsurprising that the trend decline in PHI was accompanied by a trend increase in public hospital outlays. As people abandon private health insurance, the cost of providing public health care and the cost of PHI both rise, reflecting the loss of the implicit subsidy paid by those who take out PHI in addition to paying taxes to fund public hospital treatment.

This is the reasoning behind the government's decision to support PHI. Even though it might be at some cost to the public revenue, so long as the cost incurred is outweighed by the value of the implicit subsidy, the net impact is positive. It would cost the government more to allow PHI to dwindle than to continue to support it.

Even those who choose to pay directly for private hospital treatment (rather than take out PHI) potentially raise the cost to government, as the higher PHI premiums which follow their departure from the privately insured pool drive sicker, less wealthy patients out of the private into the public hospital system.

Some commentators have argued that government support of PHI is uneconomic,3 ineffective4 or misplaced entirely on the grounds that private insurance should be allowed to wither on the vine.5 Such views ignore the implicit subsidy to public hospital costs which arises from the willingness of PHI subscribers to pay twice to keep their options open in hospital care. The willingness of such people to cross-subsidise the public hospital system can only be ignored at the expense of higher costs and longer waiting times in Australia's public hospitals.

Enhancing community rating
There is evidence that the gradual decline in the proportion of the population with PHI has produced an 'adverse selection spiral' in the pool of privately insured health risks. This is mainly reflected in the higher average age of the privately insured. In other words, it has been the young and the healthy who have opted out of PHI and chosen instead to access the public system or to 'self-insure', that is, take the chance that they will need treatment and pay for it directly through the private system should the need arise.

With a deteriorating health profile of the privately insured, the subsidy to the health care system implicit in PHI takes on an additional flavour. Those taking out PHI and subsidising the public system (if they use private facilities for treatment) or the PHI premiums (if they use public facilities for treatment) are increasingly the older and less healthy members of the community. This flies directly in the face of the principle of community rating, one of the benchmark goals of Australia's mixed health care system.

Community rating requires that the healthy subsidise the sick, not the other way around. The gradual decline of PHI reversed the principle so that, increasingly, the older and sicker subscribers to PHI contributed additional resources to the health system with the result that younger and healthier Australians could access free public health care more easily.

It is possible to estimate the extent of cross-subsidy by measuring the contribution of privately insured individuals to the costs of running the public hospital system. Figure 2 below plots the average contribution in real terms from privately insured individuals to the public hospital system from 1983-84 to 1997-98. This number is calculated by dividing total public outlays on public hospitals by the number of taxpayers (since PHI subscribers, as taxpayers, bear an equal share with other taxpayers of the costs of running the public hospitals).

The calculation overestimates the cross-subsidy to the extent that PHI subscribers access public hospital treatment without disclosing their PHI status. On the other hand, the calculation underestimates the cross-subsidy to the extent that PHI subscribers are in the higher income tax brackets and accordingly contribute disproportionately to public revenue. The calculation also ignores those who self-insure, that is, who pay directly for private hospital treatment on an 'as needs' basis.6 They also cross-subsidise the public hospital system by paying taxes and not using public hospitals.

The chart shows the cross-subsidy steadily increasing over the years from the mid 1980s, reaching $1,150 per privately insured taxpayer (in constant 2001 dollars) by 1997-98, when the first of the government's policy initiatives came into force. The faster rate of increase since 1995-96 reflects the continuing fall in numbers of people taking out PHI against the faster growth of public hospital costs.

Support for PHI in the three forms introduced by the Federal government has helped to shore up the principle of community rating by encouraging more people to take up PHI. As more of the young and healthy return to the pool of privately insured risks, the implicit subsidy from PHI users to the system at large looks less like a subsidy from the sick to the healthy and the cross-subsidy itself is smaller, bringing the system more into line with community rating. The health status of the privately insured as a group improves relative to those in the public system, and there are more young and healthy members of the PHI pool, enabling older and sicker members to pay lower premiums for PHI.

In addition, the younger, healthier subscribers to PHI begin to cross-subsidise the public system (albeit at lower levels that before the 30% rebate). Their taxes pay for hospital treatment for the old and sick in the public system; their premiums pay for hospital treatment for the old and sick in the private system; and they, being young and healthy, tend to use neither. On all counts, the principle of community rating is well served.

The effect of recent policy initiatives on the extent of cross-subsidy between PHI subscribers and the public hospital system is illustrated in Figure 3 overleaf. The chart shows the value of the cross-subsidy in the absence of the policy initiatives implemented since 1997 as the upper of the two lines diverging post-1997-98. Note that the cross-subsidy levels off, reflecting the levelling off of public hospital costs over this period as well as the higher numbers of PHI subscribers.

Including the impact of the 30% rebate reduces the per capita cross-subsidy to the lower of the two lines-the reduction is shown as the light shaded area. Three points should be noted:

• without the 30% PHI rebate, the cross-subsidy would still have been around $1,150 in 2001-02, having peaked at $1,190 per privately insured taxpayer in 1998-99-notwithstanding the infusion of younger and healthier subscribers to PHI since 1999, a cross-subsidy at this level would have continued the transfer from those already in private health funds (who were predominantly older and less healthy) to the public hospital system, continuing to compromise community rating across Australia's mixed system;
• with the 30% rebate in place, the per capita cross-subsidy fell to around $850 in 2001-02, similar to its level in 1983-84-at this level, there is some chance that the proportion of the population with PHI cover will remain at current levels, which are also similar to those last experienced in the mid-1980s; and
• the combination of more younger and healthier people taking out PHI and the lower per capita cross-subsidy from privately insured taxpayers to the public hospital system has brought the whole system closer to the ideal of community rating-in which the well cross-subsidise the sick, not the other way around.

When some people are willing to pay twice for hospital treatment-once through their income taxes and once again through PHI premiums-they provide additional resources to Australia's mixed public and private hospital system. If private health insurance were to disappear, the cost of providing public hospital treatment to all who were not prepared to pay directly for private hospital treatment (predominantly those in a financial position to self-insure) would rise dramatically.

Just as with private schools, if they didn't exist, the cost of expanding the public system to carry the extra load would be significant. For instance, in 2000-2001 alone, private hospitals in Australia performed procedures which would have cost the public hospital system around $4.3 billion to perform. In other words, had the private sector not carried its share of the hospital load in Australia in that year, public hospital outlays would have been around one-third higher in real terms.

The willingness of PHI subscribers to cross-subsidise public health helps to keep the cost of the public hospital system within manageable limits. It is worth the government paying money to PHI subscribers-as it does through the 30% PHI premium rebate-to encourage more into the private system. So long as the cost of the rebate remains below the value of the implicit subsidy-as it does on current estimates by a considerable margin (around $850 per privately insured taxpayer per annum)-the government is ahead. In a properly functioning system of health insurance, those with good health cross-subsidise those with poor health. The 30% PHI rebate moves the Australian system closer to this goal by mitigating an existing tendency to produce precisely the opposite outcome. The lower 'tax' on private insurance has also induced more people to take out PHI cover (infusing younger and healthier risks into the privately insured pool), as has the encouragement provided by lifetime health cover. Taken together, recent reforms to PHI have helped to redress the topsy-turvy nature of the Australian health insurance system by making it more likely that the healthy compensate the sick, rather than the other way around.

Endnotes
1 Access Economics, Striking a Balance: Choice, Access and Affordability in Australian Health Care (Canberra: October 2002).
2 H.E. Frech III, S. Hopkins and G. Macdonald (2003), ‘The Australian Private Health Insurance Boom: Was It Subsidies or Liberalised Regulation?’, Economic Papers 22 (2003), pp.58-64.
3 J.R. Hurley, R. Vaithianathan, T.F. Crossley and D. Cobb-Clark, ‘Parallel Private Health Insurance in Australia: A Cautionary Tale and Lessons for Canada’, Discussion Paper No.48 (Canberra: CEPR/ANU, 2002).
4 R. Vaithianathan, ‘Will Subsidising Private Health Insurance Help the Public System?’, Economic Record 78:242 (2002), pp.277-283.
5 S. Duckett, S. and T. Jackson, ‘The New Health Insurance Rebate: An Inefficient Way of Assisting Public Hospitals’, Medical Journal of Australia 72 (2000), pp.439-442.
6 Data on numbers of such persons are not available. However, according to the Industry Commission, 9% of private hospital admissions are self-pay. Industry Commission, Private Health Insurance, Report No.57 (Canberra: AGPS, 1997).

The Author
Professor Ian R. Harper is Assistant Director of the Melbourne Business School (MBS). The author acknowledges the assistance of Joshua Gans and Stephen King of MBS in developing the arguments in this article, which is based on a May 2003 report commissioned by Medibank Private Limited. The ideas and views expressed are those of the author only and should not be attributed to other parties.

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