Charles Hugh Smith has a great blog, "Of Two Minds." His recent post addresses one of the factors in the cost of health care: The buyer, or patient, has no direct role in price negotiation.

Smith, in the blog, shows a menu for maternity rates for the Santa Monica Hospital from 1952. Use of the delivery room, including all standard lab work, supplies and medicines, plus care of the newborn, costs $30. Semi-private room charges were $16 a day and newborn care was $6 a day. Total hospital costs, with two-day stay, for having a baby in 1952 at a premier West Coast hospital were $74. A four-day stay for birthing was common in 1952, which would cost $118.

I haven't been a proud new papa for many years so I don't have any personal experience with new baby charges today. I called my son who had an addition to the family earlier this year. The hospital charges for bringing his new daughter into the world were somewhere in the vicinity of $20,000 to $25,000. The amount paid by insurance to the hospital was probably a fraction of the billed charges, maybe less than half. This created a bookkeeping loss for the hospital, but since it didn't go bankrupt it was probably simply a loss on the books, not in cash flow.

The fact that my son didn't know the total more precisely adds to argument Smith makes: A big problem in controlling health care costs is that, in most cases, the patient, or consumer, is insulated from the cost by an insurance intermediary. I have visited the Web sites of several large hospitals and searched for information such as room rates, room charges, costs, fees, and the like, but have found nothing. This emphasizes just how far the patient is removed from the pricing of the product.

Smith uses the U.S. Department of Labor inflation calculator to determine that the value of $1 in 1952 has inflated to $8.14 in 2009. Using his inflation factor, the $118 hospital charges for 1952 would be $961 for a four-day stay in 2009. With the two-day stay more common today, the inflated cost is $602. Compare this with the roughly $20,000 hospital charges for my granddaughter's delivery in 2009 or to the $10,000 (perhaps) actually paid by the insurance company to the hospital. The ratio of $10,000 to $602 is 16.6, more than twice the inflation ratio (8.1). Using the full billing charge brings the increase to four times the inflation rate.

Here is my short list of what is at the center of trying to address this problem:

  • If you try to control costs, it is attacked as rationing.

  • If you depend on market forces, there is fraud and manipulation.

  • If you depend on government control, there are shortcomings on both accounts.

The ultimate source of cost control is patient responsibility for costs. Only then will real negotiation of prices and benefits be accomplished. After all, health care is a very individual process. What is a correct regimen for one individual may be totally inappropriate for another. Each case can best be determined by the patient and the doctor. When neither party has control of the price and has to conform to a statistical representation of the condition rather than the individual particulars, outcomes are way too costly and will suffer from the lost benefit of individual fine tuning.

We have grown to accept a system that has several profit center layers between the treatment and the outcome. These include insurance companies, for-profit hospitals, large marketing budgets and distribution costs for drug companies, huge liability insurance premiums, out-of-control litigation expenses and awards, unnecessary tests/procedures and outright fraud. Yes, fraud. Fraud is a profit center for the criminal.

Smith has suggested that we go back to the ideal of everyone paying cash for health care instead of using an insurance system. Every year that would work well for 98% (this is my guess) of the populace. Every 10 years that would work well for 80% to 85% (again, my guess) of the populace. However, over your lifetime you probably have only a 10% to 20% probability of avoiding a catastrophic illness/injury that would bankrupt most without insurance or charity.

What we call health insurance is lacking one crucial characteristic of insurance. The classical definition of insurance involves the payment of a small fractional premium to protect against a catastrophic event.

For instance, homeowners pay an annual fire insurance premium of the order of 0.1% of the value of the house annually. The probability of any given house burning down in any year is way less than 1 in a 1,000, so the insurance company makes a lot of money. Over 50 years, the homeowner pays about 5% of the home value for fire protection. The probability of the house burning down in a 50-year period is less than 5%, but, if it happened, the homeowner gets the full value for the house. This is the way insurance is supposed to work. The homeowner and the insurance company are both getting good value and wind up happy.

What we call health insurance is actually a prepayment plan, with expected medical expenses over many years averaged into monthly payments. A very small part of the cost of medical insurance premiums is actually covering the traditional object of insurance, which is infrequent catastrophic illness or injury.

So I would argue that we would best be served by having a combination of insurance and patient financial responsibility. After all, the principle of insurance works best when it covers the unlikely but devastating occurrence.

So couldn't we go to a system which insures medical expenses in excess of some percentage of adjusted gross income? So then expenses each year up to that amount would be born entirely by the patient? If the percentage was 10% of AGI, a family of four with the 2007 median household income of $67,000 would pay the first $6,700 of medical expenses in a year before insurance took over. Many years the expenses wouldn't meet this deductible. Insurance premiums would be reduced, maybe by as much as half (again, this is my guess. It could be much more). The annual cash flow for individuals and families would become more dependent on their use of medical services in any given year. This would increase the patient awareness of cost/benefit relationships.

However good this proposal might sound, it raises the issue of moral hazard. In insurance terms this moral hazard is related to the concept of adverse selection. Here are some of the ways the patient/consumer could try to game the system:

  • Any given year, gamble on good health and don't insure.

  • Wait until the consumer perceives an increased risk of needing medical attention and then insure.

  • Postpone medical expenses that might prevent serious disease because it will all be out of pocket.

There are ways these concerns might be addressed. One way to work within the existing health insurance system, or a reform of the system, would be to establish a standard premium cost. (I won't get into the details of how to do that -- it could be by competitive market forces, legislation or some combination.) The government could establish a program that would pay for every citizen to receive an annual medical exam, free to low income, co-pay for lower middle income and patient paid above a certain income level. The purpose of the annual exam would be to identify health risk situations. Those with situations that had doctor recommended patient actions would have the program pay for up to three patient consultations with the doctor over the following 12 months.

The purpose would be to permit health insurance premium discounts to be obtained by those who were identified as having good health habits and those who took corrective actions. Those whose doctors told them to take corrective action and ignored the advice, and those who didn't participate in the annual physical program, wouldn't be eligible for insurance premium discounts.

This idea would be costly. If 80% of the populace participated (about 240 million people), and 100 million were paid fully by the government, 100 million were partially paid (use an average of 50%) and 40 million received no subsidy, the annual government cost would be about $60 billion a year, assuming an annual cost of $400 a person. Are the benefits worth the cost?

If the reduced insurance premium cost was 10% and 150 million qualified, the savings to the insured just for premiums could be of the order of $20 billion, but the savings (through prevention) of money spent out of the large deductible could be much larger. I will leave a better estimate of savings to a more knowledgeable medical policy expert. If these savings were $100 billion (about 5% of the total health care annual expense), the direct payback would be two to one.

Of course, reduced illness would have secondary benefits to economic activity such as with fewer lost work hours. In addition, the savings of reduced medical expenses in year one should compound. Expenses in future years should be reduced by actions taken in previous years. Over many years, this compounding could increase the cost/benefit ratio much higher than two to one.

The arguments made here and those made by Smith may have many loose ends. However, we both are getting at one of the most important aspects of reforming the health care system which isn't receiving enough attention, and that is increasing the responsibility of the patient/doctor team for determining cost/benefit relationships. We need to diminish the role of profit motivation in health care and increase the discipline of consumer selection. The government can establish programs, like the one suggested as an item for discussion, to support the development of this consumer centered health care system.

We can't get effective control of health care costs until the patient/consumer has a central role.

Meanwhile, the business plan of some insurance companies would necessarily change if a proposal like this was to be implemented. Companies like Cigna ( CI - Get Report), UnitedHealth ( UNH - Get Report), and Aetna ( AET) have a business model based on the prepaid health care process.

With the proposed high deductible catastrophic care coverage process, the business model is more like property and casualty, life and long-term disability insurance, such as Aflac ( AFL ), Travelers ( TRV - Get Report) and Hartford ( HIG - Get Report) offer today. Employment would decline in the areas of claims processing, although the number of insureds would increase. The gross premiums received would be significantly reduced, as would claims paid.

Revenue and earnings of health care insurance companies would probably be reduced, although margins might improve.

At the time of publication, Lounsbury did not hold any stocks or funds mentioned.

John B. Lounsbury is a financial planner and investment adviser, providing comprehensive financial planning and investment advisory services to a select group of families on a fee-only basis. He worked for 34 years with IBM, and spent 25 years in R&D management and corporate staff positions. He also was a Series 6, 7, 63 licensed representative with a major insurance company brokerage for nine years.

Specific interests include political and economic history and investment strategy analysis. He holds degrees from the University of Vermont, Columbia University and the Illinois Institute of Technology, where he studied chemistry, physics and mathematics. He is a contributor to Seeking Alpha and his own blog, PiedmontHudson.