Reconsidering Medicaid Privatization: Weighing the Evidence and the Alternatives

1. Introduction

Medicaid provides health-care coverage to one in every five Americans, but nearly 70 percent of them receive that coverage through a private insurance company (KFF 2021a). State governments are the primary administrators of Medicaid, and they usually allocate a plurality of their budget to do so. Additionally, the federal government subsidizes the program, to the tune of about 10 percent of the overall federal budget—making that subsidy the third largest domestic federal expenditure behind Social Security and Medicare (CBO 2019).

Starting in the 1990s, almost every state and territory in the country hired private insurance companies to run their Medicaid programs. The crux of the idea behind this contractual arrangement is the design of its financial incentive, which is assumed to promote cost savings and fiscal stability. States effectively purchase private insurance for each beneficiary: The state pays the insurance company a capitation fee—a fixed amount per enrollee, per year—out of which the insurer pays for any health-care use, keeping the difference for operating costs and shareholder profits. Proponents argue that this financial design has two benefits: It provides an incentive for the insurer to control medical spending, because leftover capitation income accrues as profits, and it removes financial risk from the state budget, because the per-person cost remains fixed.

States turned to this model during the 1990s, in search of a solution to unexpected increases in the program’s costs. Early in the decade, the federal government mandated substantial expansions in eligibility during a time of rapid medical price inflation. In this environment, purchasing insurance appeared to be a logical move for a state; insurance, as a product, is intended to provide financial protection against an uncertain future. Moreover, during the preceding decade, the insurance industry had developed its administrative techniques for medical cost containment, and additionally, a number of insurers had developed Medicaid-specific insurance products over that time as well. Insurers argued that, adopted more widely, these products could introduce stability to states’ Medicaid budgets.

While the financial incentives are clearer, incentives on quality push in two opposing directions. First, capitated payments can incentivize under-provision of care, as insurers seek to maximize retention of revenue by minimizing medical outlays. Insurers reduce what they deem to be unnecessary medical spending through administrative techniques like requiring prior authorizations and negotiating lower payment rates with providers. These practices are more pronounced in Medicaid than in private markets and can hinder access to care (Cunningham and O’Malley 2008; Dunn et al. 2021). At the same time, the insurer does not want to restrict care excessively. The insurer benefits financially when its enrollees require less high-level care, like hospitalizations. Insurers lose out financially if their enrollees, unable to adequately access primary care, are driven to seek emergency services because their condition has grown severe or because they simply could not find a suitable alternative source of care. This countervailing incentive keeps quality in check, as insurers strive to deliver a profit-maximizing quality and quantity of care.

Overall, the move to contract with private insurers was intended to reduce costs, stabilize budgets over time, and at least have no negative impact on quality. Quality could even potentially improve due to the introduction of market competition. If firms have to compete for beneficiaries or compete for state contracts, then, like in any competitive marketplace, the least efficient producers would be forced out of the market in favor of those offering the same or better quality at a better price.

As we review in this issue brief, the arguments do not hold up well to scrutiny and have not been substantiated by empirical evidence in the time since the administrative change took place. First, to the extent that capitated payments incentivize cost control, the savings have not passed through to the states: The reduction in medical spending is retained by insurance companies. Second, the concept of purchasing insurance for the purpose of financial risk protection does not translate well to this context. The drivers of uncertainty in state spending, namely medical price inflation and spikes in eligibility, are not absorbed by the insurer in a capitation scheme. The state simply pays more per person when prices increase and pays for more beneficiaries when eligibility does the same. Finally, the Medicaid market lacks a source of competitive pressure for the program to benefit from private market discipline. Rather than competing with one another to offer the best plan, most insurers offer identical costs and coverage with customers assigned to them by randomized auto-enrollment. States tend not to monitor, let alone enforce or incentivize, aspects of plan quality like provider networks or access to medical services (Centers for Medicare & Medicaid Services n.d.; Layton et al. 2018; Office of Inspector General 2014).

For decades, the consensus among economics researchers has not supported the list of benefits that state legislators have associated with private insurance administration of Medicaid, such as cost savings, fiscal stability, improved health, improved health-care access, and market competition (Gruber 2017; Layton et al. 2019; Montoya et al. 2020; Sparer 2012). Nevertheless, state legislators continue to argue that private insurers will shield the state from financial risk, reduce costs, and inject quality-improving market discipline into public health-care coverage. As we review further in the brief, as recently as 2021, North Carolina joined the bulk of its peers in transitioning beneficiaries to a system administered by private insurance corporations.

By contrast, we also examine the alternative policy avenue taken in Connecticut, where 10 years ago, state officials made the opposite transition, ceasing to contract with private insurers for Medicaid delivery and instead establishing a publicly managed system of Medicaid coverage. Connecticut’s experience aligns with what the literature might suggest. The state spends less than 5 percent of its Medicaid budget on administration and overhead, approximately one-third the national average of privatized programs; maintains below-average growth rates in per-person costs; and has improved on a number of quality indicators like emergency care use and provider participation (Andrews 2021; Beck 2016; Lassman et al. 2017; Palmer et al. 2021).

This brief argues that states and the federal government can now reconsider the decision to administer Medicaid through private insurance. The financial design creates an incentive for insurers to deliver a profit-maximizing quality and quantity of care by establishing administrative structures that review and restrict utilization and then retain medical savings as insurer overhead and profits. In Connecticut, the private insurance model of Medicaid delivery invested relatively more in administrative care restriction, and administrators, while the publicly managed system invests relatively more in clinical care delivery and the providers of health care. This result indicates an opportunity for other state policymakers to rearrange existing Medicaid dollars toward beneficiary care. A more effective system that reduces overhead and offers better pay to Medicaid doctors could attract more doctors to accept Medicaid patients. That system could mitigate the segregation of providers and facilities that Medicaid beneficiaries now face as a result of the program’s low fees and high administrative burdens (Ludomirsky et al. 2022). Reallocating funds away from private insurer overhead and profits and toward care provision could improve access for Medicaid beneficiaries without requiring additional public resources. The remainder of this brief examines in more detail the evidence and political processes behind the move to administer Medicaid via private insurers, and underscores the opportunity for legislators and analysts to investigate the potential gains from establishing public administration of Medicaid benefits.