Insurance companies can make their money in two basic ways. The first is to organize themselves as a funky looking hedge fund with an odd cash flow model. Insurance companies often will invest their reserves in a wide variety of instruments, some liquid and some extremely illiquid in an attempt to get better than market rates of return. Health insurance companies, if they keep only slightly more reserves than required, often can’t play this game too aggressively as they need a lot of cash on hand. Property and other insurers that operate on longer contract horizons with fewer but bigger pay-outs are more likely to make their money as finance companies.
The other, and far more prosaic way an insurance company of any type makes money is to pay out less in claims than they collect in premium revenue.
None of this is earth shattering, but I want to reply to a comment by Raven on the Hill as it is something I’ve seen a number of times — namely that the ACA is a corporate give-away that will only feed the gaping maw of corporate America. There is a limited model where I can see that critique, but in general, I think it is more of a shiboleath instead of a model.
The insurance industry only gets paid if it funds treatment. And these days the percentage they can take is limited to 15% (the medical loss ratio) (or I think 20% in some cases) depending on the type of insurance. So how to increase profits? There is only one way: spend more on treatment.
The one case where this makes some sense is when an insurer is the only insurer in a region, and it is operating right at the threshold medical loss ratio. If the insurer is the only insurer in the region, they are taking on all of the medical risk, but they are probably fat and lazy. Here the decision to either make hard decisions and start saying no to high cost providers who want to perform low value treatment versus raising rates can look attractive. Cutting administrative costs would be a second choice (trust me, I spent a year of my life on a project that had a goal of reducing mail costs by a nickel per member per month (PMPM), three years out, the reduction was six cents PMPM, so it was a smashing success) .
There are a couple of constraints on how high the rates can go. National insurers are available to provide a ceiling on rates, state level political pressure can name and shame rate increases downwards, and finally PPACA has lowered the cost of entry for insurers to enter new markets as the exchanges can serve as the a common, low cost sales platform. If a monopolistic insurer started to charge as its base Exchange rate $1,000 PMPM for 21 year olds, I guarantee that there will be 10 insurers looking to enter that Exchange market for the next open enrollment as there is too much money on the table not to.
Now if that same insurer is operating at three or four points above the minimum required MLR, raising rates to increase profits could work. However, cutting the MLR and administrative costs are other ways to increase profits. Here the insurer could offer a narrow network with 80% of the providers of its broad network in order to exclude the high cost, always ordering expensive treatment providers.
One of the major differences in the PPACA world versus the pre-PPACA world for this monopolostic insurer is the underwriting standards. Previously, the insurer could underwrite based on medical history and experience. That meant each individual could be assigned a unique price point. In practical terms, the insurer could have several thousand price points for a single product in a single county depending on age, gender, zip code, BMI, smoking history along with dozens of perosnal and family history variables. In economic terms, underwriting allowed for an insurance company to massively segment a market. A perfectly segmented market with no information costs would lead to insurance being offered at each individuals maximum willingness to pay. This means the insurance comnpany would collect a massive amount of the social surplus as monopoly rent.
In the PPACA world, insurers have far less ability to segment the market as they can only use age, zip code and smoking history as direct pricing variables for individuals. There might be 80 PPACA allowed price categories instead of 1,500 potential price points for the same zip code in the pre-PPACA world. Some of the social surplus is returned to the general public.
That is the monopoly case. I think it is an interesting case, but it is a limited case for both empirical reasons as there are very few pure monopoly regions in this country, especially on Exchange (West Virginia is one, I think significant parts of Alabama is another), and the binding constraints of fat, dumb, lazy and already paying out at minimum allowable MLR. Now let’s take a look at the other extreme, the perfect competition model.
This second scenario assumes a lot of insurers are in the market with viable products. It also assumes that people are willing to switch when there is a decent sized mismatch between price and value received. I think insurance buyers are somewhat sticky, although far less sticky on Exchange than I would have thought before the 2015 open enrollment. The stickiness is the pricing fudge factor. People who are reasonably happy with their current insurance won’t switch en masse if there is a similar but slightly different product that is ten cents cheaper per member per month, but they will switch if the price that they pay for their current policy has a new gap of $10 to $15 PMPM.
On Exchange, most of the buyers are receiving subsidies, and most of the buyers are looking for low premium pricing. Most of the insurers are offering a wide variety of products, narrow networks, limited gatekeepers, broad networks, no restrictions on broad networks. They are trying to segment the market and sort the healthiest people into the narrow networks and the least healthy people into the higher cost products.
Now let us assume that the finance geniuses of Mayhew Insurance decree that they want to see our profit margins increase by $5 per member per month for the next open enrollment year. We have a couple of ways of doing that. Under the Raven theory, we’ll simply raise our prices by $25 per member per month on small group and individual products (80% MLR) or by $33 PMPM for large group, employer sponsored fully insured products. We’ll hold administrative costs constant, and voila, we’ll see a constant membership next year and a $5PMPM profit bump.
But what about our competitors?
Mayhew Insurance worked its plumbers extremely hard in 2014 to get a Silver plan priced within a point or two of the 2nd Silver subsidiy determination point. We also worked way too many sixty to eighty hour weeks to get mid and large group products that offered a medium to large network at the lowest price in the region. If we increase our prices by $25 PMPM over and above medical trend costs to increase our profit margin, my entire work product for 2014 becomes pointless as we’ll lose massive membership on the Exchange. People will switch out a suddenly expensive Mayhew Silver plan to jump to Other Local Insurer Silver, or Big Blue Silver or National Carrier broad Silver etc. Large groups will lock in their rates for multi-year periods, so we’ll make money on the lock-in, but we will lose current large group accounts to competitors across town, as well as be laughed at when we submit RFP responses to new leads.
Mayhew Insurance membership would crash. And it would not be a uniform crash. The people who are most likely to leave an insurer for minor pricing changes are the people who use the fewest services. The healthiest people, who are the lowest cost people, are the ones who have the lowest pain threshold for switching. A cancer patient who is undergoing treatment will want to keep their current policy because they have a care system in place that they don’t want to disrupt unless the costs are unbearable. A twenty nine year old who used their insurance for a PCP visit and birth control last year won’t care who their insurer is, so they’ll jump to save $5 per month.
Price increases over and above medical trend invite competing insurers to undercut pricing and grab most of the profitable members.
If the Finance and Accounting folks want Mayhew Insurance to increase profit margins by $5 PMPM (which is a massive increase for an increasingly low margin business), premium price increases are a low priority solution because they have significant costs. Instead we’ll see if we can craft a special narrow network which will be very attractive to people with very low utilization but we can charge a couple of extra bucks PMPM while still holding our relative Silver position, we’ll see if we can reduce mail expenses again by a dime PMPM, we’ll see if switching our preferred Hep-C cure to Harvoni instead of Solvadi reduces costs by a quarter PMPM, we’ll see if we really need a VP for Employee Morale (hookers and blow section), we’ll see if we can play with claims payment a bit to reduce manual intervention rates and to increase our free cash flow by holding claims an extra four days to play with the float.
The way the Exchange market is structured, we really don’t want to raise rates by any more than our competitors, and we have a strong incentive to keep our rate increases below that of our competitors so our relative positions improve. Our competitors have the same incentive structure.
So what does the in-between look like? How does this play out in markets where there are only two or three quasi-competetive insurers. Unless there is significant collusion, the incentive is for some price competition. The same constraints apply, in that a very high cost equilibrium invites out of area insurers to enter the market and undercut pricing with a narrow network product that sucks up all of the healthy people in the region. The competition might not be as fierce as firms may see profitability as a satisficing problem instead of an optimization problem, but there will be some incentive for the second and third firm in a market to hold rates steady or increase them at a much lower pace than the first firm that jacks up their rate to increase their allowable operating and thus allowable profit margin.
The Exchange markets so far are very unsticky markets. As long as there is a viable threat of healthy people leaving an insurer that just jacked up their rates without providing associated value or benefits, Raven on the Hill’s argument fails on practical grounds. It works under a limited set of circumstances when there is an effective monopoly insurer, but that is an uncommon scenario.
raven
Uh, that would be The Raven on the Hill.
Richard Mayhew
Updated/Corrected
raven
@Richard Mayhew: (: I’m the one that sends you the goofy emails.
patrick II
I have read (don’t know if it’s true) that pre-ACA many states were dominated by one or perhaps two health insurance companies. It always made sense to me that, under those circumstances, that, operating on a cost plus basis, insurance companies would not fight rising costs very much. So, which is wrong, — insurance companies weren’t that dominant in states, or my idea that it would cause them to operate on a cost plus basis?
April
Northern California monopoly market here, Anthem is the only game on the exchange. Our healthcare here is pretty screwed, declining number of providers, consolidating hospitals and one dang choice for insurer. That and earthquakes I guess keeps the population low and the keeps the beaches and forests feeling like they are mine and mine alone! I think we have 250K in the whole county.
Strangely, we are having a veterinarian boomlet, new offices opening everywhere. I’d have more choices if I walked around on all fours.
MomSense
As someone who was on the individual market for years, one of the things that stands out to me is that there are more options and not just one insurer in the market. For years the only choice was between terrible and awful plans provided by Anthem/Blue Cross. That is how you end up in the situation where you pay $1,600 per month with a complicated deductible, co-pay, and co-insurance model.
We did experience a fairly high premium increase from year one to year two but I think that is because Maine Community Health underestimated costs for year one. We have an aging population with a high percentage of self employed people who had been priced out of the market for a long time. I can imagine there were a lot of catch up health costs in the population.
I pay $591 per month now for a much better plan with a lower deductible and better prescription and wellness benefits. It’s still a lot of money to come up with every month but it is a huge improvement.
Richard Mayhew
@patrick II: Most major metropolitan areas will have multiple insurers, the boonies are more likely to have one dominant carrier and either nothing or de minimas competition where they will operate on a lazy cost plus basis
On Exchange, most states have multiple insurers (West Virginia is a clear counter-example) but within each region of a state, it could vary — Big Blue could dominate up north, while Purple Power dominates down south, so at a state level, it looks like a competetive market, but on the local level it is regional monopolies.
PPACA lowered the cost of entry into new markets for insurers, so it should increase competition.
MomSense
@Richard Mayhew:
I don’t know if it is possible to check this, but I don’t remember seeing any Anthem/Blue Cross plans for Maine on the exchange. Year two there were multiple Anthem offerings.
Bruce Webb
Well if you will allow a kinda lurker to blow his own horn I was the first blogger I know of to pick up the point that Richard now shows is working out in practice with this post from July 2009. HR3200 Sec 116: Golden Bullet? or Smoking Gun? Sec 116 in the House ‘Tri-Committee Bill’ introduced MLR – Medical Loss Ratio into the debate and, as I pointed out at the time, totally undercut the “massive giveaway to Big Insurance” argument then ongoing among the Single Payer Now! crowd. (Not that I objected to Single Payer as such). The way I put it back then, and six months before ACA actually passed was like this:
Back then the chief caveat was “if implemented correctly”. Because a lot of insurers were pushing back on limits premiums by age, health status, etc and it was not clear that MLR would survive. And in fact it actually disappeared from the Senate Finance versions in play over that summer and only came back in limited form in either Pelosi’s or Reid’s Leader’s Marks and in fact was only really rescued by a last minute amendment to Reid’s bill which formed the base of the ultimate legislation.
But it worked. I dubbed MLR “The Most Important Provision of H.R. 3200 that You Never Heard Of” and will take Richard’s post as an opportunity to do a victory lap.
Davis X. Machina
@MomSense: Anthem has requested a rate increase for at least one Maine ACA compliant products , so they’re offering… may not be on the exchange, tho
JMV PYro
What, no attention paid to McLaren flounce?
Kidding. Although one thing I am wondering is about the difference in impact between more rural areas and more urban ones, if there even is one at all. Obviously, you’ve had cases like Kentucky where there were huge drops in all areas once Kynect went up, but I’m interested in how the act is operating in rural vs urban communities on the whole, especially in states that haven’t expanded Medicaid yet.
Mnemosyne (iPhone)
@April:
From what people commenting here have said, customers in Central CA (ie San Luis Obispo and similar) have the same problem — monopoly market with no competition means they’re getting screwed while those of us in urban areas have plenty of choices and low rates to match.
I’m not sure how to solve the monopoly problem, but this may be where a statewide public option or mandatory nonprofit might come in handy to keep the for-profits honest.
MomSense
@Davis X. Machina:
They started offering policies year two of the exchange probably after seeing how much business Maine Community Health was doing.
The Raven on the Hill
Richard, thank you for the extended (front page!) response. I have only time for brief comments and will try to make more time for a longer response later in my day.
“namely that the ACA is a corporate give-away that will only feed the gaping maw of corporate America.”
Hey, wait a minute! That’s a much stronger statement than I made. What I do believe is that the ACA has institutionalized and subsidized an existing corporate-favorable system. Health care in the USA is expensive relative to other high-income countries and simplest explanation of this is that over time those incentives have worked.
To one specific point: yes, individual insurance companies can lower their MLR, but they are also then under competitive pressure to cut prices until their MLR is again at the limit. So the systemic incentive—not necessarily policy at any individual firm, but to all firms in the market, together—is still to raise profits by overcharging and overtreating.
The incentive is to form a health insurance oligopoly, and this is exactly what is being done. Rob Reich writes, “The Supreme Court’s recent blessing of Obamacare has precipitated a rush among the nation’s biggest health insurers to consolidate into two or three behemoths.” Now this could be fixed by legislation, but all attempts to include such fixes in the ACA, the most significant being the public option, were removed. I don’t believe the legislative barriers to effective regulation of the health insurance industry are any less now than while the ACA was being passed; if anything, matters have become worse, as Citizens United changes the campaign finance system.
Anyhow, I have to go. I want to respond further, but am going to have to study this more. Meantime, everyone read the Reich article. The relatively conservative Reich (he was Clinton I’s Secretary of Labor) has reached conclusions far more damning than my modest ones.
The Raven on the Hill
Later thoughts: I don’t think the ACA was written as a corporate giveaway, exactly, but it was written without adequate regulation. It looks like I lost a sentence in the previous post: the pre-ACA US health care system provided incentives for overpricing and overtreating, and those incentives have not been altered but not removed by the ACA. Unfortunately, that still seems to be true. I like most of the points made in the OP, but they can largely be addressed by forming insurance oligopolies, and the very sharp financiers in charge of the health insurance industry are beginning this process. As I said above, it is going to be hard to pass regulations which might address this.
(Side note, something I remembered as I was writing this morning’s comment: the US health care system used to have more public and non-profit organizations; these were largely privatized back in the 1990s by extensive manipulation of state law. An account is given in Kuttner’s 1999 Everything for Sale.)
Sam Dobermann
@The Raven on the Hill: Noone will see this but I feel I must comment re:
It isn’t the insurers that produce over treating or worthless treatments or even excessive charges for things: it’s the doctors (and the hospitals and the other providers). They give the orders for everything (I’m lumping in all the CJPs etc now).
Think about it. For a spurious treatment, test or what ever the insurer gets at most 5% profit and excessive pay for execs. But the doctor doing the treatment gets at least 50% “profit” which is his/her take home pay. And this is why it is doctors who fight against “evidence based medicine” determining what is paid for.
We have the highest paid doctors, mainly in the specialities, in the world. The doctors whose practices are time dependent rather than full of procedures are the lowest paid. Those are internal med, family practice, pediatricians and psychiatrists.
Not only that but a surprising number of doctors just out and out cheat