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.
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