We are interviewing some new Padawans. I’ve been asked to give them a high level overview of plumbing health insurance including how a newly built plan gets priced. I’ve been asked that same question here, so I’m prepping my class notes on Balloon Juice. The first few pieces will start with some massive simplifying assumptions that are completely unrealistic in the American context but will provide us with a simple pricing model to gain initial intuitive understanding. After we get a feel for how a plan is built in isolation, we’ll look at how several different knobs are twisted to tweak the results of a plan and its pricing. Finally, we’ll get a bit more complex and introduce competition to the model as well as dynamic interactions. I think there are at least three pieces here, but there will probably be more once I start writing.
The first and most basic assumption in the American context is that a plan will not be offered by an insurance company if it is a long term money loser. This assumption holds true for shareholder owned companies, it holds true for privately held companies, it holds true for co-ops, it holds true for non-profits, it holds true for national players, it holds true for regional players and it holds true for local niche insurers. No one will sell a product that loses money for long.
Let’s make a few simple and completely or mostly unrealistic working background assumptions. Assumption one is that there is a single price. Assumption two is that people can either take the insurance at a single price or decline it without penalty. Assumption three is that people have a better idea of their health condition than the insurer but there is some uncertainty. Assumption four is that health care costs are distributed unequally across the population with a power law distribution with a minimum of zero and a maximum somewhere north of $10,000,000. Assumption five is that people are generally risk averse. Next, the assumption is that the insurer is the only insurer in the region and everyone is currently uninsured. Finally, we’ll keep things simple and assume the plan is 100% fee for service. Yeah, these are some absurd assumptions.
So revenue for a health plan is equal to the number of people who sign up for the policy times the single price. Expenses are the medical costs of the covered people plus administrative expenses. The goal of a new product that is launched is to have total revenue be equal or greater than total expenses. Administrative costs are split between fixed costs and variable costs. When I was a plumber, my salary was effectively a fixed cost (now, I have no idea how my costs are assigned) as it took just as much time for me to plumb a plan with seventeen members as it did to build a plan for seventy three thousand covered lives. Customer service reps are a variable cost as we need a one for every big number of new members.
However, the Medical Loss Ratio provision of PPACA means the administrative costs can’t be too large (either 15% for large employer groups or 20%for small group/individual), the major cost driver is medical expenses. Medical expenses are eighty to eighty-five percent of total premium revenue.
Fundamentally medical expenses are the product of the number of services used times the price of those services.
So how does pricing get derived from this basic point?
Since we are assuming costs vary widely and people have a better idea of their health than the insurance company does, we can start making some assumptions. The first assumption is that people will only buy the product if and only if they think their medical expenses for the contract period are either modestly under the premium price (they are risk adverse) or over the premium price. If the premium was priced at zero dollars and there was no cost sharing, we would predict that everyone would sign up for the coverage. If the premium was priced at $30,000 per month, then the only people to sign up would be hemophiliacs, quadriplegics and cystic fibrosis sufferers. Insurance companies make their money when they have a large pool of people whose expenses are less than their premiums and a comparatively small pool of high cost individuals.
The goal of pricing a plan is to get a large pool of relatively healthy people to sign-on. That means the incentive is to get as low as possible without destroying the ability of the insurer to pay the highly likely high cost claims.
Now there are a lot of variables that are being excluded from the initial consideration. The biggest is how much each service gets paid. There is wild variance in pricing between providers in most market. The next big variable is utilization patterns. If an common medical profile is presented to fifty providers, there will be a fairly broad range of treatment options presented from watching and waiting to aggressive intervention with surgery by the end of the week.
After that, there are some big knobs to turn on the consumer/member side as deductibles, co-pays, co-insurance and pre-authorizations will all have significant effect on utilization and net insurance company costs which means they have big changes to premiums charged. After we talk about these knobs, we’ll look at what happens when premiums are heavily subsidized by either the employer or the federal government and then what happens when there is competition from other insurers.