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You are here: Home / Anderson On Health Insurance / Pricing a plan

Pricing a plan

by David Anderson|  January 26, 20155:38 am| 13 Comments

This post is in: Anderson On Health Insurance

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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.

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Reader Interactions

13Comments

  1. 1.

    Steeplejack (phone)

    January 26, 2015 at 6:44 am

    Looking forward to the rest of this miniseries, Richard. You are doing the clearest, most informative reporting on the ACA and health insurance I have seen anywhere.

  2. 2.

    satby

    January 26, 2015 at 6:49 am

    These are great posts Richard, but I get to the end of one like this and think we shouldn’t have medical insurance be a for profit enterprise at all.

  3. 3.

    The Raven on the Hill

    January 26, 2015 at 6:57 am

    “There is wild variance in pricing between providers in most market.”

    Isn’t this a way of saying “there is no market?” If there were competitive pricing, one would expect to see that range narrowed.

  4. 4.

    Richard Mayhew

    January 26, 2015 at 7:02 am

    @satby: that would be a reasonable conclusion behind the veil of ignorance

  5. 5.

    Richard Mayhew

    January 26, 2015 at 7:05 am

    @The Raven on the Hill: more like a poorly functioning market. Major academic medical center is a world class endocrinology center so it charges through the nose for bizarre cases. It has a halo effect so its knee replacements cost 2x as much as an equally good surgery at the community hospital seven miles north.

    Things are bundled with mass cross subsidization

  6. 6.

    RSA

    January 26, 2015 at 7:59 am

    This is excellent, Richard. I have only modest interest in the details of health insurance, but I’m still fascinated by your explanation of the reasoning process. Very nicely done.

  7. 7.

    Reader K

    January 26, 2015 at 8:57 am

    Knobs to turn?!?? I guess that sounds sexier than saying Excel drop downs…

  8. 8.

    balconesfault

    January 26, 2015 at 11:12 am

    Every once in awhile, I run across someone in my age range (late 40’s through 50’s) with a legit tale of woe for how their individual insurance premiums spiked post-ACA (often doubling). And not policies with some silly low cap on benefits that many people used to buy that left them hugely exposed. And I was trying to figure it out until I read the above:

    “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”

    Long term seems to be the key here? In the past, insurance could sell high deductable individual policies to those folks with the knowledge that they wouldn’t have to keep selling a policy for the same price to said individual in the future if the individual ended up getting some condition that was going to lock in structurally high medical costs. An insurer might be taking a short-term risk that the person would actually use up their deductable and need some insurance in a given year … but they weren’t taking a risk that said individual might come down with something in the next year that would cause the insured to seriously exceed the deductable every year going forward.

    With having to assume that new risk, the insurer has to price the formerly “low risk” policy accordingly. Am I seeing this correctly?

  9. 9.

    ? Martin

    January 26, 2015 at 11:23 am

    No one will sell a product that loses money for long.

    Unfortunately, I know the inside story of why CoOpportunity blew up, which actively refutes that starting assumption.

  10. 10.

    Richard Mayhew

    January 26, 2015 at 12:52 pm

    @balconesfault: I think you are overthinking things here. Right now I’m working at 50,000 feet level with basic and unrealistic assumptions without regard to deductibles, without regard to risk pool composition without regard to any of that real world stuff.

    @? Martin: Note “for long” If Co-Opportunity was seeking a loss-leader strategy with the assumption that is would be picking up the risky end of the risk pool AND get significant federal reinsurance, risk adjustment and risk-corridor payments to smooth out cash flow until 2016/2017 when membership starts to get sticky, that is a viable but risky business strategy. Once the risk corridor payments disappeared in the Cromnibus, they were fucked if they were engaged in a loss leader membership building strategy.

  11. 11.

    Richard Mayhew

    January 27, 2015 at 9:01 am

    @Reader K: We don’t use Excel… that is for amateurs… for truly great fuck-ups we need high powered software

Comments are closed.

Trackbacks

  1. Pricing a plan: member side control » Balloon Juice says:
    January 27, 2015 at 9:51 am

    […] Part 1: Pricing a plan […]

  2. Pricing a plan: provider side controls » Balloon Juice says:
    February 4, 2015 at 8:31 am

    […] Part 1: Pricing 101 […]

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