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.