Kevin Drum flagged a good Wall Street Journal article on how low interest rates will probably lead to higher medical malpractice insurance premiums.
Over the past year, several major insurers have notified tens of thousands of people of higher costs to keep their policies in force, with increases ranging from midsingle-digit percentages to more than 200%, according to financial advisers. To justify the increases, they blamed the impact on their investments from the Federal Reserve’s decision to keep interest rates lower for longer.
Kevin notes that there is a cycle of medical malpractice “crisis” used to hammer consumer protection where the earnings from investing reserves are low which leads to a premium shock which leads to doctors lobbying for relief in the form of benefit caps and more favorable standards of deference despite there being no significant increaes in claims actually being filed.
I want to bring this out to an even wider picture. All insurance companies are hedge funds with very odd business models. They take money in, they put some of that into immediate pay-outs and the rest goes to either reserves for investment, system administration or hookers and blow. Health insurance companies are far less hedge fund like than major re-insurance companies or property-casualty companies because we pay claims consistently so we always have significant net cash outflow. However there are three major pots of money that just sit on the balance sheet.
The first pot is premiums that are paid early in the year that are in excess of current expenses but will be needed to pay for end of year expenses once more individuals’ out of pocket maximums are hit. This money is usually held as cash or near cash.
The second pot are the mandatory claims reserves and state stability reserves. This is the warchest that state regulators really care about. It should be sufficiently large and sufficiently liquid to pay all claims that could be incurred if the state shut down the insurer this afternoon. Again, this money is not usually invested too aggressively. It will be in short term T-bills, it will be in AAA commercial paper. The primary objective of the company’s treasurer is to make sure this money is still there in three months, not to maximize long run growth even at the risk of volatility. It is very boring money.
The final pool of money is excess reserves. This is money that has been held on the books and not distributed out as dividents or to buy better hookers and more blow for powerful internal stakeholders. This is where insurance companies can become hedge fund like. This money is not needed to pay claims, it is not needed to keep the regulators happy. If it can earn four, five, six percent or more, it can significantly contribute to the bottom line of the company in excess of the core business operating margin. Some insurers have very low excess reserves. Others have multi-billion dollar warchests. Those insurers can rely on their investment income to subsidize the operations of their core business.
As returns on excess reserves go down, total profitabilty goes down. For some companies, that will turn a profitable year into a loser of a year. Those companies can handle that for a year or two, but they’ll raise premiums to cover operating costs as much as the market will allow.
Foxhunter
This is also occurring in the P & C market, where ROI is flat and claim costs are up. Premiums are rising accordingly, especially in the auto segment (although home premiums are up by a smaller factor, mostly in those weather-prone areas).
WereBear
Is this is just part of that MBA trend that is distressingly common? The one where they just demand money from customers and the whole concept of “business” is ignored?
David Fud
The excuses keep popping up in investment circles, and they aren’t completely wrong. Active management has underperformed because the world has flooded the markets with capital, pushing everything up regardless of quality. When the Fed starts ratcheting up rates and sells their open market purchases back into the market, investors have to actually evaluate individual companies and risk instead of the risk on/risk off paradigm driven by the Fed and their international counterparts. Volatility will increase and stockpickers and active managers will start overperforming, at least relative to the popular index investing that has dominated for the last few years.
So, after years of underperformance by active managers, it wouldn’t surprise me that the insurance companies are capitulating and complaining about the Fed. If you remove the FANG stocks from 2015, the market was flat instead of having strong gains. Four companies drove the run. When the Fed raises rates and the market gets more volatile, stock pickers will again have their day and insurers can go back to business as usual.
Victor Matheson
There is actually another huge effect of low interest rates on malpractice rates that I would argue is an even bigger effect. I would presume that the largest driver med-mal insurance rates is the size and number of payouts in a small handful of very large catastrophic injury cases, for example a child injured at birth requiring hundreds of thousands of dollars per year in care for an entire lifetime.
In legal proceedings, one set of experts will try to establish or reject liability, and a second set of experts will try to establish damages. Assuming the health care provider is at fault, the damage experts include life care planners who determine what type of care the victim will need, life expectancy experts who determine how long the victim will need care, and economists (of which I am one) who estimate what will happen to medical prices over time, what is a reasonable and safe way a person could invest their money, and any losses associated with lost job opportunities.
So here is where low interest rates matter. For future damages, the amount a victim will need in 10 years needs to be converted by an economist to a “net present value” because the victim will receive their settlement money now but won’t need to use it for care until the future. If interest rates are higher than inflation rates, the net present value is lower than future value of the health care needed because your investments go up faster than the prices of the things you need to buy in the future. If interest rates are lower than inflation the net present value is higher than the future cost of the health care.
The average medical care net discount rate over the past 5 years has been about -0.5% while in the 90s it was more like 2.0%. If an injured child needs $100,000 in annual care for 70 years, at a net discount rate of -0.5% this results in an $8.4 million med-mal. award. If you can use a 2.0% net discount rate instead, you only have a $3.7 million med mal. award. That’s a huge difference in what a med mal. insurer might have to pay today versus the past.
Sorry for the long post, everyone, but you know economists…
gene108
@WereBear:
I don’t think so.
There were assumptions made about being able to invest in safe investments and actually get a return on the investment. In the 1990’s, or early 2000’s, for example, you could stick your money in a CD and get 5% interest per year or something there abouts.
For most businesses, and retirees (who are also impacted by the low interest rates), you could expect a certain return on income from safe investments. A safe steady return, with minimal variations year after year, i.e. invest in a CD in 1996 and then invest in 1997 and the interest rates you would get would not fluctuate widely.
Then the financial crisis hit and interest rates are effectively zero, so you now get 0.5% on a 5 year CD or if you are lucky maybe almost 1%.
This has screwed up a lot of investment strategies.
Businesses are trying to find ways to cope.
Retirees, who used live off of their interest are getting screwed.
Middle class consumers, with good credit, though can reap some benefits like financing a new car with 0% interest for 60 months.
Earl
Hi Richard,
This is an off-topic question, but since you work for an insurance company, why don’t large insurers sponsor generic drug development? eg in a situation like epi-pens, where the cost is $3, they were profitably sold for $50, and they now run $600, why doesn’t blue cross + anthem go to some generic manufacturer, subsidize development of generics, and lock in a long-term cost of say $20 per generic for a decade? Similar to eg apple’s equipment development contracts, where apple buys the equipment and subsidizes R&D in exchange for a 5 or 10 year exclusive? It sees like it would be a huge win.
sherparick
First, the higher interest rates in the 1980s and 90s were higher nominal rates. Inflation after 1982 still ran at 6% for most of the eighties, so a real interest rate of 2% was a nominal rate of 8%. In the 1990s, it ran on average 4%. In the Oughts before 2008, it was 3%. After 2008, it has been between 1.5 and 2% annual inflation. All around the world, long term bonds, set by the market, not by Central Banks, have hovered at 2 to 3%, because their is a glut of savings and supply in the world, and not enough investment demand.
The Ancient Randonnuer
The best example of successfully using insurance company float for large investments is Warren Buffett’s use (more precisely Berkshire Hathaway’s use) of “float”, and Buffett loves to point out its advantages (mentioned 46 times in the 2015 Annual Report and 32 times in the 2015 Letter to Shareholders. NOTE: I am a shareholder and read the Annual Report every year). The reason so many other companies fail at this is because the don’t have a long term perspective and they don’t hire the best executives team members. Without those two ingredients the problems you point out today will always exist.
lawtalkinguy
This shows why malpractice “crisis” are bs. In California, because of one such crisis in 1975, they added MICRA. Among other protections for doctors, including drastically limiting statute of limitations, they passed a cap on non-economic damages. In 1975, the limit was $250,000. after forty years of inflation, the limit is still $250,000. In California, it is almost impossible to find an attorney to take a malpractice case unless there are very significant lost wages and clear liability. Case law has also greatly increased the burden to prevail in malpractice cases. I tell people, only somewhat jokingly, that if you go in to have your right leg amputated, and they amputate your left leg, it wouldn’t be malpractice because some defense expert will say it was a 50-50 shot.
There is no question that actual payouts are a fraction of the reason for premium hikes. Rather, insurance companies had bad investments, raised premiums, and then blamed plaintiff attorneys.