Multiple factors drive insurance rate increases

Having just written about some of the complexities of healthcare economics (see here), there’s an article in the NY Times today about double digit rate increases being charged by certain health insurers.

I think the NY Times article today touches on an incredibly complex topic. By failing to discuss many of the underlying dynamics, I think the story falls short if it’s goal is to be truly informative. Here are a couple of points that are worth noting to understand the health insurance industry:

First, it’s important to understand that insurance companies have two primary responsibilities as it pertains to the delivery of healthcare:

  1. Insurance companies sign contracts with individual providers (doctors, hospital, lab companies, etc) to make sure that charges are reasonable. For example, a doctor might bill $500 for an office visit. Someone without insurance would be obliged to pay this entire sum. The insurance company might have negotiated in advance a total charge of $100. Thus, the clients of the insurance company lock in reasonable rates for services.
  2. Once a corporation decides what services should be covered, the insurance company controls costs in part by trying to prevent members from over-using services.

These two roles are substantive, important elements in controlling costs across the system.

Early in my career on Wall St, I had an eye-opening meeting with Bill McGuire, then CEO of UnitedHealth Group. When I asked him about controlling costs, he said this was only within the purview of health insurers to a limited degree. Rather, the insurer would discuss with their clients what services should be covered and whether there should be algorithms (or ‘gates’) that patients had to pass in order to seek specialized/expensive tests and medical opinions. If companies take the point of view that they want employees (patients)¬† to have easy access to high cost specialists and that every therapy should have coverage (including such things as high priced cancer treatments that have only small benefits and life-support therapies in debilitated patients even when the medical prognosis is that there is no hope of regaining consciousness), then costs will be high. In such cases, the role of the insurance company is to determine the actuarial cost per person over a large population and price insurance policies accordingly. The role of insurance is to prevent any one party/employer from facing devastatingly high costs due to high medical costs of one or a few people. For the system as a whole, the total amount paid in insurance premiums will roughly cover the total expenses incurred. If the system wants lower healthcare bills, the ultimate purchasers of insurance will need to decide to pare back coverage of some marginally-effective but very expensive treatments.

On occasion, health insurers compete to win new business. Since health insurance is largely a commodity product, winning a new contract may mean competing on price. In the first year after a new win, a contract might actually be a losing one, where the new insurance provider under-bid in order to win the business. This is not sustainable, and the next year the insurer must increase prices substantially, but the price increase would likely bring pricing in-line with levels that might have occurred had the incumbent retained the contract and instituted modest price increases.

Sometimes price increases are large and therefore eye-catching. In these cases, it may be that insurers are pricing insurance premiums to keep up with demand. As new therapies come out and as people make more doctor appointments, costs rise.

It can be seen that, in the aggregate, insurance companies have not taken price increases far outpacing their costs by looking at profit margins. Operating profit margins remain stable in the 5-7% range. Huge price increases in excess of medical costs would lead to meaningful operating margin expansions, which is not the case.

In addition, the Affordable Care Act (the healthcare reform law, or ACA) puts a limit on the amount of profit that an insurer can earn. Insurance companies must limit their charges such that at least 80% of premiums are spent on actual payment for medical care. (The remaining 13-15% of costs incurred by insurers are for administrative fees, such as negotiating contracts, adjudicating claims, and responding to client/beneficiary needs.) The 80% minimum is imposed on a state-by-state basis. If insurance companies spend less than 80% on medical services, the excess is not kept as profit but must instead be rebated back to clients. The fact that this measurement is done on a state-by-state basis is important because while one state could theoretically be profitable at the maximum level, another state could have high costs such that the insurance company loses money in that region. In total, it is essentially impossible that an insurance company, with all the regions monitored for profitability independently, would operate at the maximum allowable regulated level of profitability across the entire company.

Finally, it is worth noting that insurance is competitive. If one insurer raises rates to an unreasonable degree, other providers would be expected to offer better rates (especially since profitability is regulated, thereby eliminating the incentive to raise rates solely to boost profits).

As with all things in healthcare, the topic is extremely complex and multifaceted. Rising costs of health insurance are admittedly increasingly burdensome for companies and individuals. However, simply pointing to insurance companies’¬†rate increases fails to recognize that many factors contribute to the inexorable rise of healthcare costs.

source: Health Insurers Raise Some Rates by Double Digits (NY Times)

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