Friday, May 7, 2010

Obamacare's January Insurance Time Bomb

Cross-posted from

One of the quirks of ObamaCare is that most of its key provisions don't go into effect until 2014. But in any 2,300-page law, there are bound to be provisions that have immediate and unintended consequences. One such provision is Section 2718, entitled "Bringing Down The Cost Of Health Care Coverage."

If only. Section 2718, at a mere 802 words, goes into effect first thing next year and will have a huge impact on the private insurance market. It is the section that converts private insurers into regulated utilities by effectively placing a ceiling on their already-low profit margins. Depending on how the law is implemented by Kathleen Sebelius, the Health and Human Services secretary, it could end up driving many insurers out of business.

It all hinges on a regulatory technicality: In the context of insurance, how do you define "profit"?

One of the key metrics for comparing the financial performance of different insurance plans is what is called the "medical loss ratio," or MLR. The MLR is the percentage of an insurer's premium revenues that are spent on actual medical care. The largest insurers typically have MLRs in the low 80s: In 2008 Aetna's MLR was 81.3%; Humana's was 79.3%; UnitedHealth's was 81.5%; and WellPoint's was 83.6%. After insurers spend on beneficiaries' health care, whatever money remains is used to pay for labor, expenses and taxes and, if anything is left over, to generate a small profit.

There are three large markets for health insurance sold in the United States: large group plans for companies with 50 or more employees (ObamaCare increases this to 100), small business plans and individual plans. Due to economies of scale, large-group plans cost less to administer than small-group plans, which in turn cost less than individual plans. In addition, large employers have more negotiating power with the insurance companies than small groups or individuals, and thus can bargain for lower premiums.

All this means that in the large-group market, insurers can spend relatively more on health-care expenses. For example, UnitedHealth's 2008 loss ratio was 81.5% overall and 82.7% for large groups. But for individuals, it was 67.8%.

Now enter the world of ObamaCare.

Section 2718 requires that from Jan. 1, 2011, onward, MLRs in the small-group and individual markets must be above 80%, and above 85% in the large-group market. Many companies will need to lay off employees or use other cost-cutting measures in order to meet these congressional targets. Some important services offered by insurance companies, such as 24-hour nurse hotlines and disease management programs for preventive care, are classified as administrative costs, and not medical expenses, solely because of the technicality that they are not payments to a third party. These programs, if they cannot be reclassified to count as part of the MLR, will get shut down--to no one's benefit.

Given that the typical profit margin for a health insurance plan is under 5%, there isn't much fat on the bone. It may well be impossible for United to move its individual-market MLR from 67.8% to 80%; instead, the company may decide to exit the business altogether.

The worst-case scenario--the one with dire consequences for the insurance market--revolves around how exactly Secretary Sebelius decides to calculate these medical loss ratios. Since health insurers are already regulated at the state level, national insurers like WellPoint have discrete plans in each of the states in which they operate. The loss ratios of these plans can range from 30% to 170%, depending on how well or poorly each plan is established in its respective state. Averaging together these disparate performers allows the insurer to keep its ill-performing plans in operation.

Will Sebelius allow insurers to meet ObamaCare's MLR mandates on a national basis, or will she require that each discrete, state-based entity to jump through the hoop?

If she decides the former, private insurance market can survive by raising premiums. If she decides to calculate loss ratios on a state-by-state basis, it will cause massive dislocation. Insurers will exit the states in which they have high fixed administrative costs (due, say, to low market share), in order to keep their units in other states in business. In essence, it will reward well-established incumbents in each state and reduce competition. The likely outcome: more insurance monopolies at the state level, which will doubtless be decried by the very people who caused them.

Over the next few months, Secretary Sebelius and her staff will work around the clock to plug the various regulatory holes in the Affordable Care Act. It is a massive undertaking. Sebelius and her White House compatriots seem to enjoy demonizing insurers. Will they spend enough time on a few sentences in Section 2718 to avoid blowing up the private insurance market? Would that even bother them? We will find out soon enough.


  1. Will this also reduce plans' efforts to reduce medical costs (by keeping medical costs high, they can maintain higher MLRs, etc.)?

  2. Anonymous, this is really the key thing that people misunderstand: the profit motive gives insurers an incentive to keep costs down (because they make more money if costs are low). They pass on some of these savings to consumers, in the form of lower premiums.

    If insurers don't have any economic incentive to work to keep costs down, they'll just let hospitals and doctors charge whatever they want, make their fixed MLR-based profit, and move on.

  3. Hi Avik,

    There's another little ticking time bomb in there. Section 9016 (if I read it right) requires that certain (i.e. non-Inventor owned) Blues hit an 85% MLR to retain their section 833 (from the code) THIS YEAR to retain their tax status. I would expect that to be a tough number to hit.

  4. Hi Jon, you're on to something.

    Prior to Obamacare, Internal Revenue Code Section 833 allowed for certain non-profit Blue Cross Blue Shield organizations and similar entities to deduct 25% of claims and expenses, and 100% of "unearned premium reserves" (what insurers are paid in advance for coverage that has not yet fully played out).

    PPACA section 9016 eliminates these deductions for plans that don't have MLRs above 85%. Many, if not most, plans do not meet this threshold. In addition, elimination of the deduction for unearned reserves disproportionately affects new entrants who are enrolling new policyholders and gaining market share. Therefore, as you suggest, this may also lead insurers to exit states where they are not well-established, further encouraging the creation of intrastate insurance monopolies.

    Also, Section 1103 requires Medicare Advantage plans to hit an MLR target of 85%, but since Medicare Advantage is already being effectively wiped out by the elimination of federal subsidies for the program.

  5. Hi Avik:

    What you say is not true. Your definition of MLR is correct. Amount spent for medical expenses of beneficaries divided by the premium collected - both by the insurance company. This amount spent does not include HSA. HSA is not established by insurance company but either by the beneficiary or beneficiare's employer. Further, the amount spent on medical expenses from HSA is not spent or expensed by the insurance comany and hence is not a part of MLR calculation.

    HSA will not become illegal since they contribute towards insurance's heath cost. They infact prevent overutilization of services, restrict the expense of insurance costs to high cost items such as speciality drugs and hospitalization costs, theyeby controlling overall cost behavior from the beneficiaries.

    Customer services, fighting and preventing farud and abuse etc are administrative costs not medical costs and are expected to be expensed from administrative budgets. IN fact, by mandating 80% and 85% MLRs, the ObamaCare has made sure that those costs are indeed reserved for beneficiaries. Either the insurance company will design benefits to pay for the costs and if they do not, they'll save money in year 1 only to have their premiums reduced in year 2 so that they meeet 805 and 85% cost structures. Either the beneficiaries will be benefited or the overall costs will come down. Either way it is a win for the society as a whole. Then remianing 20% and 15% is attributed to administrative expenses for customer services, preventing fraud etc. Because of the regulatory structure of the insurance business, the companies will be forced to spend moneys to meet those requirements as well and then pay staff and make a buck. Making a buck is not bad - that is the American way. large companies with 85% requirements for MLR will still have more dollars to share the administrative burden.

    lastly, I do not see this as a bacd thing under Obamacare. If NAIC is to draft the rules and rules have some negative effects - cannot be blamed on Obamacare.

    I know this since I am the CFO for an insurance comoany and deal with these issues every day

  6. Hi Anonymous,

    I think you meant to post this upon my more recent post (The MLR Tornado).

    As to your core argument: I certainly respect your expertise. But think of the math. An insurer has more money available for administrative costs, under this new regime, if medical losses are higher. Hence, insurers have little incentive to crack down on unnecessary medical costs.

    Also remember that there is wide variation on a plan-by-plan basis on MLRs. This will lead many insurers to exit the markets where their plans are not sufficiently established.

    I agree with you as to how HSAs *should* be accounted for.

  7. I know what will help against a lot of papers and you will have a very beautifully written essay, if you order on this site you will find your assistant, the best essay writing service 2022, an independent review