Health Insurance is Not Subject to Capitalist Principles

The Patient Protection and Affordability Act has received a lot of press, most of it negative.   However, there are a few components to the legislation which are actually an improvement on the status quo for consumers.  This article highlights one such component, the small group market reforms.

Many have said that our government should “get out of the way” and let our free market system solve our health care cost and access problems.  If you understand the principles of health insurance and risk, however, you’ll see that this isn’t possible in the small business market 1.

Insurance is the business of forecasting risk.  Insurers have to set prices slightly above their expected risk in order to make a profit and stay viable.  Now let’s consider health insurance.  You might have heard the principle ”20% of the people incur 80% of the costs”.  This is supported by a study from the Kaiser Family Foundation (kff.org) in the chart below.

Now, assume you are a health insurance company and you want to increase customers in the small employer segment (defined as 50 employees or less).  You want to set low prices, so you need to start with the lowest possible costs.  This means you need to attract the 80% of the population with the low costs or avoid those with the high costs.  How would you do this?  Actually, it’s not all that difficult.  Insurers have commonly:

1. set rates based on last year’s claims or known risks (past diagnosis, drugs prescribed)
2. excluded pre-existing conditions, or limit the amount paid out for a condition
3. provided coverage until the person hits some threshold (like $1M)
4. denied coverage entirely

I worked in a non-profit insurance company in the 1990’s that didn’t follow these practices.   At that time, we set the same prices for almost every small business (except for age and gender).  We also didn’t pay commissions to Brokers.  What happened?  Other insurers set lower rates since they had attracted the lower risk members.  Brokers sent the employees and dependents that the competition rejected to us, leaving us with a higher cost population.  This created a situation dreaded in the insurance world known as “adverse selection”.  The following year, our population cost more, so premiums went up faster than our competitors. Those members with the least risk found less expensive coverage and dropped out, causing our prices to spiral upwards.   After a while, it was obvious that the trend could not continue and we had to start playing by the same rules as the competition in order to stay in business.

As a consequence, the industry has developed a multi-step, time-consuming process for setting prices and enrolling applicants.  Its goal is to set the right prices for the right risk, so independent Brokers now run “show” rates (best possible rates) from multiple carriers, then pick one, They obtain and submit  applications from each employee with detailed medical information to the insurer.  Underwriters then review this data and may request additional information.  They use complex models built by actuaries and programmers to determine how much to rate up the group, sometimes to the maximum level allowed by the state.  In this way, a small company with one sick individual can see rates that are unaffordable or can change significantly from one year to the next.

Now imagine that the 4 practices described above are no longer allowed (as is included in the legislation).  All insurers have to play by the same rules.  They have to show prices side-by-side on the same benefit plans without regards to medical status.  With these changes, adverse selection should disappear as well as a whole level of administration2.  So what is left for the insurance companies to compete on?  How about quality, price, access and health outcomes?

I submit that disallowing these practices is the type of government intervention that benefits the American public, although some of the methods proposed can certainly be improved upon.   Take this one for instance.  The biggest mistake in the Health Reform Legislation planned for 2014 is that it allows individuals to purchase health insurance just when they need it and pay the less expensive fines all other times.  If this loophole is left in place, it will undo all the advantages that are possible.

As we have discussed, insurance is based on the principle of spreading risk.  As long as a large enough population is paying into the pool, the 20% who need the services can be covered with a little extra for administration and profit.  However, if you could pay a $100/month fine then once diagnosed with a serious condition, purchase health insurance, wouldn’t you do it?  Financial advisors everywhere will be telling their clients to save their money by paying the fines until they need care.  The only people left who will purchase insurance are the lower income earners who have most of their premiums subsidized and those with chronic conditions, creating the classic insurance death spiral.  Insurance companies will be forced to raise premiums significantly (if allowed) or leave the market.

What might work is if the government takes over the financing, but leaves the insurance companies in place to provide the administrative functions (paying claims, maintaining provider networks, analyzing outcomes etc.) and to continue  providing choice and competition.  Consider Medicare.  While the government owns the financing, the actual health care is delivered by independent providers all across the country.  Everyone pays in and those in need and are retired and over age 65, have their most necessary medical services paid for. Without Medicare, many more families would be bankrupt. In addition, those families with more money can purchase additional coverage through Medicare Supplement or HMO plans offered in the free market or by paying providers out of pocket.  Medicare is not perfect, especially because the size of the aging population is increasing faster than the younger population, but when this concept is used for the working population, it could stop an insurance catastrophe which benefits no one.

In summary, health insurance for small businesses is far different from other industries which have been regulated like airlines and telecommunications.  The concepts of spreading risk and adverse selection are what make it so different.  I only hope that our elected officials understand these concepts so that we may realize the stated goals of Health Care Reform in the small business market

1. Larger companies are more stable from a statistical standpoint and insurers can price them based on their own risk without excluding individuals or conditions. They are less likely to be unaffordable due to a single high cost claimant and less likely to fluctuate from year to year.
   
2. To further insure that adverse selection does not occur between the different carriers offered in the SHOP (small business health care exchanges), risk adjustments have been introduced as part of the bill.

About The Author

Jane Ames worked for a leading national Health Insurance company for 18 years where she was an underwriter, trainer and key participant in pricing system development and implementation in 11 states.  In 2010, Jane started her own business, Jane Ames Consulting which provides health care consulting, education and broker services to individuals and small businesses in Georgia.
Jane has a Health and Life Insurance license from the state of Georgia and has passed 2 of 3 exams in the RHU curriculum.  Jane is an active member of AAHU and delivers presentations about health care reform to business owners in the community.  In addition to an undergraduate honors degree in Mathematics from Clemson University, she has both an MBA and MHA (Masters in Health Administration) from Georgia State University.