At the reliably hyper Addicting Info, Wendy Gittleson is excited over upcoming insurance refunds due to the Affordable Care Act:
In a story that’s bound to send Republicans straight into the spin cycle, it was announced on Thursday that insurance companies will be refunding Americans $332 million because they’ve been overcharging them for healthcare.
That’s about a buck per American. And it’s funny she should mention overcharging, for reasons I’ll get to in a minute.
A generally ignored by Fox News part of the Affordable Care Act (aka, Obamacare) mandates that insurance companies spend at least $.80 of every dollar on *gulp* healthcare. The other $.20 can go toward administrative costs and all the other perks that CEOs of giant insurance companies enjoy. The law is even stricter when the policy is sold to a large employer, with a full 85 percent needing to go to healthcare. In other words, anti-Obamacare people, your insurance company is not charging you more because of Obamacare.
Actually, the ACA tends to push health insurance premiums up for three reasons:
First, the ACA specifies minimum coverage for all health insurance plans that can be used to satisfy the requirements of the Act, and anyone with less inclusive plans will have to switch to a conforming plan. All other things being equal, better coverage costs more, so some people will be paying more for insurance.
Second, the ACA limits the ability of insurers to refuse to cover pre-existing conditions or to charge more for them. To compensate for the losses they take covering people with pre-existing conditions, insurers have to increase the premiums they charge everyone in the plan.
Third, the medical loss ratio requirements of the ACA encourage insurance companies to demand higher premium payments. This is relevant to Gittleson’s post, but it requires a little explanation.
Insurance plans under the ACA are required to pay out at least 80% of premiums as benefits paid for members’ healthcare costs, taking their overhead costs (including profits for investors) out of the remaining 20% of premium payments. If, after everything has settled, it turns out they’ve paid out less than 80% of premiums received, they have to refund enough of the premium to get back up to an 80% payout. (This is what Gittleson is talking about.)
So, for example, if an insurance company took in $1 billion in premiums, it would be required to spend at least $800 million on healthcare. If instead it paid out only $700 million in benefits, it would have to refund $125 million back to plan members to get the loss ratio back to 80%.
It doesn’t work the other way around, however. If the company pays out $900 million in healthcare costs, they don’t get to send plan members a bill for $125 million. They just have to eat the $100 million loss. This asymmetry has consequences.
Assume that a particular insurance plan’s actuaries predict that the company will have to pay out $800 million in claims, and that there’s a 50/50 chance the actual claims will be over or under that amount by $100 million. Before the ACA, the company would estimate its costs at $800 million for payouts and $200 million for overhead costs, which means they’d want to charge $1 billion in premiums. When the year is over, they find out how well they did. If payouts were $900 million, they lose $100 million, but if payouts were $700 million, they’d make an extra $100 million in profits. On average, their outcome would be to have neither extra profits nor extra losses.
(You might be asking why the insurance company wouldn’t just charge an extra $100 million in premiums so they don’t lose money even if claims are $100 million higher. The answer is that I’m assuming that they are setting premium prices as high as they can in a competitive market. Every other insurance company faces the same costs, and therefore can offer insurance at the same price — which, as I said, already includes profit. If any company tried to raise its prices over that of other companies, it would lose all its customers to them.)
Under the ACA, however, the situation is no longer symmetric. With $1 billion in premiums, if payouts were $900 million, they’d lose $100 million that year, but if payouts were $700 million, instead of making an extra $100 million, they’d have to refund $125 million in premiums for a net $25 million dollar loss. So on average, with an equal chance of claims being $100 over or under estimates, the company would lose the average of $100 and $25 million — a projected loss of $62.5 million.
An insurance plan that is designed to lose an average of $62.5 million every year is bad business. To avoid the loss, insurance companies are going to want to raise premiums to $1.125 billion. Then if they had a good year and only paid out $700 million in medical costs over and above their fixed $200 million in operating costs, they would have to refund $250 million, for a loss of $25 million, but if they had a bad year and paid out $900 million in medical costs and $200 million in operating costs, they would make $25 million in profit. Symmetry would have returned, and they would once again have neither extra profits nor extra losses.
(Raising prices because of the incentives in the ACA is not blocked by competitive pressure because every other insurance company is also governed by the ACA and faces the exact same incentives.)
Obviously, I’m greatly oversimplifying, but the basic principle remains: By letting insurance companies take unexpected losses but not allowing them to keep unexpected gains, the ACA is actually encouraging insurance companies to raise their premiums to create a reserve against claims losses.
Note that insurance companies don’t actually make more profits this way, and consumers don’t actually pay any more for healthcare, because the high premiums are eventually refunded to consumers. However, the refunds don’t represent a saving for consumers either: The refunds are coming out of elevated premiums that are caused by the ACA itself. Obamacare is just forcing insurance companies to take more in premiums so they can give it back as refunds later.
Rebates are not the goal of the Affordable Care Act. In a perfect world, there would be no rebates at all. The idea is that insurance companies will charge the right amount off the bat. The goal is also for the companies to cut overhead.
Costs have been going on the right trajectory. In 2011, the year the law took effect, insurance companies owed their customers $1.1 billion. Last year, that number was cut by more than half, at $500 million. Overhead costs have gone down too – to just 11.5 percent.
That’s a good thing if insurance companies actually cut costs, but that may not be what happened. A lot of people think that insurance companies deliberately underbid their premiums this year in order to gain market share. This is suggested by the reports that a number of insurance companies didn’t participate in the ACA exchanges (presumably priced out of the market by the underbidders) and the expectation that premiums will be increasing next year.
And regardless of what happens over the short term, the ACA sets up some funny incentives over the long term. In my example above, you’ll note that when healthcare costs were high, the insurance companies made more profits, but when healthcare costs were low, the insurance companies lost money because of the way refunds are calculated. The limits on medical loss ratios mean the insurance companies essentially have to live on their 20% of the pie, so naturally they do better when the pie is bigger. In the short run, they still have to compete with each other for customers, so they will want to control increasing medical costs, but in the long run they will do better if medical spending increases.
Unfortunately, increased spending doesn’t necessarily translate to improved health, because the insurance companies will benefit as much from wasteful spending as they will from spending that produces real health benefits.
If cutting overhead to 15-20 percent seems like an unrealistic goal in the free market, perhaps they could learn a lesson or two from Medicare, which conservatively, has an overhead of just 6 percent.
That’s because Medicare recipients typically have higher healthcare costs than the younger people covered by private insurance. It’s easier to keep the overhead down when your non-overhead expenses are proportionately high.
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