The role of the health insurance company is changing rapidly, accelerated by many of the provisions in PPACA, including new regulations regarding Medical Loss Ratio.
What is Medical Loss Ratio?
One of the key tenets to healthcare reform is the requirement that health insurers maintain a minimum Medical Loss Ratio, which historically has been defined as the ratio of medical expenses to total insurance premiums (it should be called the medical expense ratio, but claims expenses in the insurance industry have been called “loses” since, well, forever, and hence the convention sticks). Insurers that fail to achieve a minimum MLR, expected to be somewhere in the range of 80-85% depending on whether the plan is large group (85%) or small group/individual (80%), will be required to provide a refund to policy holders.
Some numbers, please…
Suppose that in a given year a health insurer has 20,000 members that are charged an average premium of $4,800 per year ($400 per member per month or PMPM in industry parlance), equating to Annual Premium Revenue of $96 million per year.
If the regulated MLR is 85% the amount of money this health plan is required spend on medical expenses equals $81.6 million per year (85% of $96 million).
Suppose it turns out that medical claims actually equal $74.8 million or 78% of premium for that year. Prior to healthcare reform the excess $6.8 million would be considered profit for the health insurance company. Under reform the $6.8 million must be refunded ratably to the policy holders for that year, resulting in an average rebate of $340 per member ($6.8 million divided by 20,000).
If the opposite occurs and medical claims are $88.4 million (92% of premium), the insurance company covers the $6.8 million shortfall out of its capital (profits).
This brief, simplified example illustrates an important aspect of MLR regulation, it effectively eliminates any potential for unexpected upside to the health insurer for underwriting the risk. If the insurer does better than expected, i.e., the MLR is low, the excess profits inure back to the policy holders. This has similarities to the model of a mutual company, wherein the policy holders are actually owners of the company, without the downside of unexpected losses accruing to policyholders.
Purpose
The purpose of Minimum MLR is to regulate the “value” provided by health insurance companies. The theory is an insurance company provides greater value to its policyholders when a higher percentage of premiums is used for healthcare costs, versus, say administrative expenses or profits. By demanding a minimum MLR legislators and regulators believe they are protecting consumers from potentially uncompetitive or collusive insurance markets, among other things.
Issues Arise
This regulation presents a myriad of issues, some of which are actuarial, but most of which derive from the definition of Medical Expense. The exact components of Medical Expense are left to HHS to decide, but PPACA (specifically Sec.2718. BRINGING DOWN THE COST OF HEALTH CARE COVERAGE) does provide some guidance, declaring Medical Expense to be equal to (paraphrased): (i) reimbursement for clinical services provided to enrollees plus (ii) costs for activities that improve health care quality. It is very clear what (i) above means, i.e., the money paid for medical claims. It is in (ii) where the debate begins.
Defining “Costs for Activities that Improve Health Care Quality” will be left to the bureaucrats, and from what I can tell they are taking an open minded approach to the types of services that will be included. Over the weekend the Wall Street Journal published an Op-Ed piece by Newt Gingrich and David Merritt titled Who Decides on Health-Care Value? (New rules to micromanage insurance companies could cost patients). I present it to you not as a position that I support but rather as an introduction to the debate on this subject. Please give it a read (along with some of the comments, pro and con) and I will come back to this subject soon to take a look at some of its ramifications for investors in the healthcare sector.
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