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Making Sense of New Medical Loss Ratio Rule

What It Really Means to Insurers and Consumers

Few marketplace relationships are as laced with mutual enmity and angst as that between Americans and their health insurers. Companies in all industries complain about rising costs, but insurance firms, stockholder owned or nonprofit alike, sometimes appear to blame their customers for those costs. When they pay
Mark Pauly

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Wharton School health economist and LDI Senior Fellow Mark Pauly discusses the changes in health insurers' medical loss ratio requirements.
for the treatment of a client's broken bones, breast cancer or critically ill child, they refer to these customer interactions as "medical losses," a term that's been in the news a lot lately.

Their customers, on the other hand, complain about rising premiums but then view health insurers as money-for-nothing purveyors who never fully deliver those costly benefits.

New restrictions
University of Pennsylvania Wharton School professor Mark Pauly, has been studying insurance markets for nearly forty years. And like others in his field, he's kept a close eye on the media flurry surrounding the federal government's release of its final adjustments to the medical-loss-ratio restrictions it imposed on the industry a year ago. He characterizes those loss ratios as the mirror image of the proportion of premiums that does not go for insureds' medical costs -- what advocates of such restrictions believe to be a kind of "ripoff proportion" of the premium.

In Washington, those final rules set off vollies of partisan punditry that did surprisingly little to explain exactly how the latest changes will effect either the industry or its customers. Some, like Fortune Magazine's Rick Ungar, predicted dire consequences for all. "The medical loss ratio will ultimately lead to the death of large parts of the private, for-profit health insurance industry," he wrote.

'Sounds exaggerated'
But Penn's Pauly doesn't buy that. "Ungar's 'large parts' sounds exaggerated," he said, pulling a copy of a just-released Government Accountability Office report on 2010 medical-loss-ratio variations out of the central pile on his desk. "The GAO numbers are instructive on this and the proportion of the market effected is not that big a deal."

"Medical loss ratio" is another way of describing the amount of total annual premium revenues an insurance company pays out to cover the costs of its customers' health care. The new rules require health insurance companies, depending on their size, to spend either 80% or 85% of their total premiums on health care services. The remaining cash -- 20% or 15% -- is all that can be used for all other administrative costs and profits.

If, at the end of the year, an insurer has spent only 70% instead of 80% of its total premium money on actual medical expenses, the new law requires that it return the 10% difference to customers in the form of tax-free rebates.

A form of price control
The mechanical result of the new regulations is a form of price control. It forces insurers to spend at least a given proportion on health care services, and forbids them from using the premium for administration, brokers' commissions or insurer profits or net revenues. Theoretically, at least, this is supposed to lower the price of health policies. The debatable question is what impact it will have on the quality of the customer service and the efficiency of the medical care policy holders receive.

The health insurance business has three main segments -- individual policies, small business coverage and large group plans. Large group plans will not be much affected by these rules, but the segment likely to suffer the biggest hit -- companies selling health policies to individuals -- is also the one with the smallest number of customers, Pauly said. Only about six percent of the market buys individual-type health policies.

"If you work for a big insurance company that deals in large group plans like the Blues, Aetna, Cigna or Humana, you're not going to be affected," he said. "If you're one of those relatively few people who buy 'individual' insurance, according to the GAO data you have a 50-50 chance that your purchase will be affected."

Dramatic cuts for some insurers
Prior to the implementation of the new rules, a significant proportion of companies selling individual-type policies typically operated with medical loss ratios ranging from 70% to 50%, Pauly said. That means that from 30% to 50% of their premium revenues were spent on items other than customer health care services. In order to meet the new 80% requirement, a company with only a 50% medical loss ratio will either have to make dramatic cuts to its administrative spending and profits spending to divert 30% more of its premium cash to health care spending, or become much more generous in paying for care. That means some companies -- particularly insurers of small-to-medium small-business and individual insurers -- will no longer be able to make profits on this business unless they can change. (Many of the insurers that operate in these markets are giant companies that sell to large employers as well, but some companies do specialize in these now-vulnerable markets.)

The companies selling to larger groups, however, will not need to lower their pricing in order to adjust to the law's requirement. This is particularly true of the companies that sell to groups of 10,000 or more and dominate the U.S. health insurance market. They already typically spent 90% to 95% of their premium revenue on medical services for customers, exceeding the new minimum standard of 85%.

Some insurers will exit
"Overall," Pauly said, "I think we'll see some companies exit, especially those in the individual market, but they'll be small fry. However, some may reduce their administrative costs by not doing things they were doing before, and that their customers may have wanted. The question is, will the things they stop doing be things that were really valuable to the buyers?"

Perhaps brokers and agents, who operate as independent third-party salesmen for insurance companies of all sizes, are feeling the worst squeeze from the new regs. They have traditionally been paid a commision by the insurance companies, not paid separately (as, for example, a stock broker would be) by the policy buyers. In a scramble of eleventh-hour activities before the final rules were announced, their lobbying organizations fought hard to have the law altered.

Because their commissions are paid as an "administrative" expense, brokers' fees must come out of the same 20% portion of cash that insurance company profits, customer assistance, and claims processing costs now do. One obvious way to maintain those profits or avoid cutting customer service under the new law's restrictions is to reduce the amount brokers are paid, a maneuver already undertaken by some insurance companies since the original rules when into effect last year.

Brokers' lobbying efforts
Brokers' lobbying efforts throughout the Health and Human Services Department as well as the halls of Capitol Hill demanded that the rules be changed to re-categorize their payments as a form of "medical service," thus eligible for inclusion in the much fatter 80% side of the medical-loss-ratio equation.

Unfortunately, law doesn't allow HHS to make such a change even if its skeptical top executives wanted to; only Congress has the power to do that. And although there were a few bills floating around the House that envision granting insurance brokers some slack, they haven't advanced in any meaningful way.

"No question," Pauly said, "the biggest losers in all of this will be the brokers, particularly those in the small business and individual market. There's been a fair amount of talk about potentially unbundling the broker fee from the insurance company and for brokers to directly charge the buyer instead, as in, 'You want a consultation about what insurance is best for you? That's fine, but it will cost you fifty bucks.' The same goes for insurer services: if it becomes even harder for you to get someone on the 1-800 number to explain the status of your claim, will that frustration be offset by the premium rebate you received, and would you be willing to pay a separate fee to be upgraded to first in line?"

"In some ways," Pauly said, "this probably is good because the market will ultimately tell us whether brokers' services really were worth fifty bucks or not."

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