The new Patient Protection and Affordable Care Act contains a number of provisions that should significantly alter the structure, conduct and performance of the health insurance industry in the United States. One provision I think stands out among the many is the minimum-medical-loss-ratio requirement for health insurers. The medical loss ratio (MLR) represents the portion of the premiums health insurers pay out as medical claims costs. It is important to remember that while medical claims are costs to health insurers, they are revenues to health care providers, such as hospitals, physicians, drug retailers, medical device manufacturers and all the rest of the health care providers that potentially gain from the medical food chain.
According to the act, health insurers will be required to pay out at least 80 percent of their premiums as medical claims for those covered by individual health insurance and 85 percent of premiums for those covered by group health insurance plans. If the actual MLR falls below those minimum requirements, health insurers are required to rebate the difference to consumers. Essentially, this regulation places a cap on the amount of revenue health insurers will be able to generate in excess of medical claims. The hope is that such a cap will translate into lower health insurance premiums.
By design, this provision suggests that the health insurance industry behaves noncompetitively such that individual insurers have some market power to raise their premiums unreasonably above medical claims costs. Otherwise, how could health insurers earn revenues that are far in excess of their medical expenses? Interestingly, ample evidence exists to believe that the health insurance industry sets premiums in a noncompetitive manner. Studies by the American Medical Association suggest that most metropolitan areas are dominated by one or a few health insurers. This dominance may provide health insurers with the market power necessary to elevate their premiums, which ultimately harms consumers and reduces the number of people with health insurance coverage. In fact, a couple of working papers at the National Bureau of Economic Research indicate that health insurers possess sufficient market power to charge higher premiums to more profitable employers and set higher prices overall in less competitive markets. In addition, one of these studies implies that general practitioners are paid less and fewer physicians practice primary care in areas where health insurers possess market or monopoly power.
But one can only wonder if this minimum MLR provision will squash the incentive for health insurers to seek cost savings from health care providers. An insurer who aggressively and successfully negotiates health care cost savings below the 80 percent and 85 percent of premium thresholds will go unrewarded. So why work so hard? Indeed, the mandated MLR may help facilitate tacit price collusion among health insurers by setting a common cost upon which a similar markup rate can be applied to determine premiums.
In fact, health insurers have been relatively successful at controlling health care costs in the past. From 1993 to 1999, the so-called heyday of restrictive managed care plans, health insurers held the rise in health care costs to the growth of gross domestic product (GDP). Restrictive managed care plans like HMOs (health maintenance organizations) accomplished that objective by aggressively negotiating prices and utilization practices with health care providers. But since that time, many people have left restrictive managed care plans for preferred-provider organizations, or PPOs, which are considered by many as managed-care-lite plans. Not surprisingly, health care costs as a percentage of GDP rose significantly after 1999.
In spirit, the mandated MLR is similar to the fuel-adjustment mechanism faced by electric companies during the late 1970s. Those companies were automatically allowed to increase their utility rates if fuel prices suddenly increased beyond a preset rate based upon a formula. At least one study suggests that electric utility companies negotiated less aggressively with fossil fuel suppliers because of this fuel-adjustment mechanism.
If the goal is to contain health insurance premiums by keeping the MLR at a reasonable level, the government should invite more price competition, not introduce greater price regulations, into the health insurance industry. Increased competition will force health insurers to keep premiums at an acceptable level along with all the components that may make up premiums, including medical claims costs, underwriting costs, marketing costs, claims-processing costs and profits.
Greater competition in the health insurance industry could be introduced by more carefully scrutinizing mergers among large health insurers or allowing consumers to purchase health insurance across state lines. The health insurance exchanges also proposed by the new act should enable consumers as a group to countervail the seller power of health insurers, at least to some degree. Heightened competition may help create an environment in which health insurers once again do a better job of containing health care costs, as they did during the 1990s.
Rexford E. Santerre is a professor of finance and health care management at the University of Connecticut.