Saturday, November 16, 2013

At Least One Fatal Flaw (In the ACA)

I have copied and pasted below the Affordable Care Act section designed to assure that health insurance companies, in the absence of a free competitive market, do not overcharge for premiums and enjoy excessive profits.  Reading this short section will help explain why few if any in Congress or the Executive Branch read the whole 906 pages before passing the law and why we had to pass the law and turn it over to the regulators in Health and Human Services to find out what is in it.  

In plain English, this section of the ACA requires that benefits paid out by insurance companies in the large group market must equal 85% of the premiums collected.  A company that fails to meet that target must rebate some of the premium income to policy holders.  For insurance companies in smaller markets, states may ease that requirement to as low as 80%.

That sounds innocent, but reflects government naiveté about the economics of running a business.  It could just as well have said that insurance companies in the large group market are guaranteed that 15% of premiums collected will be available to cover costs and profits, or, for non-profits, to cover costs plus investment in expanding the business. 

I’m not sure about the accounting rules for insurance companies, but for manufacturers, a key result is the Gross Margin, the difference between the Revenue and Cost of Goods Sold, the money that is available to cover overhead, advertising, selling, etc., the costs generally called SG&A, or Sales, General, and Administrative.  Research and Development also must be paid for from that Gross Margin.  It would have been interesting if the company I worked for had benefitted from a government guaranteed Gross Margin, but that wasn’t the case.  We were subject to all kinds of competitive pressures including variable market prices for our products and for the raw materials and utilities we purchased.

Thanks to the Affordable Care Act, Health insurance companies will not face such competitive pressures.  Given the guarantee of a certain percentage gross margin, what will be the logical strategy of both for-profit and not-for-profit insurance companies?  It will be to maximize premiums and benefits because 15% of a bigger number is a bigger number, and there are economies of scale available.  It will not cost as much to serve the second million policy holders as it did to serve the first million.   And the result of that strategy, of course, will be greater spending on health care.  Paying out more benefits in one year will justify raising premiums in the following year, and the absolute margin for overheads and profits will continue to expand.  It is exactly the opposite of what has happened over the past couple of decades for openly competitive markets for such as computers and televisions, laser eye surgery, and teeth whitening.  Prices and margins have continually decreased.

Health care spending has already expanded because of the pay-for-procedure precedent that has been established by Medicare and other insurers.  If an insurer will pay $1000 for a CT Scan, the obvious strategy for a hospital is to invest in the equipment and do as many CT Scans as possible.  Once the equipment is bought and the staff are hired and trained, all the costs except electricity and laundry are fixed, and, once those fixed costs are covered, almost all additional revenue is profit.  All providers are getting reimbursed the same amount, so cost reductions go straight to the bottom line, and there is no motivation to reduce prices. “Do more scans” becomes the motto.  And health care spending rises.  The law of unintended consequences rules.  Except I suppose that the insurance companies saw all along the likely result of this provision so for them, it will be an intended consequence.  We really can't blame them.  If they are highly regulated and not allowed to compete, they have to try to make sure the rules favor them.

And with the fixed availability of 15% of the premiums to the insurance companies to cover their costs, the motto becomes, “Collect More Premiums; Pay More Benefits.”  And, policy holders can expect rebates because the best financial strategy for insurers will be to get the full 15% each year by having to rebate. Much better to overcharge a bit and then send rebates than to end up with a smaller gross margin. Unfortunately, just as we tend to celebrate our income tax refunds of our own money, we will probably brag on those insurance companies that rebate some of our own money.  It's an example of the Stockholm Syndrome.  

There are only two ways to reduce health care spending in the USA.  One is to restrict and ration availability.  The other is to allow free market competition and make providers compete for customers based on what they are able to pay.  So far, we haven’t made either choice, and it will be business as usual for total national health care spending growth.  Well, there is a third option: Healthy living.  And I’m guessing that having to pay for our own health care might tend to motivate healthier living. 

Now, just for fun, please read this little except from the Affordable Care Act.

‘‘(A) REQUIREMENT.—Beginning not later than January
1, 2011, a health insurance issuer offering group or individual
health insurance coverage (including a grandfathered
health plan) shall, with respect to each plan year,
provide an annual rebate to each enrollee under such coverage,
on a pro rata basis, if the ratio of the amount of premium
revenue expended by the issuer on costs described
in paragraphs (1) and (2) of subsection (a) to the total
amount of premium revenue (excluding Federal and State
taxes and licensing or regulatory fees and after accounting
for payments or receipts for risk adjustment, risk corridors,
and reinsurance under sections 1341, 1342, and
1343 of the Patient Protection and Affordable Care Act) for
the plan year (except as provided in subparagraph (B)(ii)),
is less than—
‘‘(i) with respect to a health insurance issuer offering
coverage in the large group market, 85 percent, or
such higher percentage as a State may by regulation
determine; or
‘‘(ii) with respect to a health insurance issuer offering
coverage in the small group market or in the individual
market, 80 percent, or such higher percentage
as a State may by regulation determine, except that
the Secretary may adjust such percentage with respect
to a State if the Secretary determines that the application
of such 80 percent may destabilize the individual
market in such State.

Note the ominous phrase, “…the Secretary may…”  It occurs 390 times in the Affordable Care Act. 


  1. insurance companies in the current working exchanges are competing with each other based on coverage and price. A friend of mine here in FL chose a major insurance company (BCBS) and paid $1000.00 less than anyone else for basically the same coverage. There is definitely competition even though you continually assert that there. is not..

    1. Well, for Medicare at least, there is certainly competition based on the amount of mail I get, part of their overhead, from certain companies wanting me to change to their plans. But they all have to provide the same benefits, don't they? Size will normally win just because of the economies of scale. I guess BCBS is very big in Florida and may eventually crowd everybody else out and enjoy the 15% gross margin without much of a struggle. It is what I would suggest if responsible for their strategy. From their website: "Florida Blue has approximately 4 million health care members and serves 15.5 million people in 16 states through its affiliated companies." I use BC/BS of SC for Medigap. I wonder if it is considered an "affiliated company." For the ACA, I think coverage is always the same, dictated by the act, though copays and deductibles and maximum out of pocket may vary within a very narrow range given the big picture of the possibility of hundreds of thousands of dollars of medical expense in some cases.

  2. There is competition. My son enjoyed a virtual bevy of choices, and though the basic coverage was similar, the deductibles and lifetime limits varied quire a bit - a few versus many thousands. The coverage payouts also vary depending on the color of the plan. The margins based on premiums is essentially limited to 15% but you can compete by offering policies at lower margins or offering better services for the same margins. You cannot just charge whatever you want to increase profits you will be restrained by the price competition. Profit margins for health insurance companies are currently in the low single digits without the ACA. I have seen folks, it seems always on Fox, that claim their premiums are now going through the roof due to the ACA. My anecdotal experience, with people I know and trust, have told me that the ACA is working great for them. My niece nor her husband had employer based insurance, my son is a new small businessman, and my friend alluded to above is retired (he sold his business) but is not old enough for Medicare. He did receive a cancellation letter but was able to obtain a much better policy. It seems to me that part of the problem now is that the ACA opposition is not interested in improving the system and making the ACA work, and that they never have had an alternative except to let things go as they are. The progressives would have preferred a single payer, or even a public option, but they accepted the Heritage Foundation/Romneycare basics- they did compromise- all to no avail. The Ryan Medicare proposal without going into detail has the same "exchange" principle as well.