Anatomy of a Thirty Percent Premium Increase

Much has been written lately about health insurance premium increases of 30% or more.  These comments are usually in the context of insurance company abuse implying that these increases are little more than schemes to generate higher profits. More on health insurance company profits can be found here.

One blog I read was outraged that WellPoint had a profit margin target of 7%. In fact, that percentage is in the range of profit allowed for a regulated public utility.  For more on typical industry profit margins look here.

So, how does one get to a premium increase in double digits?

Several components make up a health insurance premium. The main one being health care claims, the others are things like reserves, retention (expenses) and profit for the insurance company to take the risk and provide the coverage.

To make this simple, let us take a group of 5000 people.  We are trying to determine their premiums for 2011.  Our goal is to assure that we collect sufficient premium to cover all the claims and expenses incurred by the group from January 1, 2011 through December 31, 2011.  The problem is that we do not know what those costs will be.  We have to assume the group stays the same (e.g., demographic profile, family mix) and that the rate of health care inflation and overall trend (that is increases in prices and the use of health care services) tracks with projections.  In any group, there will be people who have no claims, claims that do not exceed their deductible, modest claims and a few catastrophic claims.  In fact, typically about 20% of the people in a group incur 60% or more of all claims. Everyone in the pool shares the total cost even if they have no claims of their own, which is why we call it insurance. That is also why if you do not apply underwriting rules as to whom you let into the pool (e.g., waiting periods, pre-existing conditions); the costs for everyone will increase. However, for purposes of this simplified illustration, we will ignore that issue.

Our job now is to determine what the premium must be for all of 2011.  Let us say that as of July 2010 the average claims incurred by each member of the group are $1,000.  Let’s also say that all expenses (e.g., administrative costs, reserves). add an additional 15% to operating the program.  Therefore, right now we are charging each person $1,150 for coverage. 

Let us assume that the rate of medical inflation is 7%, which means we have to apply a 7% annual increase to incurred claims for the one-year period ending July 1, 2010. That results in an increase over the current claims of 10.49% (7/12 times 18 months- to be sure we cover claims incurred through December 31, 2011).  Therefore, the new premium is $1,271 per month including the administrative costs.  That means the average participant’s premium went up 10.5 % in one year. 

But wait, the above assumes that the actual claims incurred in the remainder of 2010 are exactly as predicted in the middle of 2010. What if there is an unexpected rise in claims (more visits to the emergency room, a bad flu season, etc,) and we learn that the claim cost per person in 2010 is not the predicted $1,000 but rather $1,200? Somehow, we have to capture the cost for those additional claims.  Since we cannot increase the 2010 premium retroactively, we must capture the loss in future premiums. Now the new premium looks more like this: $1,200 times 10.49%  (using the same 7% trend factor) = $1326 plus 15% to operate the plan and keep it solvent results in a new premium of $1,525 for a total percentage increase (over the current $1,150) of 32.57%.

Remember, if you are insuring this risk, your goal is collect enough money to pay all the claims, but you will not know that total cost for several months after the end of 2011 in this example.  As you can see, even with modest health care inflation, it is not difficult to reach a 30% premium increase in a given year. If you were insuring this risk, wouldn’t you want to set premiums with the goal of covering all claim costs and retention?  There are other factors of course, what if in the above example, younger healthier people drop from the group and are replaced with higher cost individuals, what if next year you were required to accept anyone who wanted coverage at any time and charge them the same as the rest of the group.  There is a potential that you will have underestimated the costs of this group for 2011 and then be required to make up the loss in 2012 generating an even higher premium increase that year.

Clearly, there is one key variable besides claims and that is the illustrative 15% in administrative costs, providing for reserves, paying expenses for running the program and being compensated for taking this risk are components of any program, even government run program (except the risk is with the taxpayers). Reducing claim administrative costs leads to more fraud, more errors in claim processing and higher claim costs (as it does with Medicare).  The point is that administration and even profit are not the key factors; rather the cost of health care and the escalation of those costs are the primary drivers of health insurance premiums.

We should acknowledge that the overhead, including marketing, advertising and administration expense for the individual health insurance market are much higher than for groups.  This stands to reason.  If you can sell to a group of thousands using one sales representative, it is a lot cheaper than marketing to thousands of individuals, but that does not mean there is abuse, it means we need to find ways to be more efficient in consolidating segments of the market so it is less costly to sell insurance.

Finally, keep in mind that about seventy million Americans are covered by employer self-funded health benefit plans.  The process for determining the cost of the these plans, hence the premiums charged to employees is the same as outlined above except that the expense portion is a negotiated fee per employee per  month.  This covers the administrators costs for processing claims, hearing appeals, setting up networks of health care providers, etc.  The administrator may be a large insurance company, but there is no insurance involved, the driver of plans costs is the claims incurred by the employees and their dependents.  The employer, frequently using an independent actuary, determines the premiums and the increase in those premium each year.

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