The Practical Boundaries of Health Insurance Regulation

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Richard Evans / Scott Hinds

212.531.6101 / .6102 /

April 26, 2010

The Practical Boundaries of Health Insurance Regulation

  • We believe the market’s fears regarding health insurance regulation ignore the practical limits faced by both politicians and regulators
  • Federal reforms increase the health system’s reliance on private capital for underwriting of health insurance – ignoring Medicare and Medicaid, private capital would have underwritten 48 percent of health insurance prior to reforms, and will now underwrite 53 percent as a consequence of reforms
  • Private capital plainly cannot be compelled into underwriting, and as a practical matter cannot be expected to appear without reasonable risk-adjusted returns. Insurers’ ROIC’s already are slightly sub-par relative to the SP500; lowering margins both reduces profitability and adds risks, a double-negative for ROIC. The logical end result of over-tightening for-profit insurers’ margins is to encourage the associated capital to seek alternative uses, just as more is needed
  • Ironically, tighter regulations pose greater risks to not-for-profits than for-profits. Not-for-profits are over-represented in more tightly regulated states, have less capacity to absorb the underwriting risks of further regulatory tightening, and if forced to deplete reserves almost certainly cannot re-capitalize without converting to for-profit. Thus the net effect of over-tightening may be to increase the health system’s reliance on for-profit capital, which presumably runs counter to political intent
  • Further on the topic of intentions, we show that state health insurance regulators tend to be appointed (40) rather than elected (11), and tend (50/51) to be part of a broader insurance commission that regulates all insurance lines according to actuarial principles that seek to balance availability and affordability for subscribers / beneficiaries, and ability to pay claims on the part of insurers
  • Intentions aside, we note that without further legislation regulators’ authority to meaningfully reduce underwriting profitability is substantially limited in states that represent more than half of for-profit underwriters’ business


We conclude that the majority of insurance regulators are unlikely to meaningfully reduce underwriting profits even if given the authority to do so. Objectively, we conclude that as-written, federal and state law provides regulators with limited options for meaningfully reducing the profitability of insurers – MLR limits are reasonably permissive, the law calls for their relatively broad (issuer level) application; and, for-profit insurers appear to have the option of raising premiums as a defensive measure to tight and/or narrowly applied MLR limits across more than half of their aggregate portfolio.

Background and Detail

Uncertainties surrounding both the translation of federal health insurance reforms into regulation, and related high-profile actions of select state insurance regulators, are fueling skepticism regarding health insurers’ mid- to longer-term earnings prospects.

To our minds insurers’ share price reactions reflect some loss of perspective, both in the big picture sense of what is necessary for health insurance markets to function under reforms, and in the more narrow practical sense of what various players in the drama feasibly will or will not, and can or cannot do.

Throughout this note, our arguments rest on four essential principles:

  1. Federal reform laws increase the health system’s reliance on private capital (both for-profit and not-for-profit) for underwriting health insurance[1]
  2. Regulation of health insurers’ premiums and/or profit margins does not change the rate of underlying health cost growth[2]
  3. Reducing underwriting margins both lowers profits and adds risks, reducing the attractiveness of health insurance underwriting as a use of private capital. For-profit insurers’ ROIC’s arguably are slightly sub-par, and would fall (potentially much) further, creating risk that private capital exits. The reserves of not-for-profit insurers are placed at risk, which – ironically — raises the odds that they have to attract private for-profit capital[3]
  4. Despite notable exceptions, regulators of health insurance work to balance considerations of affordability against the risks that underwriters will either exit markets or be unable to pay claims

In the immediate debate over health insurance regulation, we sense the fear that insurers’ margins will be reduced by restrictive definition of medical loss ratio (MLR), very narrow application of MLR limits, regulatory actions that hold premium growth to rates below health cost growth, or some combination of these.

We note that the National Association of Insurance Commissioners (NAIC) plays a substantial role in both matters – their involvement in defining MLR’s is mandated by the recently-passed federal law, and their membership consists in large part of the regulators that manage insurance markets (health and otherwise) at the state level. We further note that of the fifty-one (including D.C.) state health insurance regulators, 40 are appointed, only 11 are elected; and, all but one (Rhode Island) is part of a larger insurance commission that regulates all lines of insurance (e.g. including life and property / casualty). In that NAIC’s actions – and those of state insurance commissions broadly — tend to be driven by the application of actuarial principles to underlying fact, this raises our confidence the four ‘essential principles’ of our argument – particularly the fourth – ultimately govern the regulation of health insurance. More simply, we believe actuaries recognize a growing need to both attract for-profit to, and preserve not-for-profit capital in, health insurance underwriting, and that risk-adjusted returns to capital will be preserved as a result.

In effect, the foregoing argues that common sense eventually prevails, as we believe it will. Nevertheless it plainly makes sense to examine what happens if we remove this assumption. Starting with the definition of MLR, the question is whether or not for-profit insurers will meet the minimum standards after re-definition. Subjectively, we rely on the argument that at current levels of profitability, for-profit insurers’ ROIC’s already appear at least slightly sub-par. Any re-definition of MLR’s that works to force an increase in true medical costs relative to revenue, both reduces profits and adds risks, both of which work to reduce ROIC and thus the attractiveness of health insurance underwriting to private capital – precisely when the health system’s reliance on private capital is increasing[4]. Objectively, we rely on our estimates of insurers’ current MLR’s and the impact of eventual regulations, which show that insurers appear to already meet the federal law’s MLR limits. Exhibit 1 shows commercial underwriting MLR’s for the large-capitalization insurers, before and after a series of adjustments[5]. Recall that the most restrictive new federal requirement is an MLR of 80 for large groups (the individual and small group requirement is 75); and, that the legislation allows for re-classification of expenses into MLR if these expenses contribute to improving the quality of care. Also, the law calls for reducing revenues used in the MLR calculation by an amount equal to contributions to reserves[6] and state taxes[7] and fees. The large cap insurers meet the more restrictive 80 MLR requirement on an as-reported basis, before applying any modifications. Reducing revenues (for taxes and fees) used in the MLR calculation raises MLR’s by roughly 170bp. And, each one percent of operating expense that is re-classified into medical costs raises the MLR by roughly 20bp. We show in the exhibit that ‘statutory’ MLRs would reach an even higher standard of 85 in the least profitable of these years by re-classifying only 7 percent (as a percent of expenses, not sales) of OPEX as medical costs; reaching this target in the most profitable year shown would require re-classifying 17.25 percent of OPEX.

Turning to the narrow application of MLR limits, we revisit the arguments we made in last week’s note, though with additional state-level data. The more narrowly MLR limits are applied, the less likely an underwriting portfolio is to have profitable contracts that work to offset unprofitable contracts – meaning the underwriter can no longer afford to have any, or at least many, unprofitable contracts. In markets where no (or weak) premium restrictions are in place, this means charging substantially higher premiums to eliminate unprofitable contracts, then rebating up to the required MLR after the fact. Ultimately the underwriter achieves the same MLR as would have been achieved under broad limits, though fewer persons would have been insured because of the higher gross premiums, and those persons who were insured would have had their dollars tied up for a considerable period of time between payment of premiums and receipt of any rebate(s). We emphasize that this response by insurers – raising premiums to avoiding losing contracts – can only be blocked in markets where regulators have the authority to deny premium increases. This authority has been proposed for the federal regulator, and exists only selectively at the state level. State regulators whose markets include roughly half of the country’s privately insured have some type of pre-approval authority (Exhibit 2); regulators in other states either simply require prior filing (31 percent of privately insured), or have no requirement at all (18 percent of privately insured). Thus if MLR limits ultimately prove to be restrictive (contrary to our estimate that they will not), and are applied very narrowly, underwriters have the option of raising premiums as a defensive response in states representing roughly half of total premiums. Conversely, if MLR limits are both restrictive and narrowly applied; and defensive premiums are blocked in states where this authority exists (which assumes that all such states discount or even ignore the actuarial consequences), then insurers’ only responses would be to either accept the reduced returns, or exit these more restrictive markets.

We note that for-profit insurers are more common in more loosely regulated geographies, and conversely that not-for-profit insurers are more highly represented in tightly regulated geographies (Exhibit 2, again). This implies that somewhat more than half of for-profit insurers’ aggregate portfolio is in less restrictive geographies where tight and/or narrow MLR limits can be offset by premium increases at least in part; and implies that blocking premium increases along with restrictive and/or narrow MLR limits is does more to deplete the reserves of not-for-profit underwriters than to reduce the profits of for-profit underwriters. Taken to its extreme, depleting the reserves of not-for-profits arguably leads to their conversion to for-profit. Also, we note with considerable interest that premiums tend to correlate positively with the intensity of regulation – being higher in more tightly regulated markets. At the moment we cannot make conclusions on this correlation, being as yet unable to answer either the chicken-or-egg part of the riddle (were premiums high, forcing tighter regulatory response; or did tight regulation drive premiums higher), or determine whether the more relevant measure of risk-adjusted underwriting margins also correlates with degree of regulation.

At this point in our argument, we’ve assumed that regulators generally will work to balance affordability, choice, and adequate returns on capital; and that where this is not true, that the nature of current federal and state law works to (geographically) limit the pressure that regulators can apply. This begs the question of whether the associated laws will change further, which in turns brings us to politics. The most fundamental political battle line in health care is that of free markets v. government. We commonly hear the argument that present government is motivated to more tightly restrict private insurers’ margins in order to reduce their role in a post-reform insurance market – and we accept that this may be true. Nevertheless we emphasize that excessive reduction of underwriting margins – however it is done – is more likely to deplete not-for-profit reserves than to eliminate returns to for-profits. Not-for-profit reserves, once lost, almost certainly cannot be re-established without private for-profit capital. Thus the logical end result of attempting to hold back health costs by tightening underwriting restrictions is to expand, rather than to reduce, the role of for-profit capital in health insurance underwriting.

  1. Ignoring private capital in Medicare and Medicaid, a recent OACT report shows that private insurance is responsible for 53% of health spending by 2019, almost 5% more than would have been the case without the change in federal law
  2. Assuming no change in the nature of insurance. Today’s insurance contracts greatly restrict insurers’ ability to build tight networks and channel patients, which is to say insurers have little negotiating leverage vis a vis providers, whose inflating costs translate directly into inflating premiums. If, on the other hand, insurance contracts were such that tight networks could be established – which would require beneficiaries to sacrifice some degree of choice – then insurers would have means to affect health cost growth, and so might fairly be expected to react to premium and/or profit pressures by placing similar pressures on health providers. We believe that beneficiaries ultimately will choose to enroll in more tightly managed networks in exchange for lower premiums
  3. Presumably this means converting to for-profit, as de novo not-for-profit capital almost certainly cannot be found in sufficient quantity. And, assuming the underwriting restrictions that lead to depletion of not-for-profit reserves are held in place, attracting private capital will at least be very expensive, and might in fact be impossible
  4. We focus on ROIC in the belief that substantial de novo sources of capital for health insurance underwriting can only come from for-profit sources. Not-for-profit reserves, if depleted, almost certainly cannot be fully re-constituted by not-for-profit capital
  5. CORRECTION: Please note that last week’s call incorrectly included Federal taxes as a revenue reduction in a comparable exhibit estimating MLR effects of the legislation; and, this same exhibit also under-estimated the impact on MLR’s of re-classifying OPEX as medical cost
  6. Across all lines of business these averaged 1.33 percent of net premiums between 2002 and 2009.
  7. Working from 2009 tax rates we calculate that state taxes are roughly 16 percent of the combined state / federal tax burden
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