How Health Insurers Benefit From High Medical Costs

I spent some time in the medical industry coding insurance billing systems and I also worked at a Pet Insurance company for a few years. Thanks to my degree in Economics and my personal curiosity, I learned a few things about how insurance works. I’m no great expert, but I have some grasp of the basics. I was pondering the subject of private insurance due to a meme someone shared on Facebook about our for-profit insurance system and it sparked a thought about how they have a financial incentive to see ever increasing medical prices. That might seem counterintuitive since insurance companies are the main payers of these bills, so lets look at why they benefit from it.

Quick Explanation of Insurance

Insurance programs were created to spread out the risk of medical expenses. Lost of people pay a regular monthly rate, a premium, into a collective fund, and when someone takes ill, the fund pays, benefits, to help cover their medical expenses. This way, people have a fixed medical expense and can survive the shocks of an expensive medical bill. Some people will be lucky and not need the benefits and will pay more than they pull from the system, while other will be less fortunate and require more medical costs than they have paid.

As people pay into the insurance pool, that money is kept to pay out claims. This money is generally referred to as the Float. Insurance needs this pool of money so that when a claim comes in, they can cover it in a timely manner. Some of this money is put in Reserves which are held in easy liquid assets so they can pay out claims quickly, while the rest of it is typically invested.

All insurance companies also have operating costs that include the managers, statisticians, adjusters, and typical expenses every business has.

Where the Profit Comes From

There are two main sources for profit in the insurance business. The traditional source is the difference between the Premiums and the Benefits. Even if there are no profits, the Premiums need to be somewhat larger than the Benefits or else the operation would go bankrupt. The term for the ratio between premiums and benefit is MLR (Medical Loss Ratio).

Many people assume that this is the primary source of profit for insurance companies. Traditionally, that is true, and smaller insurance companies can make money this way. Indeed, at one time, insurance companies would try to make this gap as large as they could manage by denying claims and hiking premiums as much as they could. But these days, government regulations in every state strictly limit the MLR for insurance companies. Generally its an 80/20 ratio or something close to it. Companies must pay out 80% of the premiums they collect. If they get off that ratio they have to lower or raise Premiums to balance things out. This takes away their incentive to try and game the system to take greater profits.

As a result of this, insurance companies have shifted over time to making most of their profit from investing the Float, that pool of money that hangs out waiting to be paid out. Large insurance companies hold massive amounts of money in their Float pool and can make significant money loaning/investing that money. There are regulations on this investment as well, but the money made from it is basically pure profit for the insurance companies.

How the Incentive Works

• Insurance Companies make profit from investing the Float
• The larger their Float, the more profit they can make
• There are two ways they can increase the Float
  • Get more customers
  • Collect larger premiums
• The fixed MLR means the only way to increase premiums is to increase payouts
• Increased costs for medical care increase payouts, which means they can increase premiums, which means they can have a larger Float to invest.

Due to the regulations, its almost impossible for insurance companies to meaningfully compete on prices. the 80/20 ratio doesn’t allow much wiggle room. But it also means that no matter how high the medical bills go, they can, and in fact must, recoup those costs through higher premiums.

Thoughts

I don’t know if insurance companies actually try to jack up medical costs, but when you have a payer of a service that benefits from paying high prices, they certainly don’t have a strong incentive to control costs. There is one counter incentive here. Providers of health care can negotiate different prices to different insurers. An insurer who negotiates a lower price, would not see that as profit due to the ratios, but they might be able to offer a more competitive premium than their competitors which would get them more customers (the other way to increase their Float).

I don’t know nearly enough to evaluate whether this incentive to accept and encourage higher prices is actually driving up health care prices, but I suspect it probably does, at least in some circumstances, and especially with the largest insurers who have more or less gathered as many customers as they can in a market.

Unfortunately I don’t see a lot of ways to change this incentive without either price controls on medical services or premium controls that would drive companies to offer less benefits. You could remove the MLR requirements but then we’d be back to a situation where companies are incentivized to deny care to make profit.

Personally, I’m for universal public health insurance which removes the profit incentives on the insurance side entirely and the Float income can be used to help fund the benefits rather than profits. While public insurance has its own challenges, they lead to a more stable market that the average person can afford and which those in need can benefit from.