Let us suppose, for the moment, that enrollment in the Exchanges increases as healthcare.gov becomes less dysfunctional and as we get closer to the January 1, 2014 and March 1, 2014 deadlines. It is, after all, unrealistic to think that enrollment will remain at the pathetic/paltry/miserable levels recounted by today’s testimony from Kathleen Sebelius, notwithstanding her counting of people who merely put a plan in their shopping cart. But it does seem likely to many , including me, that
- sticker shock,
- the small and difficult-to-enforce penalties for 2014,
- President Obama’s decision to let insurers “uncancel” ungrandfatherable policies and let some of those insureds stay out the Exchanges,
- the website debacle, and
- whatever short-sightedness or financial liquidity issues led to most of even the sickest uninsured Americans not enrolling in the Pre-existing Condition Insurance Plan
will likewise lead the enrollment in the Exchanges to be considerably smaller than projected. This is particularly likely to remain true, I believe, in states such as Texas in which institutional forces and political culture often do not encourage participation and in which fewer than 3,000 out the estimated 3,000,000 eligible to do so have enrolled thus far.
The key question is how resilient are the Exchanges to low enrollments in which, one would expect, the enrollees are — even more than they were projected to be — disproportionately older and disproportionately less healthy. And have the Exchanges been rendered yet more fragile by what many cheered as the surprisingly low premiums charged by many insurers? Could those insurers, who are likely to swoop up most of the business in a price sensitive market, in fact be about to face the winners curse? The answer to these questions may lie deep in the details of one of the least studied and yet one of the most important set of provisions in the Affordable Care Act: the reinsurance and risk adjustment provisions contained in sections 1341-1343 of that Act and now codified at 42 U.S.C. §§ 18061-18063.
Here’s the (long) paragraph-length explanation of how these reinsurance and risk adjustment provisions work. 42 U.S.C. § 18061 basically creates a transitional (2014-16) government operated stop-loss reinsurance program funded out of a special tax on other health plans ($63 per covered life). The reinsurance attaches when a person covered by a plan in an Exchange incurs $60,000 or more in claims per year. After that point, the reinsurer pays for 80% of the claims up to a cap of $250,000. Thus, if an individual had claims of $180,000 in a year, the government would reimburse the insurer for $96,000, which is 80% of the difference between $180,000 and $60,000. What this provision appears to do is make insurer profit and loss less sensitive to attracting high claims insureds. 42 U.S.C. § 18062 basically redistributes money in a complex way from insurers whose Exchange plans profit to insurers whose Exchange plans lose money. Again, the idea is to reduce the insurer anxiety either that their plan and their marketing (if any) happens to attract an unhealthy pool or that they selected a premium too low for the actual risk that materializes. Finally, 42 U.S.C. § 18063, the only program that is supposed to persist past 2016, imagines an incredibly complex system in which the risk posed by an insurer’s pool is assessed and the states or, in their default, the federal government (see 42 U.S.C. 18041(c)(1)(B)(ii)(II)), transfers at least some money from those with the riskiest pools to those with the least.
Will these provisions really rescue the insurers?
All of this might seem a comfort to insurers that might permit them to survive and continue in the Exchanges even if the pools are, on average, considerably more expensive than originally projected. But to get a better handle on the degree of solace these provisions might provide, we need to look at some of the limitations of these programs and the actual numbers.
Stop-loss reinsurance under 42 U.S.C. § 18061
First, let’s look at how much risk the transitional reinsurance provided by 42 U.S.C. § 18061 really slurps up. What I contend is that while this provision should — and probably did — lower the premiums the insurer would otherwise need to charge to avoid losing money, it does less to rescue insurers if the pool is less healthy than they foresaw. While to really see this, we need to get deep into the weeds and do some math, I’m going to hold off on that fun for now. We have to save some things, such as the Actuarial Value Calculator, for other blog entries. I believe I have developed a plain English explanation that gets us most of the way there.
The key concept is to recognize that sophisticated insurers (are there other kinds?) took the free reinsurance into account when they priced their policies. They computed an expected value of the reinsurance reimbursements and lowered their rates by something approximating that amount. They were able to charge lower rates than they otherwise would because some of the claims bill would be picked up by the government. But this does not mean that the insurers end up having profits that are insensitive to the actual claims incurred by their pool. Unless all of the higher-than-expected claims are stuffed into the zone in which the reinsurance kicks in ($60,000 to $250,000), the insurers will be hurt when the pool has higher claims than expected. But such an assumption is incredibly implausible. If the insurer assumed that only, say, 2% of its insureds would have claims between $20,000 and $25,000 but, as it turns out, 4% of its insureds have such claims, nothing in 42 U.S.C. § 18061 will help such an insurer with that unanticipated loss. Moreover, because the reinsurance even within the relevant zone is incomplete, the insurer will lose money if claims between $60,000 and $250,000 are higher than expected. The effect of the transitional stop-loss reinsurance on reducing the consequences of adverse selection is thus likely to be small.
In the end, what this transitional reinsurance mostly does is mostly to tax non-Exchange policies $63 per covered life in order to make policies within the Exchange more attractive to policyholders. And, yes, that fact should make Exchange-based policies cheaper and reduce the problem of adverse selection. After all, if the insurance were free presumably there would be little adverse selection — everyone would get it. But the reinsurance fails to reduce insurer vulnerability to adverse selection much more than, say, providing more generous tax credits and cost sharing reductions would have done. If the pool ends up being less healthy than the insurer anticipated — an almost certain consequence of lower-than-expected enrollments, 42 U.S.C. § 18061 is hardly going to end up relieving the insurer of most of the unhappy consequences of having written policies in that environment.
Footnote: There is one more wrinkle, but it only means that the transitional reinsurance is a yet weaker rescue vehicle: the government’s obligations under the transitional reinsurance provisions are limited. There’s “only” $12 billion in 2014 and this ramps down to $4 billion in 2015. If those amounts aren’t adequate to pay reinsurance claims, each claim gets reduced pro rata. The reason I relegate this point to a “footnote,” however, is that if the pools are really small then even if claims per person are way higher than expected, the aggregate amount of claims in the reinsured zone of $60,000 to $250,000 aren’t going to be that big. My back-of-the-envelope computation suggests that the $12 billion allocated for transitional reinsurance should not be insufficient unless at least 2 million people enroll on the exchanges; since right now we are almost certainly at less than 100,000, 2 million seems a lot of insureds away.
“Risk Corridors” under 42 U.S.C. § 18062
The biggie in this field is the “Risk Corridors” provisions contained in 42 U.S.C. § 18062. It essentially creates this massive transfer scheme, taking money from insurers who had profitable pools and giving it to those who did not. In some sense, it converts insurers from entities bearing risk to mere fronts for government funded health insurance. If I were prone to accuse the Affordable Care Act of creating “socialized medicine,” my Exhibit A would be the stealth “Risk Corridors” provision of 42 U.S.C. § 18062.
The graphic below shows how the scheme works. The x-axis of the graph shows hypothetical aggregate net premiums (what 18062 calls “the target amount”) an insurer might receive for some plan in some state. The y-axis shows the profits the insurer receives as a function of those aggregate net premiums assuming that claims (a/k/a “allowable costs”) are $11.4 million. The purple line shows what profits would have been as a function of premiums if 42 U.S.C. sec. 18062 did not exist. The blue line shows what profits will be after the payments required by 42 U.S.C. 18062 are taken into account. The khaki-shaded zone shows the payments insurers are supposed to receive (and the Secretary of HHS supposed to pay) under the statute. The green zone shows the payments insurers are supposed to make (and the Secretary of HHS supposed to receive) under the statute.
We can create a similar graphic in which the role of claims and premiums is reversed. The x-axis of the graph shows hypothetical aggregate claims costs (what 18062 calls “the allowable costs”) an insurer might receive for some plan in some state. The y-axis shows the profits the insurer receives as a function of those aggregate claims costs assuming that net premiums are $8.6 million. The purple line again shows what profits would have been as a function of premiums if 42 U.S.C. sec. 18062 did not exist. The blue line again shows what profits will be after the payments required by 42 U.S.C. 18062 are taken into account. The khaki-shaded zone again shows the payments insurers are supposed to receive (and the Secretary of HHS supposed to pay) under the statute. The green zone again shows the payments insurers are supposed to make (and the Secretary of HHS supposed to receive) under the statute.
If one looks at the slope of the blue lines — the ones that show profits after 18062 risk corridors are taken into account — they are much less steep for most of the domain than the purple lines — the one that show profits before 18062 risk corridors are taken into account. What this means is that, in some sense, it doesn’t matter to insurers all that much whether they price too low or too high, whether claims are lower than they thought or — due to adverse selection or otherwise — higher than they thought. Either they are going to pay money to the government or they are going to get money from the government. The risk of writing policies in the Exchange is greatly diminished.
In some sense, then, if section 18062 (1342) is fully implemented — an issue to which I will shortly return — insurers don’t act very much as profit-making enterprises within the Exchange making or losing money on the spread between premiums and claims. (This is even more true after the corporate income tax is taken into account) Instead, they are almost fronting for the government, providing their license, their claims processing abilities and their credibility to a scheme in which the government really bears the risk associated with the new Exchange-based system of providing insurance. A cynic might term the Exchanges as having gone 80% of the way towards a single payor system in which there is but minor variation in the benefits offered by insurance policies and claims processing contracted out to various insurance companies with the experience to do so.
The incentives issue
There are several implications of this consideration of 42 U.S.C. 18062. The first is to consider what incentives the system sets up for insurers. My tentative belief is that it incentivizes insurers to offer a low premium if they want to go into the Exchanges and this statutory provision may explain in substantial part why insurers priced their policies at rates lower than most expected. Let me see if I can sketch out the argument. If the insurer prices high, they are going to get very little business. Other insurers will take their business away by going low. If they price low, they will get a lot of the business. Sure, they may lose money if they price too low, but, if so, the government will reimburse them for most of their losses. And if they price right or still too high, they can make some money.
The graphic below illustrates this concept. The x-axis shows possible premiums the insurer might charge. The y-axis shows the profit of the insurer associated with that profit. As one can see, before section 18062, the insurer does best to charge about $2,840 in premiums; after 18062, the insurer does best to charge about $2,677 in premiums. Although the assumptions chosen to produce this graphic were somewhat arbitrary, it is interesting and suggestive to me that the magnitude of the reduction in premiums is roughly similar to that observed in the actual market place in which premiums came in several hundred dollars below that originally projected.
The imbalance issue
There’s a second issue suggested by the two graphics above (the ones with the shading) showing the effect of premiums and claims on profitability. They highlight that there is is no reason to think that the amount the Secretary receives will be equal to the amount the Secretary takes in. That would be true only if insurers happen, in aggregate, to price the policies just right. If insurers have underpriced the policies because they expected a larger — and correlatively healthier — pool, the graphics may quite accurately reflect what occurs and the Secretary will be obligated to pay out far more than the Secretary takes in. I have found no one who has written on this problem, no one who can explain where the money will come from to make the needed payments, or what mechanism will be used to reduce payments in the event, as I suspect, there will be an imbalance between the money collected and the money the Secretary is supposed to pay out.
And one final thing
Extra credit: Can anyone spot the uncorrected typo in 42 U.S.C. 18062? For answer, look here.
Risk Adjustment Under 42 U.S.C. §18063
The transitional reinsurance and risk corridors provisions only last until 2016. After that, assuming the Affordable Care Act survives in something like its present form for that long, insurers are protected from adverse selection only by the sleeping giant among the trio of protection measures: the “risk adjustment” provisions in ACA section 1343, codified at 42 U.S.C. §18063. The idea here is to equalize the playing field for insurers not based on the amount they actually pay out in claims (stop-loss reinsurance) or their actual profits (risk corridors) but on the risk they took in accepting insureds. It thus envisions this massive bureaucratic scheme whereby each individual purchasing a policy on an Exchange is scored (based on a complex federal methodology involving “Hierarchical Condition Codes“) and then, the insurers with high scores get paid by the insurers with low scores with the Secretary of HHS figuring out exactly how it works. To do this, the Secretary will need masses of sensitive information, including fairly granular accounts of the medical conditions of each person enrolled on an Exchange. The idea in the end, though, is to calm insurer fears that because of peculiarities of their plans, bad luck, or other factors, they tend up with a worse than average pool.
This provision will not save the Affordable Care Act from an adverse selection death spiral if enrollment stays low. This is because Risk Adjustment simply protects insurers from worse-than-average draws from the pool of insureds purchasing Exchange policies. It does nothing to protect insurers from having an overall pool of insureds purchasing Exchange policies that is higher risk than anticipated. If that larger pool is high risk on average, however, insurers will need to price their policies high, which will lead the lesser risk insureds to drop out, which will result in prices being raised again — the death spiral story.
The Bottom Line
The bottom line here is that two of the provisions (18061 and 18063) that purport to protect insurers from adverse selection really do little to protect insurers from the sort of adverse selection that is now appearing quite likely to develop: lower risk persons staying out of the Exchanges, period. The remaining provision, 18062, “Risk Corridors” in theory could give insurers some confidence that they will not lose their shirts if the pool stays small and high risk. But this is only true to the extent that insurers believe the Secretary of HHS will find some currently unknown pot of money with which to make payments when the number of insurer losers in the Exchanges far outstrips the number of insurer winners. If insurers doubt that the Secretary will be able to find the money and may simply resort to some pro-rata reduction in payouts under 18062(b)(1), they will have be less pacified in what must be their growing fears that the pool of insureds inside the Exchanges will, on balance, be far higher risk than they anticipated. And, if the Secretary finds money with which to honor the promises in section 18062, look for protests from those who were told that the Affordable Care Act would not have all that large a price tag.
Late Breaking News
As it turns out, the reinsurance and risk adjustment provisions are in the news today in an elliptical remark made at the end of a letter sent by the Center for Consumer Information & Insurance Oversight (CCIIO) that implements President Obama’s transitional “fix” with respect to canceled nongroup policies. He states:
Though this transitional policy was not anticipated by health insurance issuers when setting rates for 2014, the risk corridor program should help ameliorate unanticipated changes in premium revenue. We intend to explore ways to modify the risk corridor program final rules to provide additional assistance.
I believe this passage amounts to recognition by the President that providing a non-Exchange insurance substitute for generally healthy people who otherwise likely would have gone into the Exchanges will end up making adverse selection worse and further increase likely losses by insurers writing in the Exchanges. This, by the way, is why insurers are apparently furious about the President’s “fix.” The question, though, is where is the money going to come from to make the insurer’s whole. The statute appears to envision a zero sum game in which the winners compensate the losers. It does not appear to contemplate what seems ever more likely to occur: a game in which the only winning move is not to play.
If you are interesting in this topic, you should read the articles by Professor Mark Hall. I don’t alway agree with Professor Hall, but I have tremendous respect for his analysis. He is, in my view, one of the leading scholars with a generally positive view about the Affordable Care Act. You can find the articles here and here.