Opening The Black Box (Part 1)

Posted by Eric Schultz on November 11, 2010 7 comments

How can it be that health insurers indicate that total medical cost is rising 8 – 10% but a small employer may see premium increases as high as 20% – 30%, or more? Increasingly, we read or hear about small employers that were shocked after receiving very large health insurance premium increases. There is no question that we collectively need to find better strategies to reduce cost of care, but it’s also important to understand how insurance premiums are calculated.

So the purpose of this blog is to open up the so-called “black box” for calculating insurance premiums. To begin, I will only focus with the part of the insurance market that can see some of the biggest swings – namely the “merged market,” which includes small employers (50 or fewer employees) and individuals.

I recently sat with one of our senior actuaries (Greg) and asked if he could give me a straight-forward example of a small employer’s health insurance premium renewal and to explain how the rate was calculated and why a premium would go up or down substantially.

The “Base Rate”
So, let’s start with how the premium rate is calculated for a typical merged market customer. We start with something called the “base rate,” which can be thought of as a dollar amount that the health insurer needs to charge for an “average” customer. (And, by the way, in Massachusetts, about 90% of what the insurer needs to charge goes to paying for medical claims.)

But not all customers are “average,” and the laws in Massachusetts allow health insurers to modify the base rate for each customer to reflect the impact of certain factors. These “rating factors” have demonstrated their reliability in explaining the cost of claims a customer will likely incur in the future.

How we Adjust the Base Rate
What factors do state regulators allow?

• Age: The age factor for an employer group measures the average age of the members covered through that employer.
• Industry of the customer: Employees of certain industries consistently show higher or lower medical costs relative to the average.
• Geographic location: The customer’s location is considered since certain areas of the state have hospitals, physicians and other providers that are much more or less costly than other areas.
• Size of the employer group (the number of employees), as well as the percentage of those employees who choose to purchase insurance.
• Wellness and tobacco use: These are relatively new factors that I expect the market will want to use more and more. For example, I increasingly hear that non-tobacco users should be allowed to pay less for their insurance premium.

What these factors all share is that they contribute to a more accurate prediction of how future medical claims costs will vary by customer. And the policy question is how much should these factors adjust the base rate up or down?

Average Base Rate vs Individual Experience
State legislators and regulators try to find the fair balance somewhere between charging all customers the same “average” base rate, and, on the other end of the spectrum, adjusting that average according to the amount of medical claims each customer will incur in the future.

That is why health insurers are allowed to use some rating factors to modify premium rates…but with limitations. For example, consider the role of the age factor. Actuarial studies document that the oldest employees with insurance will incur 4 to 5 times the medical claims cost of the youngest. Yet Massachusetts law lets the maximum ratio to be 2 times. So the application of the rating factor is allowed, but just partially. Therefore, the smaller this ratio becomes, the greater the cost shift from older to younger persons.

Furthermore, there are some factors that relate to the cost and use of medical services that are not allowed at all by Massachusetts law. For example, the regulations forbid health insurers to charge higher rates to employer groups with members who have suffered with high cost conditions or who are likely to do so in the next year. The spirit of this regulation is that the burden of sharing the cost of very sick members should be borne by the whole population, rather than just one small employer group.

Year over Year Increase to Premium

Okay, so the premium rate for an employer group is determined by the average base rate and the group’s particular rating factors, as allowed by state regulations. What determines how much that rate will change from one year to the next? Well, the answer is surprisingly straightforward: it will depend on the CHANGE in the base rate and the CHANGE in the customer’s rating factors.

But, as they say, the devil is always in the details. (If you can hang in there, please keep reading…) Why does the average “base rate” change from one year to the next? As we said, the base rate is the dollar amount that needs to be charged to the average customer so that the health insurer can cover the cost of claims (about 90% of the rate), administrative expenses (about 9%), and a contribution margin (of about 1%). The base rate will increase because the cost of medical claims is increasing.  (In fact, administrative expenses have been declining.)  For Harvard Pilgrim and many other carriers in recent years the “trend” in the cost of medical claims has been about 10%, mostly due to the increase in reimbursements to health providers, increases in the use of higher cost services, and the expected impact of new state and federal health care mandates.

If that was the only change, then all customers would get about a 10% increase. But the other determinant of an employer’s premium rate is its rating factors. Are these likely to change? Unless the employer moves to another geographic area or changes its entire business, the area factor and the industry factor won’t change. For most accounts, it is the age factor which drives the difference.

Let’s assume the customer:

• Will keep their benefits exactly the same;
• Will maintain an identical employee and dependent population (other than growing one year older);
• Has employees reasonably distributed across many age categories.

In this example, their health insurance premiums would increase by approximately 14%. This is because the base rate increased by 10% and the cost associated with the population’s average age increasing by one year (assuming no retirements) drives roughly a 4% increase in cost.

With normal turnover (older employees retiring, younger employees hired), the impact of aging is about 1 – 2% on average for accounts producing an 11% to 12% increase in the example above.

If you figured out that the mix of employee ages and the change in the mix of employee ages from one year to the next must be a major driver in premium change, you are correct!  Imagine what might happen if, in this economy, an employer laid off the youngest workers…

In Part II of “Opening The Black Box,” I want to provide an example that drives a premium decrease of 37%, and a premium increase of 16% and 52%. In these three examples, it is the change in the employer group’s age factor that explains these results. I will also discuss how a recently enacted law will address this.