The medical loss ratio is a key financial. Impact Of Medical Loss Regulation On The Financial Performance Of Health Insurers. Medical Loss Regulation

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1 Medical Loss Regulation doi: /hlthaff HEALTH AFFAIRS 32, NO. 9 (2013): Project HOPE The People-to-People Health Foundation, Inc. By Michael McCue, Mark Hall, and Xinliang Liu Impact Of Medical Loss Regulation On The Financial Performance Of Health Insurers Michael McCue (mccue@vcu.edu) is a professor of health administration at Virginia Commonwealth University, in Richmond. Mark Hall is a professor of law and public health at Wake Forest University, in Winston- Salem, North Carolina. Xinliang Liu is an assistant professor in the College of Health and Public Affairs, University of Central Florida, in Orlando. ABSTRACT The Affordable Care Act s regulation of medical loss ratios requires health insurers to use at least percent of the premiums they collect for direct medical expenses (care delivery) or for efforts to improve the quality of care. To gauge this rule s effect on insurers financial performance, we measured changes between 2010 and 2011 in key financial ratios reflecting insurers operating profits, administrative costs, and medical claims. We found that the largest changes occurred in the individual market, where for-profit insurers reduced their median administrative cost ratio and operating margin by more than two percentage points each, resulting in a seven-percentage-point increase in their median medical loss ratio. Financial ratios changed much less for insurers in the small- and large-group markets. The medical loss ratio is a key financial metric for health insurers. It reflects what portion of premium dollars an insurer devotes not to administrative overhead or corporate profits but to medical care and activities related to improving the quality of care. Wall Street investors reward insurers that have lower medical loss ratios, because those insurers tend to be more profitable. In contrast, consumers, providers, and regulators prefer insurers that have higher medical loss ratios, because a higher ratio signals that the insurer is more efficiently administering its plans and that less of the premium pie is being spent or kept by the insurer or its agents. One of the Affordable Care Act s most notable insurance regulations and consumer protections is its limit on health insurers medical loss ratios. Starting January 1, 2011, insurers were required to devote at least 80 percent of their individual and small-group premiums, and at least 85 percent of their large-group premiums, not to overhead or profits but to expenses related to delivering medical care and improving quality. 1 Insurers that paid out less than these regulated amounts were required to refund the difference to their members in the form of rebates. To help monitor this law, which is enforced by the Centers for Medicare and Medicaid Services (CMS), the National Association of Insurance Commissioners (NAIC) developed a standardized reporting form called the Supplemental Health Care Exhibit to show premiums, medical claims, quality improvement expenses, administrative costs, and underwriting gains and losses across the three commercial insurance markets (individual, small-group, and largegroup insurers). 2 The use of this form brought greater specificity and standardization to the computation of medical loss ratios and their key components than had prevailed previously, when variations in state-level filings made comprehensive national analyses more difficult. 3,4 For instance, life insurers for the first time were required to use the same standardized reporting as health insurers for their comprehensive major medical policies. This is important because both life insurers and health insurers sell health coverage, and in the past it had not been possible to analyze the important life insurer component of the health insurance market 1546 Health Affairs SEPTEMBER :9

2 which often tends to be fee-for-service indemnity-style coverage. 5 This standardized reporting began in 2010, the year before the new medical loss ratio rule took effect. Using data from these reports and similar data from CMS, prior studies 6 8 have analyzed the size and distribution of insurers rebates to policyholders and the characteristics of the insurers that paid the rebates. However, those studies focused primarily on health insurers whose medical loss ratios fell below the regulatory minimum. The literature is silent with respect to the impact of the Affordable Care Act s medical loss ratio rule on the industry as a whole, including the impact on insurers key financial performance ratios such as administrative costs and operating margins both for insurers that owe rebates and those that do not. The standardized financial reporting that began in 2010 the year before the new medical loss ratio rule took effect allowed us to conduct an uncontrolled natural experiment to examine how the new rule influenced key financial performance ratios in its first year. This one-year window is hardly definitive, however. At best, it can only suggest the new rule s possible influences. Our analysis was not able to determine whether patterns over this limited period were a continuation of preexisting trends or whether they were the result of factors other than the new rule. 9 Nevertheless, we might expect insurers in different markets, and different types of insurers, to react differently to the major new federal regulation that required them to spend a specified percentage of the premiums they collected on health care services. Administrative costs and profit levels differ among the individual, smallgroup, and large-group markets, and the particular medical loss ratio benchmarks established under health reform have differing relationships to these preexisting market conditions. Thus, the benchmarks might be easier to meet in some market segments than in others. In addition, for-profit insurers and nonprofit insurers probably face different degrees of financial pressure to increase or maintain earnings. Both types of insurers must generate some level of surplus to remain financially solvent, but forprofit insurers also need to reward their investors. Furthermore, compared to nonprofits, for-profit insurers tend to have leaner capital reserves because they can generate additional capital by issuing stock which nonprofits cannot do. And insurers that are affiliated with forprofit companies can depend on their corporate parent to provide capital when needed. It should also be noted that the Affordable Care Act s medical loss ratio rule affects nonprofit insurers somewhat differently than it does forprofit insurers. Both types of insurers must refund in the form of rebates any excess overhead amounts they accumulate, but nonprofit insurers are also at risk of losing their favored tax status under federal law if they fail to meet the mandated medical loss ratio targets. 10 This creates an added incentive for them to meet the targets. To explore how these different factors may have shaped insurers responses to the new medical loss ratio rule, this study examined changes in key financial performance ratios between 2010 and 2011 for each segment of the insurance market, and for nonprofit and for-profit insurers within each segment. Study Data And Methods Sample We first identified all health insurers that offered comprehensive medical insurance in 2010 and 2011 and that filed their annual financial reports using the NAIC Supplemental Health Care Exhibit. Multistate insurers are required to complete the supplemental form for each state in which they have a corporate subsidiary that offers comprehensive health medical insurance. We found 1,219 health insurers 11 in the individual market, 804 in the small-group market, and 750 in the large-group market. In each market segment, we then determined (based on AIS s Directory of Health Plans: and filings with the NAIC) which insurers were for profit and which were nonprofit. Nonprofit insurers are permitted to generate at least some profit, but they cannot distribute profits to investors or others. As a result, their profits are often referred to as underwriting gains. For insurers that are subsidiaries of a larger company, we defined profit status according to the parent company s status, assuming that its operating structure and philosophy would influence the performance of its subsidiaries. 13 Analysis To measure the financial operating performance for each segment of the insurance market, we computed three ratios from key financial accounts that affect the pretax income or loss from operations (which is reported as underwriting gain or loss), 14 across the three market segments, and separately for nonprofit and for-profit insurers within each segment. The first ratio is the medical loss ratio, defined as total net incurred medical claims and total expenses incurred for improving health care quality as a percentage of the net adjusted premiums earned. 15 The second, the administrative cost ratio, is defined as total administrative ex- SEPTEMBER :9 Health Affairs 1547

3 Medical Loss Regulation Exhibit 1 Median Financial Ratios Of Insurers In The Individual Market, 2010 And 2011 Insurers 2010 (%) 2011 (%) All Medical loss ratio *** Administrative cost ratio *** Operating margin *** Nonprofit Medical loss ratio Administrative cost ratio * Operating margin For profit Medical loss ratio *** Administrative cost ratio *** Operating margin *** Change from 2010 to 2011 (percentage points) SOURCE Authors analysis of data reported by insurers to the National Association of Insurance Commissioners on the Supplemental Health Care Exhibit, 2010 and 2011 (see Note 2 in text). NOTES Sample sizes are as follows. All: N = 1,219; nonprofit: n = 150; for profit: n = 1,069. Percent change from 2010 to 2011 may not equal the 2011 value minus the 2010 value because of rounding. *p < 0:10 ***p < 0:01 penses and claims adjustment expenses as a percentage of the net adjusted premiums earned. And the third, the operating margin, is defined as the percentage of pre-federal-tax operating income earned (also known as the underwriting gain or loss) from the net adjusted premiums earned. Each insurer s operating margin is 100 percent minus the sum of its medical loss ratio and administrative cost ratio. 16 Because of the wide variation and non-normal distribution of the data, the study measured median values and the top and bottom quartiles of each financial measure. We used a Wilcoxon matched pair sign rank test to assess changes in the median values of the entire distribution for each financial measure. The findings that measure changes in median values are presented in the exhibits. Because we matched each pair, each insurer acted as its own control, which helped reduce statistical error and increase statistical power. 17 The online Appendix 18 presents additional descriptive analyses of the top and bottom quartile values for each financial ratio from 2010 to Limitations This study is limited by its focus on only one year of regulatory change and its measurement of only a few key variables. However, the change in 2011 was important and unprecedented, so a distinct response could be expected. The patterns of response reported here fit logically with insurers general corporate characteristics and the conditions of their different market segments just prior to the implementation of the new regulation. Another limitation of the study is that it is descriptive in nature. As a result, we were unable to control for other factors that might have varied with time or for typical year-to-year variation in the outcomes. Study Results Individual Market Insurers For the individual market, the median medical loss ratio increased by 5.5 percentage points between 2010 and 2011 (Exhibit 1). The median administrative cost ratio and operating margin declined by 2.6 percentage points and 1.3 percentage points, respectively. Insurers in the bottom quartile increased their medical loss ratios by almost eleven percentage points, and even some insurers in the top quartile saw increases, of up to two percentage points (see the online Appendix). 18 Insurers in both high and low quartiles also had declining administrative costs and operating margins. The administrative cost ratio for insurers in the top quartile declined by four percentage points, and these insurers median operating margin declined by six percentage points. For insurers in the bottom quartile, both administrative cost ratio and operating margin declined by less than two percentage points. Changes for nonprofit insurers in the individual market were much smaller (Exhibit 1). Only the change in administrative cost ratio was even marginally significant. However, the changes in all three financial measures were significant in the case of for-profit insurers. Their median medical loss ratio increased by 7.1 percentage points, while their median administrative cost ratio and operating margin declined by 2.9 and 2.2 percentage points, respectively. This pattern appears to be directly related to the new medical loss ratio rule. The median medical loss ratio for nonprofit insurers was already well above the 80 percent minimum in 2010, so they did not have to make any significant changes to comply with the new rule in In contrast, for-profit insurers had to substantially increase their medical loss ratio to approach the regulatory threshold. Group Health Insurers For insurers in the small-group market overall, only the change in median administrative cost ratio was significant, declining by one percentage point between 2010 and 2011 (Exhibit 2). The median medical loss ratio for small-group insurers was above the 80 percent threshold in both years. The picture did not differ greatly for insurers in the top and bottom quartiles (see the online Appendix). 18 Among nonprofit insurers in the small-group market, a slight decline in both the medical loss ratio and the administrative cost ratio resulted in 1548 Health Affairs SEPTEMBER :9

4 a one-percentage-point increase in the median operating margin (Exhibit 2). Among for-profit insurers, only the drop in the administrative cost ratio was significant. For all large-group insurers, the median administrative cost ratio declined significantly, by almost a percentage point (Exhibit 3). The change in the median medical loss ratio was not significant, and the change in the operating margin was only marginally significant (p <0:10). As was the case in the small-group market, nonprofit and for-profit insurers performed similarly in the large-group market, as did insurers in the top and bottom quartiles (see the online Appendix). 18 Even though the annual changes were similar in these market segments, it is notable (as discussed below) that in each segment, nonprofit insurers reported lower operating margins and administrative costs, and higher medical loss ratios in both years, compared to for-profit insurers. Exhibit 2 Median Financial Ratios Of Insurers In The Small-Group Market, 2010 And 2011 Insurers 2010 (%) 2011 (%) All Medical loss ratio Administrative cost ratio *** Operating margin Nonprofit Medical loss ratio ** Administrative cost ratio ** Operating margin *** For profit Medical loss ratio Administrative cost ratio *** Operating margin Change from 2010 to 2011 (percentage points) SOURCE Authors analysis of data reported by insurers to the National Association of Insurance Commissioners on the Supplemental Health Care Exhibit, 2010 and 2011 (see Note 2 in text). NOTE Sample sizes are as follows. All: N = 804; nonprofit: n =185;forprofit:n = 619. **p < 0:05 ***p < 0:01 Discussion In 2011 the Affordable Care Act s regulation of medical loss ratios required health insurers to return $1.1 billion to consumers in the form of rebates. 19 These rebates are not the only consumer benefits that flow from the regulation, however. To minimize rebates, insurers can reduce their administrative costs, their operating margins, or both. A net reduction in both of these overhead financial measures should translate into restrained premium increases. When we examined changes in these key financial ratios, we found that the new medical loss ratio rule apparently contributed in its first year of operation to a decline in administrative costs in each of the three health insurance market segments, for both for-profit and nonprofit insurers. The largest decrease in administrative costs occurred in the individual market, where the median insurer reduced its administrative cost ratio by 2.6 percentage points (Exhibit 1). In the small- and large-group markets, the administrative cost ratio declined one percentage point or less (Exhibits 2 and 3). This pattern is consistent with the observation that insurers median medical loss ratio in 2010 was much lower in the individual market than in the group markets. For-profit insurers offering individual insurance increased their medical claims and quality improvement expenses, reduced their premiums, or both so that their median medical loss ratio came much closer to the required minimum, moving from 71.8 percent in 2010 to 79.0 percent in 2011 (Exhibit 1). These insurers changes in the small- and large-group markets were much smaller, because greater economies of scale in sales and administration made it easier to meet the minimum medical loss ratios required by the new rule. 10 The patterns in profitability across the individual and group markets are noteworthy. In the individual market, median operating margins for all insurers were near the break-even point in 2011, declining from 1.2 percent in 2010 (Exhibit 1). But in the small- and large-group markets, median operating margins in 2011 were 3.6 percent and 1.8 percent, respectively, which was not a significant increase from 2010 (Exhibits 2 and 3). Thus, it appears that operat- Exhibit 3 Median Financial Ratios Of Insurers In The Large-Group Market, 2010 And 2011 Insurers 2010 (%) 2011 (%) All Medical loss ratio Administrative cost ratio *** Operating margin * Nonprofit Medical loss ratio Administrative cost ratio ** Operating margin ** For profit Medical loss ratio Administrative cost ratio *** Operating margin Change from 2010 to 2011 (percentage points) SOURCE Authors analysis of data reported by insurers to the National Association of Insurance Commissioners on the Supplemental Health Care Exhibit, 2010 and 2011 (see Note 2 in text). NOTE Sample sizes are as follows. All: N = 750; nonprofit: n = 216; for profit: n = 534. *p < 0:10 **p < 0:05 ***p < 0:01 SEPTEMBER :9 Health Affairs 1549

5 Medical Loss Regulation ing gain in the group markets helped offset declining margins in the individual market. For-profit insurers ratios changed much more noticeably than those of nonprofits in the individual market (Exhibit 1). The median medical loss ratio among for-profits increased by more than seven percentage points between 2010 and 2011, with accompanying reductions in administrative costs and profits. For nonprofits, in contrast, the small increase in median medical loss ratio was not significant, nor was the small reduction in overhead. Compared to for-profit insurers ratios, in 2010 nonprofits median medical loss ratio was sixteen percentage points higher and their median administrative cost ratio was eight percentage points lower. Thus, forprofits had much more room for improvement than nonprofits did. We found a different pattern in the smallgroup market (Exhibit 2). There, too, the median medical loss ratio was substantially higher and the administrative cost ratio lower for nonprofits, compared to for-profit insurers, in However, the median for-profit insurer had a medical loss ratio of 77.7 percent close to the 80 percent benchmark so the regulatory impetus to improve was not as strong as in the individual market. Accordingly, for-profits showed only a small decline in their median small-group administrative cost ratios between 2010 and 2011, and their other changes were not significant. In contrast, the median medical loss ratio for nonprofit insurers in the small-group market was substantially above the regulatory minimum. As a result, their median administrative cost barely changed between 2010 and 2011, and their median operating margin increased by 1.2 percent points. In the large-group market, changes in financial ratios were similar for nonprofit and forprofit insurers (Exhibit 3). There, too, however, nonprofits began and ended the study period with a higher median medical loss ratio, lower administrative costs, and lower profits than forprofit insurers had. Although we did not test this for statistical significance, the magnitude of difference in 2011 financial ratios appears notable. Compared to for-profit insurers, in 2010 and 2011 nonprofits in the large-group market had higher median medical loss ratios and lower median administrative cost ratios and operating profit margins differences of about five percentage points for the medical loss ratio. Even larger differences were seen in the small-group market. Further analysis would be required to know with greater certainty whether these apparent patterns and differences resulted primarily from the new medical loss ratio rule and these insurers corporate traits or from other regulatory factors and market conditions. 20 Conclusion Overall, insurers reduced their administrative costs in the individual, small-group, and largegroup markets. However, the reductions seem to be linked to an increase in the medical loss ratio only in the individual market, and only in the case of for-profit insurers, which also reduced their operating margins. In other cases, where medical loss ratios were closer to the regulatory minimum, it appears that reduced administrative costs were absorbed at least partially by small increases in profits. The authors recognize the Commonwealth Fund for its financial support of this research. NOTES 1 Seven states (Georgia, Iowa, Kentucky, Maine, Nevada, New Hampshire, and North Carolina) received waivers from the Department of Health and Human Services, allowing them to have lower regulated medical loss ratios so as to keep insurers from leaving the market. Department of Health and Human Services. Health insurance issuers implementing medical loss ratio (MLR) requirements under the Patient Protection and Affordable Care Act; interim final rule. Fed Regist [serial on the Internet] Dec 1 [cited 2013 Aug 1]. Available from: National Association of Insurance Commissioners. NAIC Blanks (E) Working Group: blanks agenda item submission form: supplemental health care exhibit part 1 [Internet]. Kansas City (MO): NAIC; 2010; [cited 2013 Aug 6]. Available from: documents/index_health_ reform_mlr_blanks_proposal.pdf 3 Robinson JC. Use and abuse of the medical loss ratio to measure health plan performance. Health Aff (Millwood). 1997;16(4): Turnbull N, Kane NM. The impact of accounting and actuarial practice differences on medical loss ratios: an exploratory study of five HMOs. Inquiry. 1999;36(3): Although life insurers cover only a fraction of the health insurance market, the majority of the insurers that offer health insurance are life insurers. This is especially the case in the individual insurance market. We did not analyze life insurers separately from health insurers, however. Thus, for simplicity, we refer to any insurer that sells health coverage as a health insurer. 6 Abraham JM, Karaca-Mandic P. Regulating the medical loss ratio: 1550 Health Affairs SEPTEMBER :9

6 implications for the individual market. Am J Manag Care. 2011;17(3): Hall MA, McCue MJ. Estimating the impact of the medical loss ratio rule: a state-by-state analysis [Internet]. New York (NY): Commonwealth Fund; 2012 Apr [cited 2013 Aug 1]. (Issue Brief). Available from: media/files/publications/issue %20Brief/2012/Mar/1587_Hall_ medical_loss_ratio_ib.pdf 8 Kaiser Family Foundation. Insurer rebates under the medical loss ratio: 2012 estimates [Internet]. Menlo Park (CA): KFF; 2012 Apr [cited 2013 Aug 1]. Available from: kaiserfamilyfoundation.files.word press.com/2013/01/8305.pdf 9 Note, for instance, that medical loss ratios historically have varied from state to state, based in part on different market and regulatory conditions (see Note 6). In addition, the ratios have not been static but have varied over time. Harrington SE (Wharton School, University of Pennsylvania). Medical loss ratio regulation under the Affordable Care Act [Internet]. Unpublished paper [2012 Oct; cited 2013 Aug 1]. Available for download from: papers.ssrn.com/sol3/delivery.cfm/ SSRN_ID _code pdf? abstractid= &mirid=1 10 Nonprofits are subject to a tax penalty if their overall medical loss ratio falls below 85 percent, which is stricter than the 80 percent medical loss ratio that determines insurers rebate obligation in the individual and small-group markets. Kirchhoff SM, Mulvey J. Medical loss ratio requirements under the Patient Protection and Affordable Care Act (ACA): issues for Congress [Internet]. Washington (DC): Congressional Research Service; 2012 Sep 18 [cited 2013 Aug 1]. Available from: sgp/crs/misc/r42735.pdf 11 The study excluded the following insurers: all property and casualty insurers that offered health insurance and reported their data using the NAIC property and casualty form; managed care insurers in California that did not use NAIC forms because they were regulated only by California s Department of Managed Care and not by the state s Department of Insurance (these insurers file their medical loss ratio data only with the Centers of Medicaid and Medicare Services, not with NAIC); and health insurers that did not have filings for both study periods. However, the study included fifty-six California life insurers that were regulated by California s Department of Insurance. Comparing our NAIC data with data from CMS shows that our sample of health insurers covered 90 percent of all insured members in the individual and small-group markets (twenty-seven million out of thirty million members) and 76 percent of all insured large-group members (thirty-eight million out of fifty million). 12 Atlantic Information Services. AIS s directory of health plans: Washington (DC): Atlantic Information Services; We also analyzed financial ratios according to whether or not insurers were publicly traded, recognizing that some for-profit insurers are privately held. However, the results for this ownership trait did not differ markedly from overall market results, so we do not report them here. 13 We identified as nonprofit 12 percent of the insurers in the individual market, 23 percent in the smallgroup market, and 29 percent in the large-group market. Nonprofits accounted for a small portion of insurers in the individual market because that segment has many more commercial life insurers than the group markets do, and most of those insurers are for profit. 14 The underwriting gain or loss is defined as the net adjusted premium earned (line 1.12 on NAIC s Supplemental Health Care Exhibit; see Note 2) minus net incurred claims (line 5.7) minus total defined expenses incurred to improve health care quality (line 6.3) minus total claims adjusted expenses (line 8.3) minus total general and administrative expenses (line 10.5). Premiums and claims are net of reinsurance, meaning that reinsurance premiums paid are subtracted from premiums earned, and claims reimbursed by reinsurance are subtracted from claims paid. 15 The medical loss ratio computed for this study differs somewhat from the medical loss ratio that insurers report to CMS to determine if they owe their members a rebate. The CMS computation makes a different adjustment than we did for claims that have been incurred but not yet paid. Also, CMS gives insurers with fewer than 75,000 members a sliding-scale adjustment that increases their medical loss ratio to account for the statistical fluctuation in smaller risk pools, as well as an adjustment for insurers offering high-deductible plans to account for the greater proportionate administrative costs of such plans. Nevertheless, our unadjusted medical loss ratio used the same basic elements as the CMS formula, and it is a reasonable approximation of overall and median performance by insurers throughout the market. 16 However, because we calculated the median for each of these ratios for all insurers in each market segment, instead of reporting aggregate ratios for all insurers, the ratios we report do not necessarily sum to 100 percent. 17 Black T. Doing quantitative research in the social sciences. London: Sage Publications; To access the Appendix, click on the Appendix link in the box to the right of the article online. 19 Department of Health and Human Services. The 80/20 rule: providing value and rebates to millions of consumers [Internet]. Washington (DC): HHS; [cited 2013 Aug 2]. Available from: /06/mlr-rebates a.html 20 Also, insurers may have changed their accounting and reporting practices somewhat in response to the new rule. SEPTEMBER :9 Health Affairs 1551