Back to Basics

We will be publishing a series of “Back to Basics” articles to give Members of Congress and others a grounding in some of the principles of health care financing.


By Greg Scandlen

When people discuss “the uninsured” they are not usually speaking of insurance at all, they are talking about third-party payment of health care services. Insurance is a contract between two persons. The contract says that one person will pay a premium so that the other person will pay a benefit when an unfortunate event occurs. This is how life insurance, homeowners insurance, auto insurance and almost all other forms of insurance operate.

So-called “health insurance” has come to be a very different breed of animal. Most health insurance is based on a three-party arrangement in which a person pays a premium to an insurance company, which pays a physician or a hospital to provide a service to the consumer. It is a triangular relationship that causes great confusion and administrative costs, and results in little accountability between the three parties. It also results in excessive utilization as patients are insulated even from knowing the price of the services they consume. Once the premium has been paid, the services are all free or nearly so. There is no economic constraint whatsoever on consumption of services. The only constraint is imposed by the payer through some form of rationing, which is very expensive to enforce and very intrusive on the relationship between patient and provider.

Our near-exclusive reliance on third-party payment to finance health care services has resulted in our health care system being in a state of perpetual crisis as we lurch between panic about cost increases one year, poor quality the next, and inadequate access after that.

The only way to achieve an optimal balance between the competing demands of cost, quality and access is through consumer choice and decision-making about how to spend resources. Expanding our current system of third-party payment will only compound a problem that has proven to be unsolvable in the past.


Prepayment of health care services (prepaid health care) is also fundamentally different than insurance (pooling risk.) It is a distinction that too often escapes policymakers and too often leads to misguided policies such as community rating, mandated benefits, and other forms of social welfare in the guise of insurance coverage. In discussing risk pools, policymakers tend to put the emphasis on “pool” and not on “risk.” In this view, a health insurance company is a big pool of unrestricted money from which people withdraw funds to pay for the services they need. This thinking leads to a “tragedy of the commons” phenomenon where people try to pull as much as possible out of the pool before it runs dry. It is small wonder that health care costs are out of control.

The emphasis in the expression “risk pooling” should be on “risk,” not on “pool.” The thing that is being pooled is risk. A risk is an uncertainty. If we voluntarily pool our uncertainties, some of us will incur a “loss” (the risk of bad outcomes will be realized), but most of us will not. The risk pool provides all its members with protection against a catastrophe, but we are happier if we never have to collect a benefit.

There is no big unallocated pool of money in this arrangement because every dollar held by the insurance company is already contractually obligated. Because insurance is a two-party contract, the premiums are paid to secure a specific benefit. The insurance company is required to hold enough money in reserve to pay all the benefits it is contractually obligated to pay. Because a risk is an uncertainty, the company does not know who will get the money or when it will be released, but it knows from experience that a certain number of customers will have losses, and it is obligated to pay the contracted amount when the loss occurs.

Prepaid health care is something else entirely. It is not “insurance” because there is no “risk” involved. We may know for example that we are likely to consume $6,000 in care over the next five years, so we pay 60 monthly premiums of $100 because it is more convenient to spread out the cost in equal increments. There is an element of cost sharing involved because a few people may consume only $4,000 while a few others consume $8,000, but at its core the principle is the same – it is a way of financing known consumption.

In that sense, there is no particular advantage to “pre-paying” for health care services over “post-paying” for the same service. That is, as in our example of normal child birth expenses cited above, one can pay in advance $100 a month for five years to get a benefit of $6,000 when the baby is born, or one could have the baby, incur $6,000 in expenses and pay it back at $100/month for five years. Providers prefer pre-payment because it saves them the trouble of having to collect a debt, but there is no fundamental difference in the economics of the transaction.

Yet in counting the uninsured, someone with a pre-paid program is considered insured while someone with a post-payment program is not, even though in both cases the patient has to make 60 equal payments of $100 to cover the $6,000 expense.

One more thing on risk pools – Many people assume that if we are pooling risk, the bigger the pool the better. But, in fact, all of the benefits of risk pooling are achieved with a relatively small number of people. The optimal size of a risk pool is frequently debated among actuaries and depends on a host of factors, (See, for instance, this study of Sonoma County’s Medicaid program) but most of the beneficial effects of pooling can be achieved with as few as 25,000 covered lives. It is simply not the case that bigger pools are better.

People also often argue that one of the advantages of employer-based coverage is “risk pooling,” but a 50-person print shop is far too small for pooling risk. For that matter, so is a 500 person manufacturing company. The employees of these companies are also likely to be similar in age, geographic location, exposure to hazards and infections, income and education. Rather than spreading risk, the employer actually concentrates it. The employer may be more efficient from a marketing perspective, but not from a risk perspective.

In fact, pooling risk is the whole purpose of an insurance company. The insurer may cover hundreds of thousands of people, from many different walks of life and geographic areas.


MLRs: The Seductive Myth of ObamaCare

By Ross Schriftman

Would you invest your money in a company whose managers spend most of their time focused on how to reduce 15% of their spending?  Wouldn’t you find it weird if they conducted lots of meetings about how to cut back on the number of desk staplers they purchased rather than figuring out how to keep their overall prices competitive and improving their customer service so they could sell more of their products or services?

Unfortunately the new health care “reform” law in Washington is forcing health insurance companies to do just that.  Within the massive act referred to as ObamaCare there is a whole section dealing with Medical Loss Ratios. (Also referred to as Minimum Loss Ratios).  Insurance companies are going to be required to spend no more than an arbitrary 15% of your premium dollars on “administrative” costs in the large group market and no more than 20% in the small group and individual markets.  If they do spend more they will be required to refund customers.

For years I have heard advocates supporting more government regulation of health insurance promote this concept.  They honestly believe that if the government could simply get insurance companies to spend less on running their companies the savings would pay for all kinds of new benefits and give everyone lower premiums.  This is a simplistic answer to a complex problem but the idea is very seductive. They really believe that the government can make a private industry more efficient by piling on even more regulations. In reality they will be lucky to reduce costs by more than one or two percent.  In reality this absurd provision will have many unintended consequences which will drive up dissatisfaction among the public for Obamacare.

By the way, last year most health insurance companies were already in the minimum loss range talked about.  The industry made a whopping $3 billion in profit last quarter which actually breaks down to less than 3% of premiums collected.  The drug companies enjoyed a 7% profit last year.
So where will they find the savings for our health insurance premium dollars?

What is included in the administrative side of the equation?  The new regulations list includes paying claims, collecting premiums, fraud management, some taxes and paying employees as administrative costs.  They also include paying out commissions to insurance agents including independent agents, who must pay all of their own expenses themselves.  It also includes compliance costs such as making sure every word in plan materials are in compliance and the printing and distribution of dozens of required documents to consumers.  Finally, the insurance companies are required to set up an administrative process to send out refunds if they spend too much on administration which this provision in itself adds to their costs.

With these added costs how will insurance companies comply?  Where do they have wiggle-room?  The answer is customer service.  Already health insurance companies are laying off employees leaving those who still have a job with even more work to do.  Call center wait times for customers will increase dramatically.  Insurance companies are now sending letters to the insurance agents they partner with telling them that their compensation for selling and servicing their health insurance will be cut by as much as 40%.  Many agents are considering selling other lines of insurance that will allow them to remain in business.  Many small businesses and individuals rely on their personal insurance agent to help them navigate all the new rules of ObamaCare.  Health insurance agents help keep insurance companies rates competitive by shopping coverage for their clients every year.  With fewer agents to help them many small business will now be forced to hire benefit managers at the very time when they are struggling to meet payroll and keep their own workers.  The “reform” law has forced these business owners to spend countless hours trying to figure out if they are in compliance with the new law.  Medical Loss Ratios will cut off many of them from the help they need by no longer having their own agent to help them.

The whole idea of medical loss ratios was to keep premiums down.  Instead, in order to comply some insurance companies are raising their premiums so that they can match their 15% or 20% share with the added reporting and other requirements demanded by our government officials.  In addition, health plans that do a poor job of wellness and end up with a sicker group of customers will be rewarded by not having to give refunds while those who help their customers stay healthy will be penalized with more administrative costs.

The Medical Loss Ratio provision is just another example of our government gone wild.  Rather than having this bizarre rule and requiring refunds the next Congress should throw out Obamacare and instead focus on wellness, health education and streamlining the regulations on the health insurance industry.  The elimination of medical loss ratios will actually lower administrative costs, improve innovation and may result in lower rate increases going forward.  I believe my clients would rather see better rates at renewal time than getting some kind of refund after it has gone through a nightmarish administrative process overseen by government bureaucrats that ends up costing them money.