The relationship between health care premiums and costs in the U.S. is not convoluted — it is direct and linear.
Premium levels for fire insurance would be extremely high if people could wait until their houses were on fire before buying their insurance.
Premium levels for automobile insurance would be extremely high if people could wait until they had an accident before purchasing their car insurance.
Premium levels for life insurance would be extremely high if people could wait to buy their life insurance policies until after the insured person was dead.
Fire insurance works as a business. It exists, survives, and even thrives as an economic system because people whose houses are not currently on fire buy the insurance and pay their premiums on a regular basis. The premium revenue from people whose houses do not burn gets used by the insurance company to pay claims from the houses that actually do burn.
Life insurance also needs to have premiums paid by living people in order to pay claims for the people who die.
For any insurance product, the key to financial success and survival is to have enough customers paying the premiums, so the insurance company has enough money in the bank to pay claim expenses for the insured people when the insured people need those payments to be made.
We need to apply those principles to the health insurance policy debates and decisions in this country.
As we look at health insurance laws for the country, we need lawmakers to understand the basic cash flow concept that in order for health insurance to operate, succeed, and survive as a business, we need some people who buy insurance who spend less than their premium payments on their personal care costs.
The same principle and process that allows life insurance companies and fire insurance companies to survive needs to be in place for our health insurance coverage for the people who enroll in health insurance through the health care exchanges that have been created by the government to sell coverage in all states.
Health insurance companies need people paying their premiums who are using less care than the cost of their premium, so the additional revenue from those customers can be used by each insurer to pay for the care that is needed by those who have significant levels of care expense.
People too often think of health insurance as being somehow independent of the issues of relative risk and expense levels. Some people believe that insurers have some magical fund or source of money that they can use to pay their claims — and that the money to pay the claims will exist independently of the cash flow created by people paying for their insurance. That clearly is not true. Health insurance — like fire insurance and automobile insurance — can only function if there are enough people paying premiums to allow the insurance company to have enough money to pay the claims for the people who need care.
Far too many people do not understand that reality or have any sense of how health care premiums are actually calculated. We need to understand the premium setting process in order to understand what the basic ingredients are that will allow a private marketplace for health insurance to survive and function in this country.
Some people think of health care premium setting as a mysterious and free standing process involving some kinds of vague but powerful market forces, and involving various kinds of explicit and independent judgments about various competition related economic factors and some array of market force related issues by the people who set the premium levels for insurance companies.
That is an inaccurate assumption.
Premium calculations for health insurance are not, in fact, at all mysterious or competition-linked market based. Creating premium levels for health insurance is a very basic and direct process. It is entirely anchored in the actual cost of care for any insured group of people. Care costs create premium costs. .
The reality could not be simpler. Health care costs for each set of insured people create the insurance premium levels for that set of people.
Average costs create premiums. Premium levels in health insurance are actually and functionally the simple average cost to provide health care for any insured group.
People are sometimes confused about that process because other insurance products have more complicated pricing mechanisms and approaches.
Life insurance, for example, incorporates complicated actuarial tables into their rate setting that attempt to evaluate and predict the probability of any given person dying in any given year. The business model for life insurance stretches out for decades much of the time.
Life insurance actuaries tend to build complex formulas, which calculate issues like the probability of a person dying while insured, and they tie those calculations to other projections about the investment returns that are likely to be earned from the premium revenue held by the insurance company.
Health insurance does not use any of those kinds of actuarial tables or multi-year time frames. It does not need or use those formulas or approaches because the care costs that create health care premiums are immediate. The risk exposures for health insurance are annual, and they create no long-term financial exposures for the insurance company.
Health insurance companies simply total the costs of providing care for any insured group, and they mathematically divide those costs by the total members of the insured group of people to create the group’s premium need. Premiums, for every insured group of people, simply represent the average cost of care use by the group.
Insurance companies understand people use significantly more care, on average, as they age, so the insurance premium calculation formula generally assumes an increase in the number of procedures and care costs that will be incurred each year as people become older.
Payments for care create the total cost of care for each group — and payment levels, therefore, very directly create the premiums calculated and used for health insurance. If care costs for any insured group of people change, premium changes. The relationship is direct and linear.
If drug companies increase the cost of a drug, for example, the insurance companies pay the higher price for that drug. That higher payment by the insurer for that drug directly increases the average cost of care for that set of insured people.
Premiums for that group then increase to reflect the expense created by the higher drug price. Every dollar in new drug expenses paid by the insurer is added to the premium level for that group so the insurer will have enough money to pay for that drug in the future.
Likewise, every medical fee and price increase — and every hospital bill price increase paid by the insurer raises the premium and the increase in premium directly matches the fee or bill increase from the providers of care. Those higher fees get passed on to the consumer through higher premiums because they increase the average cost of care for the insured group.
Other health care cost increases directly affect premiums as well. If a new care benefit is mandated by a public agency or by a state legislature for an insurer, then the cost of that mandated benefit directly increases the average cost of care for the insured group, and their premium is increased to match the additional mandated expense.
Each benefit increase that adds to the cost of care — whether it is mandated by some source or voluntarily chosen by the insured person — simply and directly increases the premium charged by that amount.
Benefit increases add to premiums. Using the same mathematical process, benefit reductions that are implemented for any insured group of people bring premiums down. Both benefit increases and benefit reductions have a direct and immediate impact on premiums, and people who are both selling insurance and buying insurance look at benefit levels as a way of changing the premium levels for any group of people.
Insurers often try to keep premium levels down, because they can face real difficulties if their premium levels rise to levels that create adverse reactions by the people they insure.
Insurers know they are more likely to sell insurance and more likely to keep their customers if they can keep their premium levels down, so many insurance companies do a number of very intentional things to reduce the average cost of care for their insured customers.
Healthy people tend to have lower costs of care. Insurers often try to enroll as many healthy people as they can to keep premium needs down. They try to enroll healthy people because healthy people have fewer health care expenses and having fewer expenses for the members of any insured group can directly reduce the average cost of care for their group.
It used to be legal for health insurance companies to perform health screens against people wanting to buy individual insurance. That health screening approach allowed the insurance company to identify and reject people with higher health care needs that they believed would increase the average costs of care for their insured group.
That screening process created obvious problems for many people with personal health conditions because the people with current or pre existing conditions were often rejected from buying health insurance — but that process also created lower premiums for those people who were healthy enough to buy insurance, because keeping less healthy people from buying insurance kept the average cost of care down for the people who actually do purchase the insurance.
Insurance companies have several reasons why many insurers prefer lower premiums. Many health insurers actually fear high premium levels because, in a voluntary insurance market situation, insurers know that when they increase premium levels, their customers will see the premium increase, and then each affected customer will make personal decisions about whether or not to continue to purchase coverage at the higher price.
People have an understandable tendency to make insurance related decisions in their own financial best interest. When premium levels go up for any voluntary insurance customer, the insured people tend to use their own individual health status as a gauge to determine whether to continue their coverage.
Decision patterns in those situations are fairly understandable and highly predictable. .
People with a serious heart condition or terminal cancer will almost always continue to buy their health care insurance — even when their personal premium prices increase significantly.
On the other hand — people who are in good health with very few current care expenses often make the decision to stop buying health insurance when their own premiums increase significantly.
That is an important set of decisions for both individuals and insurance companies, because the premium actually is based on the average cost of care for the actual people who make up any given insured group and those decisions about cancelling coverage change the average cost of care for the group.
If the healthy people in a given group stop buying their health insurance that pattern of decisions can create what insurance companies call an “actuarial death spiral.”
All insurers fear the actuarial death spiral. The financial realities that cause those death spirals to be feared are not hard to understand. Fire insurance companies would go broke quickly if their only customers were burning houses.
Health care has its own cost related version of those burning houses.
Care costs are never distributed evenly. When you look at the cost distribution levels for health insurance, there tend to be a few very expensive members in any given group. For many insured groups, for example, it is a typical experience to have about five percent of the insured people who, in total, incur about half of the total costs for the group.
Likewise — in a high percentage of groups, nearly 10 percent of the members tend to incur more than 60 percent of the costs. That 10 percent of the insured people obviously spend a lot more money on care than they pay in premiums. Insurance companies tend to focus attention on those most expensive patients — and a growing number of insurers are building various programs to make care both better and less expensive for those high cost patients.
Some of the best insurers try to implement programs to anticipate who might become high costs and to help those people maintain better health. Some insurers are putting programs in place to reduce the likelihood of given patients having their health deteriorate to the point where they will join the most expense 10 percent of the patients.
All of those programs have value and help bring down the average cost of care for a group of insured people — but the truth is that the most expensive 10 percent of the patients are not the ones who create the actuarial death spiral.
The people who create the actuarial death spirals in almost all settings are actually the people who do not use any care at all.
The most important number for an insurance company and for the people who make health care policy about the health care exchange functionality for America to understand relative to actuarial death spirals is the fact that roughly half of the people in any given insured group incurs zero care expenses in any given year. Zero is a very important number when you are computing average numbers.
Having a zero care expense for about half of the people in a typical insured group is key to the mathematics that create the average cost of care for that group.
People with zero expenses in an insured population all pay full premium — so their premium revenue and dollars paid in by them are included in the total available money that can be used to purchase care for the group — but those people use no insured care dollars, themselves. The average cost of care for the entire group is much lower when those people are in the group, because the people who use no care and who make no claims in a year are all included in the cost averages for the total insured group.
If the healthy, low-expense subset populations in any insured group ever decide to stop their coverage and leave the group because they believe their personal premium increases are too high, then the insurer’s average cost of care for the remaining insured population changes significantly — and the new higher premium that was just calculated for the group is immediately inadequate because that new premium does not reflect the new actual average cost of care for the remaining people in the group.
When low-expense customers leave any group, and when their zero expenses are no longer part of the average cost of care — the full care expenses from the rest of the people who kept their coverage are still within the group. But we now must divide the same total expense for the entire group by half as many people in order to calculate the new average cost of care for the group.
We can all do that math. It is pretty simple. The average cost of care for the remaining group actually doubles when half of the insured population who used no care dollars decide to cancel their coverage and leave the group. Premium charged to the group members who did not cancel coverage immediately and literally doubles, just for the insurance company to break even on paying the claims for the remaining people in that group.
Rate increases for health insurance coverage in those situations create multiple sets of problems. Doubled premium levels that happen for any insured group obviously have their own consequences. A cascade of events often follows. Insured people make decisions.
When premium doubles for those remaining consumers in any insured group, the people who are still in the group then each decide whether or not to continue to buy health insurance.
As stated before, the patients in the group who have terminal cancer, late stage heart disease, or other expensive health conditions will almost all continue to pay their premium and keep their insurance.
However, the healthiest people in the remaining group are less likely to keep their coverage in place. The relatively healthy people who are still in the group often make the decision to stop buying coverage at that point. When the next set of relatively healthy people who are still in the group also decide to stop buying coverage, the premium increases that reflect the average cost of the people who are still insured jump again — creating a whole new set of decisions for the people who continue to be insured by that group.
Those kinds of situations have occurred in some of the state insurance exchanges. Some of the exchanges have maintained stable enrollment with lower average costs of care — but some have experienced various levels of local actuarial death spirals. When the average cost of care for the remaining population in any insurance setting gets too high, some insurers have stopped selling health insurance in some markets entirely.
None of the risk expense realities, or the average cost issues creating premium levels disappear or melt away at state lines. Some states clearly have lower costs today than others, and there are major premium differences from state-to-state.
As Congress goes forward to achieve the next levels of health care reform with a focus on bringing down care premiums, they need to remember that the mathematics creating health care premiums are not mystical, magical, or market competition based. Insurance competition does not create rates. Health care costs create rates.
The premium calculation for health insurance in every market is just arithmetic. Premium levels are simply the average cost of care for each insured group under any market model, so any insurers who decide to sell their insurance in new markets will end up having their premium levels reflecting the costs of care in those new markets.
Having more competition in markets would be a good thing — and we need to understand that the competition in each setting will create premium levels for those settings that reflect the average cost of care for their insured population in those settings.
We need a market model for health care that creates the lowest possible average costs of care for insured Americans. We need to understand what the real cost drivers are for care — and we need to have the courage and insight to address those cost drivers.
Any reform proposal should be judged by the standard and the goal of care improvement and creating actual cost reductions for care.
Today — health care costs create insurance premium levels. Premiums reflect what insurers pay for care.
It is arithmetic — not economic theory or political ideology — that creates unaffordable premiums for Americans today.