U.S. Health Insurance: how the money flows

A brilliant research colleague of mine recently posted the following questions about U.S. health insurance companies:

  • How do these insurance companies work?
  • How does money move through the organization?
  • If we could follow the dollar …where does it go? Do they invest it? Cost is going up, but these companies are still making much money. How do they do that?
  • Who makes the decisions inside the organizations? What are their decision making processes?

I love this topic, and more and more about the economics of health care in this first year of Obamacare is unfolding every day. To understand how the money flows, let’s glance at a chronology of health insurance industry money.

Pricing. There are two basic types of health insurance pricing:

  • Community pricing
  • Actuarial pricing

Community pricing: economists look at a whole community to figure out what it costs to take care of that community. They then divide that total dollar amount by the number of people in the community. The resulting figure becomes the price per person for health insurance premiums.

Community pricing was the standard practice after World War II in the U.S. Back then the government left health insurance companies to run tax free; and it was a time when the average cost of insurance company administration was 5% leaving 95% of insurance premium dollars to be dispensed on health care. Back then premium prices were low – the sick and the healthy paid the same amount, but that didn’t bother anyone. Then, in the 1970s we saw an explosion of a) demographics and b) medical technology. People started living longer. Specifically, in the year 2000 as many people over the age of 100 were alive as were people over the age of 65 in 1965. The longer people live, the more likely they will need health care. But back in 1965, there were no CT scans nor super expensive medications. So booming demographics and expensive technology, along with c) laws that demand that more and more health conditions must be covered by insurance, drove health insurance premium prices sky high.

Actuarial pricing: economists look at an individual person to determine the risk of getting sick to price insurance premiums. In this case, healthy people have low premiums and sick people have higher premiums.

Obamacare is a hybrid of community and actuarial pricing. The theory is that if enough young, healthy people buy health insurance they do not use, it will offset the costs of paying for chronically sick people. We don’t know yet if this “economics of balance” will work ……

But back to actuarial pricing -> insurance companies figured out how to weed out the sick people by denying care according to pre-existing conditions. Denial of care practices evolved 1975 – 1992 as health care costs began to explode. Large scale HMOs became the popular practice by the early 1990s when Wall Street entered health care to financialize it as they did so by focusing on management practices. During this evolution, management/administrative expenses crept up from 5% to 35% of health care operating budgets. One year the head of United Healthcare was paid a salary of $1.2 billion dollars! Finally, the government intervened by passing a law that the maximum amount of health care premium dollars allowed to be spent on administration was 20%. Since then, regardless of how health care is priced, we have the 80/20 rule mandating that 80% (and in some cases 85%) of premium dollars must be spent on providing care.

Gaming the System. It was not just health insurance exectives that practiced greed & cheat during this time. Providers (hopsitals, doctors) responded to the management of health care by gaming the system: for instance, hospital administrators would tell doctors to discharge patients as soon as possible, and often before they were ready. Because the less time a patient spent in the hospital, the more profit for that hospital. And if a patient needed a CT scan during their stay, for instance, doctors were ordered to discharge the patient and re-order the test as an outpatient procedure. While doctors may have felt uncomfortable, they did what they were told because 1) they were rated by hospital administrators and 2) they figured the patient who left too early would come back, allowing the hospital to collect money for two admissions instead of one. Another popular trick for gaming the system was via hospital codes and prices: wildly inflated hospital prices, that in many places are still prevalent today.

Government regulators have been working to stop the greed, for instance via Medicare and Medicaid audits like the RAC audit  and ZPIC audit.

How Insurance Companies Make Money. There are two basic ways health insurance companies make money:

  • Premiums
  • Investments

When premium money comes into a health insurance company, it is referred to as a “loss” to set a mindset to avoid dispensing care. Health insurance companies try to minimize losses by setting up doctor panels and negotiating in-network contracts, for instance….practices that determine how much money a health insurance company pays providers for care (reimbursement). One such practice to determine health care reimbursement is called a Diagnosis Related Group (DRG). So let’s say it is determined that the cost of someone having a heart attack is $X. The health insurance company says to the hospital “We are going to pay you $X for a heart attack. Many heart attack patients who come in will experience complications that cost you more, and many other patients will experience easy recoveries that will cost you less, so it’s your job to decide how to manage the patients and practice medicine so you don’t go broke.” For this reason, doctors have been pressured to practice the cheapest medicine possible to maximize hospital profits by seeing as many patients per day as possible – a practice called fee-for-service. But Obamacare is forcing providers and insurance companies like Blue Cross  away from fee-for-service health care. And Aetna recently published information on health insurance premium rates to inform customers how they are using their money.

Again, 80% of the money within a health insurance company must be spent on care. If there is ever any money left over from that 80%, health insurance companies must give back to customers via premium rebate checks.

In terms of investments, many health insurance companies are putting their money into digital health. A recent RockHealth funding report showed 2014 digital health funding activity to date.  Whether or not these investments will be profitable is yet to be determined.

Moving Forward with Obamacare. Until Obamacare, individuals could only qualify for health insurance through employer work benefits, Medicaid (if financially qualified), or Medicare (if over the age of 65). This left millions of Americans without health insurance, creating a chaotic and uncontrollable economic landscape. Obamacare is rapidly spiking the number of people with health insurance, hypothetically balancing the economics. We don’t know yet. Like one insurance adjuster said to me “Pricing Obamacare health care plans is a bit like throwing darts: we don’t know yet how to make a profit until the many unknown accounting variables (are the newly insured paying their monthly premiums, how many are using state exchange plans vs. Medicaid, how many providers are accepting Obamacare contracts, etc.) settle in.” My guess is that at the close of 2014, once we have the chance to analyze Obamacare Year 1, insurance companies will come out to say they need to elevate premiums, while consumers and larger companies will demand more affordable health care.

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