Unintended Consequences and the Future of Health Insurance

With the most recent mega-merger of Cigna and Express Scripts, it’s worthwhile to take a look at the basic business model of health plans to understand what motivates their M&A. The best place to start this investigation is with a facet of regulation that has thus far negatively effected the healthcare consumer, but ultimately could prove to be a big winner: the Medical Loss Ratio standards. 

The Medical Loss Ratio (MLR) standard limits the amount of profit a health plan can reap from regular course insurance business. The health insurance business model is fairly straightforward: revenue comes in the form of monthly insurance premiums. Plans then pay out a portion of those premiums to providers for services rendered to policyholders. They also use revenue from premiums to cover the administrative expenses like salaries, offices, and other regular business items. Remaining funds, after providers have been paid and administrative costs have been tended to, is profit. 

MLR regulations dictate that health plans must spend a given percentage (typically 80-85%) of collected premium payments directly on paying the health costs of their policyholders, and not on administrative costs or profits. Should a health plan have a good year with healthy policyholders and spend less than the MLR threshold on policyholder care, they must rebate the difference back to policyholders. In practical effect, this means health plans will always spend at least 85% of revenue on caring for policyholders. 

Now put yourself in the shoes of a health plan CEO. Your main operational goal is to steadily increase earnings per share, the same as for any public company chief. Because the MLR puts a floor on your care expenditure at 85% of revenue, you aren’t actually incentivized to decrease the cost of the provision of healthcare. If you negotiate really strong contracts with providers to drop the cost of care by 20%, you still pay out the same 85% of premium income with a larger share going to policyholder rebates. You could use these savings to lower premiums to match the MLR, but then the real dollars available for administrative cost and profits diminishes, which means you need to cut salaries, layoff employees, and take a beating from Wall Street as your profits drop. 

In fact, the easiest way for you, the health plan CEO, to steadily grow profits is by increasing premiums. As you increase the size of the entire pie, the size of each piece gets bigger. An increase in overall premium revenue means that the 15% of revenues available for administration and profits increases in real dollar value. If this means you’re now only spending 80% of premium revenue on policyholder care, you simply rebate the difference back. Suddenly the increasing cost of health care provision isn’t such a worry, because it’s a justification to increase premiums which in turn increase profitability. Increasing profitability means you get to keep your job, and probably get a nice bonus as well. 

If health plans operated in a truly free market, the above strategy wouldn’t be possible. A health plan CEO couldn’t simply increase premiums as other health plans would undercut increased prices. Most consumers have little choice of which health plan they patronize, due to lack of options in the individual marketplace, or because their purchasing power is filtered through their employer who may have their own preference. There is little concerted downward pressure on premiums in the insurance marketplace. 

Even still, health plans can’t simply double their prices overnight. Price increase is not a reliable source of profit growth, nor is it a convincing story for Wall Street and investors. Health plans must get creative to contend with limited profit growth due to MLR requirements, and with the changing landscape of the healthcare industry. 

Consider the recently announced Cigna acquisition of Express Scripts. Cigna, a health plan, is a customer of Express Scripts, a pharmacy benefits manager. As Express Scripts will become a subsidiary, all of the profits they generate as a PBM will flow to Cigna, including the profits derived from servicing Cigna as a customer. This isn’t just roundabout accounting for the same dollars. Cigna will still pay the same amount to Express Scripts, and it will count as the same amount towards their MLR requirement as cost of care, but some of that expenditure will now flow to Cigna as additional profit. The net result is increased profitability without raising prices or running afoul of regulation. 

Vertical integration is typically employed to cut out intermediate profits in the value chain and deliver a lower overall price, thus increasing competitive advantage. SpaceX cut out the extremely circuitous value chain of building rockets by doing much of their manufacturing in house instead of through contractors. By cutting out the profit margin of each contractor, they could lower the overall price of a rocket enough to be extremely competitive. 

As you see time and again in healthcare, the regular laws of economics don’t apply. With little price competition, the benefits of vertical integration go directly to the bottom line. As CVS and Aetna complete their merger and Aetna policyholders are encouraged to visit CVS clinics, the profits derived from those clinics will count both towards Aetna’s MLR requirement, and as realized profits on the books of the combined enterprise. This sort of vertical integration is beneficial to health plans for this reason and many others, so it is likely to continue.

The basic truth behind this vertical integration is that health plans will need to look beyond ordinary course health insurance in order to have sustained growth. And vertical integration isn’t the only path forward. 

Insurers are, in effect, aggregators. They aggregate patient demand and use it as leverage to negotiate contracts with providers. Why couldn’t they aggregate this demand in other ways as well? Perhaps there is a future where health plans are simply customer acquisition mechanisms for conglomerates, operating on a break-even basis as a means to attract and retain customers. Amazon launched their Netflix competitor, Prime Video, as a way to attract and retain customers to their Prime subscription (and it has worked very nicely for them). Perhaps Amazon will introduce a competitively priced health insurance plan that comes integrated with a Prime membership, thus ensuring all of their policyholders purchase their consumer goods from Amazon. 

A year ago that might have sounded ridiculous, but given what we’ve seen from CVS and Aetna, and even from Amazon itself, I’m not sure that sort of future is that far off. In fact, the use of health plans as a customer acquisition tool may be exactly what health plans need to save them from themselves. By de-emphasizing profit as their key operational goal and instead promoting customer satisfaction, health plans could start to realize their ideal societal role: the promotion of good health. They could also head off their oncoming demise as Americans embrace the idea of Medicare for All in larger and larger numbers.


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