February 26, 2013 1 Comment
There has been a lot of discussion lately about the premium rating restrictions in the ACA. I want to put some of this discussion in the context of the full set of regulations in the ACA because I feel that most of the discussion focuses on one particular rule and neglects to recognize that the rule interacts with other new policies in ways that could change the conclusions people are making about the potential effects of that policy. First, I’ll give some quick background for anyone who just wants to understand what the new laws about premium setting mean. Then, I’ll try to give a picture of how the rate setting policy interacts with other policies such as risk adjustment which will also go into effect around the country next January.
Currently in most states insurers selling plans on the individual market (i.e. not employer-provided insurance) can charge different people different premiums for the same coverage. They vary these premiums based on expected cost. I’ll give two examples. First, let’s say there’s a pair of twin sisters, both age 35. One of the sisters has asthma, while the other is perfectly healthy. If both sisters attempt to purchase a plan from Blue Cross, Blue Cross is currently able to charge the sisters different premiums for the same plan, and they often do (sometimes they outright reject the sister with asthma). Second, let’s say there are two healthy brothers who were born 20 years apart. Tim is 35 and Tom is 55. Neither brother has any chronic conditions. Again, let’s say both brothers attempt to purchase the same plan from Blue Cross. Again, Blue Cross is able to (and does) charge different premiums for the two brothers based on the expected costs of a healthy 35 year old vs. the expected costs of a healthy 55 year old.
The ACA changes the rules regarding premium setting in the individual market. Charging different premiums based on health (example 1) will be prohibited starting next January. Insurers will also be prohibited from rejecting anyone who wants to purchase coverage. Therefore, our twin sisters will be charged the same premium for the same coverage. The premium paid by the sister with Asthma will likely go down and the premium paid by the healthy sister will likely go up. Charging premiums based on age, however, will still be allowed, though limited to a ratio of 3:1. This means that, as long as the ratio of Tom’s premium to Tim’s premium is less than 3:1, the insurer can continue to charge them the same premiums it was charging before.
Much of the discussion is about the new 3:1 age rate band. Insurers are warning that young people will experience “rate shock” when the law goes into effect because the insurers will have to raise their premiums on the young by a lot to comply with the 3:1 rate band. This is probably true. If we assume perfect competition, premiums are equal to average cost. According to calculations I’ve done using the Medical Expenditure Panel Survey (MEPS) the average health care costs for a 64 year old likely to be purchasing a policy on one of the new state health insurance exchanges are about 9 times the costs of a 21 year old. According to this metric, rate shock will be rather extreme for the young. Insurers argue that due to this rate band policy, the young will not purchase insurance and instead pay the penalty for being uninsured. This will induce adverse selection and cause major problems for the exchanges.
I don’t argue that this “rate shock” won’t occur. It probably will, though not to the extent the insurers claim it will because of several factors, mainly that the old and the young are likely to purchase different policies. The young will purchase bronze and silver plans and the old will purchase gold and platinum plans. If only healthy old people buy the lower coverage plans, the age rate bands are unlikely to bind, and the young will still pay similar premiums. However, if this age-based segmentation occurs, adverse selection into the comprehensive plans is likely to be extreme, causing large welfare losses.
This brings me to the real purpose of this post. There is another very important policy in the ACA that deals with this adverse selection problem: Risk adjustment. To give a simplified explanation, risk adjustment is a policy where an insurer sets its own premiums, but a regulator (the exchange) collects those premiums and pools all of the premiums for all of the plans in the exchange into one giant pot. The regulator then reallocates the premiums based on the premium the plan set and on the expected cost of individuals in the plan. The expected cost calculation is based on age, gender, and past health insurance claims. For example, it would predict that a 55 year old male with diabetes would cost much more than a 55 year old male without diabetes. It would also predict that a healthy 55 year old female would cost much more than a healthy 35 year old female. This policy attempts to remove the incentives for plans to select cheap enrollees. It makes all individuals equally attractive to plans (at least based on health status) so that the plans don’t attempt to induce selection using costly methods or by inefficiently rationing services that high-risk individuals demand, such as access to diabetes or mental health specialists (note that if it is efficient to ration access to diabetes specialists, then risk adjustment does not provide additional incentives for plans to inefficiently provide access; if implemented correctly, it just gets plans closer to the efficient allocation of services; see Frank, Glazer, and McGuire 2000, Glazer and McGuire 2000, and Glazer and McGuire 2002). It also causes risk pooling between plans to limit the effects of the age-based segmentation discussed above.
Herein lies the issue with the insurers’ complaints about the age-based rate band policy. My point is a technical one, but an important one. Rate shock is a big worry, but not because of the age-based premium rating restrictions; rather, rate shock is a worry because of risk adjustment. The risk adjustment models that will be used by HHS to predict cost include age as a predictor of cost. Therefore, the risk adjusting of premiums described above will make a 35 year old and a 55 year old look pretty similar in terms of cost. In a competitive environment, this would mean that a plan would charge them the same premium. In simulations using MEPS data and the CMS-HCC risk adjustment model, McGuire et al. (2012) show that assuming perfect competition, after implementing even partial risk adjustment, the 3:1 rate band is not binding. In other words, plans would charge a 55 year old and a 25 year old premiums that vary by less than 3:1. In simulations I’ve done for another project, if premiums are fully risk adjusted, the premiums plans charge are virtually identical. This means that the premiums charged to the young will spike, but not because of the rate bands. Rather, they’ll spike because of risk adjustment.
All of the policy discussion going on is about the effects of the rate bands and how they will cause extreme adverse selection on the exchanges. Unfortunately, nobody is discussing the real driver of this rate shock and selection: risk adjustment. This is probably because the purpose of risk adjustment is to limit selection, not to expand it. Unfortunately, that only works if mandates work. Since the ACA’s mandate may not be large enough to get the young to buy insurance, it could instead cause more selection due to premium compression. There is a fix to this, though a complex one: Take into account the tradeoff between the gains from risk adjustment (due to improved selection incentives to health plans) and the losses from the premium compression it causes (due to the young dropping out and driving up the costs for those remaining in the exchange; i.e. adverse selection) and use partial risk adjustment instead of full. The optimal amount of risk adjustment that should be used will depend on the demand curves of the young, and it is likely to be far less than 100%. Again, unfortunately nobody is talking about this. Instead, the focus is on rate bands that are unlikely to bind after risk adjustment.
All of this has assumed perfect competition between health plans. In my next post, I’ll talk about what happens when we introduce imperfect competition (which is probably more realistic) and provide an argument for why the insurers may really be arguing for the elimination of the rate bands. Hint: it’s not because of rate shock on the young.
McGuire, Thomas et al. 2012. Integrating Risk Adjustment and Enrollee Premiums in Health Plan Payment
Glazer, Jacob and Thomas McGuire. 2000. Optimal Risk Adjustment. American Economic Review
Frank, Richard, Jacob Glazer, and Thomas McGuire. 2000. Measuring Adverse Selection in Managed Care. Journal of Health Economics
Glazer, Jacob and Thomas McGuire. 2002. Setting Plan Premiums to Ensure Efficient Quality in Health Care: Minimum Variance Optimal Risk Adjustment. Journal of Public Economics