Why is health insurance so expensive?
Pricing for health insurance or insurance in general is best understood by breaking it down into various components of an insurer’s business model, how insurers view us in terms of profit or loss. This article is primarily for educational purposes, but it can also serve as a way for us as consumers to accurately predict prices.
Factors Affecting Premium
Premium rates for a particular benefit depend on
(1) morbidity,
(2) provider payment arrangements,
(3) fees,
(4) persistence,
(5) interest, and
(6) profit margins and contingency.
Morbidity: When dealing with mortality rates for life insurance, the only element considered is the number of deaths expected during a year compared to the total number of people exposed in the class. In contrast, in measuring morbidity, the annual cost of claims for a given age-sex-occupational class is the product of (a) the annual frequency of a particular event (b) the average number of claims when that event occurs event. For example, the annual frequency of hospitalization for a given age and sex might be 10 percent, the average length of hospital stay might be four to five days, and therefore the annual cost of the claim for a daily hospital benefit of $500 would be $250 (0.1 x 5 x $500).
In health insurance, although mortality is a consideration, the primary consideration is the cost of morbidity. The annual claim cost may vary, depending on the type and amount of benefits, based on factors such as age, gender, occupational class, and geographic area. Since most policies contain more than one benefit, it is necessary to obtain a separate annual claim cost for each type of benefit. Most morbidity tables used to calculate the net annual cost of claiming disability income benefits exclude experience during the calendar year in which a policy is issued. Attempts to identify the influence of underwriting on experience per policy year have not been very successful in contrast to the success of life insurance practice. The select experience pattern under disability insurance is quite different from that for mortality under individual life policies.
It is even more important to note that there appears to be substantial adverse selection by those applying for disability income policies whose elimination periods are short and maximum durations are long. Studies show that between the ages of 50 and 65 there is a substantial increase in morbidity for the duration of the policy that continues until the coverage ends. Applicants who are insured between the ages of 20 and 30 develop a higher level of morbidity after age 50 than applicants who are insured after age 50. In addition, the experience varies considerably, depending on the type of benefit being considered. The experience is further complicated in the case of health insurance by continued inflation in the cost of medical services, and in the case of disability insurance, by levels of employment and personal income. Obviously, the relationship between selection and final experience must be taken into account when establishing gross premiums, so that premiums for insurance issued at advanced ages adequately reflect selection savings,
Provider Payment Arrangements: Premium rates for HMOs and other health care organizations are affected by the degree to which providers share in the cost. The intent for providers to participate in the cost of the benefit plan is to reduce the cost of plan benefits through fee concessions and provide incentives for providers to monitor utilization, particularly in the areas of expensive specialist referrals and in hospital admissions. In traditional indemnity insurance products, providers are paid on a fee-for-service (FFS) basis. Managed care plans generally have negotiated fee agreements with hospitals, doctors, pharmacies, and other providers.
Vendor cost sharing can take many forms, each of which has its own subtle impacts on underlying cost and behavioral incentives. An example of such an arrangement is capitation. A capitation payment is one in which the insurer subcontracts with a provider to perform a defined range of services in exchange for a fixed amount per month per plan member. This arrangement represents the end of the spectrum in risk sharing where virtually all risk is transferred to the provider. The only risk left with the insurer is the solvency of the providers and their ability to provide services. The primary purpose of these arrangements is to increase provider awareness of cost and utilization. Such mechanisms must be built to be beneficial to both the providers and the insurer. If not, the contractual agreement will eventually dismantle the entire program.
Expenses: In order to obtain appropriate expense rates for the determination of premium rates, it is necessary to carry out detailed cost studies in which the various expense items can be expressed as (a) a percentage of the premium, including taxes on premiums and agent commissions (b) an amount per policy, including the cost of underwriting and issuing a policy, and (c) an amount per claim paid, such as the cost of investigating and verifying a claim. Due to non-leveled commission rates, premium expense rates are generally highest in the first policy year, decrease over subsequent policy years, and then level out for the remainder of the policy term. The types of expenses per policy are much higher in the first year of the policy, reflecting the cost of underwriting and issuing the policy. The rate of expense per policy after the first policy year is relatively constant, except for the resulting impact of inflation.
Persistence: The persistence rate for a group of policies is defined as the ratio of the number of policies that continue coverage on a premium expiration date to the number of policies that were in force on the prior expiration date. Thus, if out of 100 policies, 75 policies are in force on the policy’s first anniversary, the first-year annual persistence rate is 75 percent. The persistence rate generally improves with the life of the policy, and for some types of coverage, the annual persistence rate will be 95 percent or more after the fifth policy year. Naturally, other factors affect persistence rates. In general, persistence rates tend to be higher at older ages and better for less hazardous occupations. Generally, persistence is better for coverage of major medical expenses and disability income than for coverage of basic hospital expenses. Persistence is important in rating health insurance for two reasons. First, expenses are higher in the first year than in subsequent years due to the typically higher first-year commission rate. In addition, health insurance claim rates tend to increase as the age of the insured increases. In view of these factors, which vary according to the issue age and the duration of the policy, the level of the premium rate will depend on the lapse rate.
Interest: When a level premium is used, the insurer will have, after the first few years of the policy, an accumulation of funds from the excess of premium income over the amounts paid for claims and expenses. As with premium level life insurance, funds accumulated during the early policy years will be needed in later policy years when premium income is not sufficient to pay claims and expenses. In calculating premium rates, therefore, it is necessary to assume an appropriate interest rate to reflect investment earnings on these accumulations. Interest rates are less important in calculating premiums for medical expenses than they are in calculating life insurance premiums. The ratio of claims to premiums in health insurance during the first few years of the policy is substantially higher than in premium level life insurance. Consequently, more of the premium is used for claim payments soon after it is received by the insurance company and is therefore not available for investment, as is the case with premium level life insurance. It is important to note the interest in measuring the average cost of claims based on long-term disability income and long-term care coverage. The value of the disability annuity can be significantly reduced due to interest discounting.
Profit and Contingency Margins: As with life insurance premium rates, a margin for contingencies and profits needs to be entered into the premium rate calculation. One method of doing this is to calculate a premium based on the most likely assumptions and then increase the premium by a percentage to provide some margin for contingencies and gains. Another method is to introduce conservative assumptions of morbidity, expense, persistence, and interest and determine a premium on that basis. Yet another would be to develop a gross premium that is consistent with a specified minimum required internal rate of return.
If you would like more details on the process involved in premium pricing or would like to receive a hassle-free quote, please feel free to visit our website at http://www.health-insurance-buyer.com for more information. .