The pricing of health insurance or insurance in general is better understood if broken down into several components of an insurers business model, how the carriers look at us in terms of profit or loss. This article is mainly for educational purposes but it can be served also as a way for us as consumers to predict pricing accurately.
Factors Affecting the Premium
The premium rates for a particular benefit depend on:
(2) provider payment arrangements,
(5) interest, and
(6) profit and contingency margins.
Morbidity: In dealing with mortality rates for life insurance the only element considered is the number of expected deaths during a year compared with the total number of persons exposed in the class. In contrast, in the measurement of morbidity, the annual claim cost for a given age-sex-occupational class is the product of (a) the annual frequency of a particular event (b) the average claim when such an event occurs. For example, the annual frequency of hospitalization for a given age and sex might be 10 percent, the average duration of hospital stay might be four to five days, and therefore, the annual claim cost for a $500 daily hospital benefit would be $250 (0.1 x 5 x $500).
In health insurance, although mortality is a consideration, the primary consideration is the morbidity cost. Annual claim cost may vary, depending upon the kind and amount of benefits, according to such factors as age, sex, occupational class, and geographical area. Inasmuch as most policies contain more than one benefit, it is necessary to obtain separate annual claim cost for each type of benefit. Most morbidity tables used to calculate net annual claim cost of disability income benefits exclude the experience during the calendar year that a policy is issued. Attempts to identify the influence of underwriting on experience by policy year have not been very successful in contrast to the success of the practice for life insurance. The pattern of select experience under disability insurance is quite different fro that for mortality under individual life policies.
It is even more important to note that there is apparently substantial adverse selection by those applying for disability income policies who's elimination periods are short and maximum durations are long. Studies show that at ages 50 to 65 there is a substantial increase in morbidity by policy duration that continues until the coverage terminates. Applicants who become insured in their twenties and thirties develop a higher level of morbidity after age 50 than those applicants who become insured after age 50. Furthermore, the experience is varies considerably, depending on the type of benefit under consideration. The experience is further complicated in the case of medical expense insurance by the continuing inflation in the cost of medical services, and in the case of disability insurance, by levels of employment and personal income. Obviously, consideration should be given to the relationship of select to ultimate experience in establishing gross premiums, so that the premiums for insurance issued at advanced ages properly reflect the savings from selection,
Provider Payment Arrangements: Premium rates for HMOs and other medical care organizations are affected by the degree to which providers participate in the cost. Having providers participate in benefit plan cost is intended both to reduce the cost of plan benefits through rate concessions and to provide incentives for the providers to control utilization, particularly in the areas of referrals to expensive specialist and in hospital admissions. Under traditional indemnity insurance products, providers are paid on a fee-for-service (FFS) basis. Managed care plans have typically negotiated fee arrangements with hospitals, physicians, pharmacies, and other providers.
Provider cost sharing can take on many forms, each of which have their 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 return for a set amount per month per plan enrollee. This arrangement represents the very end of the spectrum in risk sharing in that virtually all risk is passed along to the provider. The only risk remaining with the insurer is the solvency of the providers and their ability to deliver services. The fundamental purpose of these arrangements is to increase the provider's awareness of cost and utilization. Such mechanisms must be constructed to be beneficial for both the providers and the insurer. Otherwise, the contractual arrangement will eventually dismantle the entire program.
Expenses: to obtain suitable expense rates for determination of premium rates, it is necessary to make detailed cost studies in which the various expense items may be expressed as (a) a percentage of the premium including premium taxes and agents commissions (b) an amount per policy including cost of underwriting and issuing a policy, and (c) an amount per paid claim such as the cost of investigating and verifying a claim. Because of the nonlevel commission rates, the per-premium types of expenses usually are larger in the first policy year, decrease during the next few policy years, and then are level for the remaining policy duration. The per policy types of expenses are much larger in the first policy year, reflecting the cost of underwriting and issuing the policy. The per-policy type of expense after the first policy year is relatively constant, except for the impact resulting from inflation.
Persistency: The persistency rate for a group of policies is defined as the ratio of the number of policies that continue coverage on a premium-due date to the number of policies that were in force as of the preceding due-date. Thus, if out of 100 policies, 75 policies are in force on the fist policy anniversary, the first-year annual persistency rate is 75 percent. The persistency rate usually improves with policy duration, and for some types of coverage the annual persistency rate will be 95 percent or higher after the fifth policy year. Naturally, other factors affect persistency rates. In general, persistency rates usually are higher at the older issue ages and better for the less hazardous occupations. Persistency usually is better in connection with major medical expense and disability income coverage than on basic hospital expense coverage. Persistency is important in health insurance rating for two reasons. First, expenses are higher during the first year than in subsequent years because of the typically higher first year commission rate. Also, claim rates under health insurance tend to increase as the age of the insured increases. In view of these factors, which vary by age at issue and policy duration, the premium-rate level will depend on the rate of lapse.
Interest: When a level premium is used, the insurer will have, after the first few policy years, an accumulation of funds arising from the excess of premium income over the amounts paid for claims and expenses. As in level premium life insurance, the funds accumulated during the early policy years will be needed in the later policy years, when the premium income is not sufficient to pay claims and expenses. In computing premium rates, therefore it is necessary to assume a suitable interest rate to reflect the investment earnings on these accumulations. Interest rates are of less significance in the calculation of medical expense premiums than in calculating life insurance premiums. The ratio of claims to premiums under health insurance during the early policy years is substantially greater than under level premium life insurance. Accordingly, more of the premium is used for claim payments soon after it is received by the insurance company, and it is, therefore not available for investment, as is the case of level premium life insurance. It is important to consider interest in measuring the average claim cost under long term disability income and long term care coverage. The value of the disability annuity can be significantly reduced because of the interest discount.
Profit and Contingency Margins: As with life insurance premium rates, it is necessary to introduce a margin for contingencies and profit into the premium-rate calculation. One method of doing so is to calculate a premium on the basis of most probable assumptions and then increase the premium by a percentage to provide some margin for contingencies and profit. Another method is to introduce conservative morbidity, expense, persistency, and interest assumptions and determine a premium on that basis. Still another would be to develop a gross premium that is consistent with a specific minimum required internal rate of return.