Medical Loss Ratio Regulation under the Affordable Care Act

Perspective

Scott E. Harrington

Medical Loss Ratio

Regulation under the

Affordable Care Act

The minimum medical loss ratio (MLR) regulations in the Affordable Care Act

guarantee that a specific percentage of health insurance premiums is spent on medical

care and specified activities to improve health care quality. This paper analyzes the

regulations’ potential unintended consequences and incentive effects, including: higher

medical costs and premiums for some insurers; less innovation to align consumer,

provider, and health plan incentives; less consumer choice and increased market

concentration; and the risk that insurers will pay rebates if claim costs are lower than

projected when premiums are established, despite the regulations’ permitted ‘‘credibility

adjustments.’’ The paper discusses modifications and alternatives to the MLR

regulations to help achieve their stated goals with less potential for adverse effects.

The Affordable Care Act (ACA) established

minimum medical loss ratio (MLR) require-

ments of 80% for the individual and small

group health insurance markets and 85% for

the large group market. Beginning with 2011

experience and pursuant to regulations pro-

mulgated by the U.S. Department of Health

and Human Services (HHS), insurers whose

medical claims and expenditures on specified

activities to improve health care quality total

less than the required percentages of premi-

ums (less certain taxes and fees) in a given

state must rebate the shortfalls to customers.

Although industry aggregate MLRs generally

have exceeded the required percentages (U.S.

GAO 2011a; Houchens 2011), MLRs vary

significantly across insurers and markets. The

HHS announced in June 2012 that rebates for

2011 would total $1.1 billion, with 38%,17%,

and 11% of consumers receiving rebates in

the individual, small group, and large group

markets, respectively, and an average rebate

per household of $151 (above $500 in some

states, U.S. HHS 2012a).

Minimum loss ratio requirements have

long been a feature of health insurance and

property/casualty insurance regulation in

many states. About half had pre-ACA

requirements that insurers’ rate filings with

state regulators provide for a minimum MLR

for individual health insurance, and roughly

20 states had minimums for the small group

and/or large group health insurance markets

(NAIC 2009; AHIP 2010). Compared with

Scott E. Harrington, Ph.D., is the Alan B. Miller Professor in the Health Care Management Department at the

Wharton School, University of Pennsylvania. Financial support for this research was provided by the AHIP Foundation

and its Institute for Health Systems Solutions. Address correspondence to Prof. Harrington at 206 Colonial Penn

Center, 3641 Locust Walk, Philadelphia, PA 19104. Email: [email protected].edu

Inquiry 50: 9–26 (Spring 2013). ’ 2013 Excellus Health Plan, Inc.

ISSN 0046-9580 10.5034/inquiryjrnl_50.01.05

www.inquiryjournal.org 9

most traditional state-based requirements, the

ACA’s MLR requirements differ in several

key respects. First, state MLR regulations

establish a modest ex ante floor for projected

medical costs in relation to premiums when

policies are sold, rather than require ex post

premium rebates if actual MLRs fall below

the minimum after provision of coverage.

Second, state regulations generally define

the MLR as the ratio of medical costs to

premiums, without addition of expenditures

on quality improvement activities to the

numerator or deduction of any taxes or fees

from the denominator. Third, the state mini-

mums generally are lower than the ACA

thresholds, typically ranging from 60% to

75%.

The stated goals of the ACA’s minimum

MLR regime are to promote transparency,

consumer value, and greater efficiency of

health insurers. Taking those goals as given,

this paper analyzes the MLR regulations’

potential unintended consequences and in-

centive effects, and it considers alternatives

that might achieve the regulations’ goals with

less risk of adverse effects. The analysis is all

the more important given that related regu-

lations on prices and expenditures have been

imposed historically in other contexts without

a full understanding of the potential effects,

often leading to their modification or repeal.

Particular attention is paid to the increased

potential for unintended consequences from

the inherent statistical volatility of insurers’

claims experience, which cannot be addressed

precisely through ‘‘credibility adjustments’’

that are based on the volume of insurers’

business. Due to the unpredictable nature of

medical costs, the federal MLR regulations

may require that an insurer with lower than

projected claim costs pay rebates even if the

target MLR used in its pricing is equal to or

greater than the regulatory minimum, with-

out giving the insurer the ability to charge

additional amounts to consumers if claim

costs are higher than projected. While requir-

ing rebates for any reason superficially may

seem attractive to some observers and policy-

holders, insurance markets function best when

there is minimal unpredictability of insurers’

costs. The additional (and asymmetric) uncer-

tainty created by the MLR regulations’ rebate

requirements may lead to higher upfront

premiums for some insurers, and it could lead

some insurers to withdraw from certain

markets.

By capping insurers’ margins for non-claim

expenses and profits, the MLR regulations

also may discourage innovation to better

align consumer, provider, and health plan

incentives, especially when statistical uncer-

tainty makes it more difficult for insurers to

predict whether they will meet the MLR

minimums. The regulations could lead to

more consolidation and greater market con-

centration as smaller insurers with the most

difficulty meeting MLR targets and bearing

the fixed costs of compliance are acquired by

larger insurers.

The MLR regulations also create tension

between the concepts of ‘‘cost reduction’’ and

‘‘quality improvement’’ activities. At a time

when it is becoming increasingly clear that

certain health care services yield little or no

improvement in outcomes or can actually

harm health, the regulations classify some

expenses as involving ‘‘cost reduction,’’ which

must be treated as administrative expenses,

and others as expenditures on ‘‘quality

improvement activity,’’ which are counted

toward meeting the MLR minimums. That

approach risks unintended distortions in

expense decisions and innovation, raising

concern that the classifications’ long-term

effects could undermine broader efforts to

promote health system change.

Overall, the possible unintended conse-

quences and incentive effects of the complex

and evolving rules that encompass the MLR

regulations may impede the goals of enhanc-

ing the affordability of health care and

insurance and improving health care quality.

The regulations are at odds with a range of

efforts at health system change, including

those to promote choice and competition

through health insurance exchanges and

broad initiatives to improve efficiency in

health care spending. They also could com-

plicate efforts to provide consumers with

clear and credible information to assist in

choosing health care coverage that best meets

their needs.

While these conclusions may surprise some,

the goal of achieving beneficial changes in

Inquiry/Volume 50, Spring 2013

health care finance and delivery makes it

important that these concerns be understood

and carefully weighed against the potential

benefits of the regulations. More attention

should be paid to the underlying tension

between the MLR regulations and forward-

looking efforts to transform the health care

system, including careful consideration of

alternatives or modifications to the minimum

MLR approach. Increased transparency is

one possibility, particularly if it focuses on

reliable metrics that provide consumers with

information relating to ultimate value. In this

regard, supporters point to the MLR report-

ing requirements as providing consumers with

important information. But if consumers do

not understand what a specific MLR number

represents, or the number is not put in

context in relation to other considerations—

and with suitable caveats regarding statistical

variation across products or time—it may

falsely imply that one plan is of better quality

or a better choice than another.

The next section describes the federal MLR

regulations in more detail and considers their

relationship to ACA provisions and regula-

tions concerning health insurance rate review.

Arguments that the MLR regulations will

improve consumer welfare by increasing

transparency, improving insurer efficiency,

and providing better value to consumers are

then contrasted with the traditional economic

rationales for, and limitations of, price

controls and related regulation. The paper

then discusses the risk to insurers of paying

rebates due to statistical volatility beyond

that contemplated in the regulations’ credi-

bility adjustments. The regulations’ potential

unintended consequences for premiums, cost

control, coverage design, and other behavior

are then elaborated. The paper concludes by

discussing modifications and alternatives to

the MLR regulations that could help achieve

their stated goals with less potential for

adverse effects.

Overview of the Regulations

Section 2718 of the ACA, ‘‘Bringing Down

the Cost of Health Coverage,’’ requires health

insurers, beginning with their 2011 experi-

ence, to provide customers with premium

rebates if the ratio of the sum of reimburse-

ments ‘‘for clinical services’’ and expenditures

‘‘for activities that improve health care

quality’’ to the ‘‘total amount of premium

revenue (excluding Federal and State taxes

and licensing or regulatory fees)’’ falls below

85% in the large group market and 80% in the

small group and individual markets. States

are permitted to specify higher thresholds.

The HHS secretary is authorized to adjust the

individual market threshold if ‘‘the Secretary

determines that the application of the 80

percent may destabilize the individual market

in such State.’’ Pursuant to that provision,

HHS indicated that approval of state requests

for adjustments would be based on whether

exit of one or more insurers would be

reasonably likely to destabilize the individual

market. Seventeen states applied for adjust-

ments; seven were granted some adjustment.

Section 2718 charged the National Associ-

ation of Insurance Commissioners (NAIC)

with developing definitions and methodolo-

gies for implementing the minimum MLR

and rebate system. After receiving input from

health insurers, agents and brokers, medical

care providers, and consumer advocates, the

NAIC proposed regulations in October 2010

(NAIC 2010). HHS issued an Interim Final

Rule in December 2010, which adopted the

NAIC proposal and relaxed the minimum

MLR requirements for limited benefit medi-

cal plans and health plans for expatriates

(U.S. HHS 2010). After receiving comments,

HHS issued a Final Rule in December 2011

(U.S. HHS, 2011).

The MLR regulations define activities to

improve quality as those that ‘‘increase the

likelihood of desired health care outcomes in

ways that are capable of being objectively

measured and of producing verifiable results

and achievements.’’ They must be designed

primarily to: 1) improve health outcomes and

reduce disparities; 2) prevent hospital read-

missions; 3) improve safety, reduce medical

errors, and lower infection and mortality

rates; 4) implement, promote, and increase

wellness and health; and 5) enhance the use of

data to improve quality, transparency, and

outcomes and support meaningful use of

health information technology. HHS guid-

ance indicates that while ‘‘an issuer does not

Medical Loss Ratio Regulation

have to present initial evidence proving the

effectiveness of the quality improvement

activity, the issuer will have to show measur-

able results stemming from the executed

quality improvement activity.’’

Expenditures designed primarily to control

costs cannot be counted as expenditures on

quality improvement. The prohibition specif-

ically includes expenditures for: 1) retrospec-

tive and concurrent utilization review; 2)

reducing fraud, except for ‘‘detection/recov-

ery expenses up to the amount recovered that

reduces incurred claims’’; 3) developing and

administering provider contracts and net-

works; 4) provider credentialing; 5) market-

ing; and 6) calculating and administering

individual enrollee or employee incentives.

MLRs and rebates must be calculated

at the licensed entity level within a state

(‘‘entity-state’’ level). The requirements apply

to an entity’s aggregate experience for all

plans sold in the state. If a parent corporation

has more than one subsidiary licensed in a

state, each subsidiary is treated as a separate

entity— there is no aggregation of experience

across subsidiaries. As specified in the statute,

the MLR calculation for 2011 reflects data

for 2011 only. For reporting year 2012,

experience for 2012 alone will be used if the

entity’s experience is fully credible (explained

later) and combined experience for 2011 and

2012 will be used if otherwise. For 2013 and

later, the calculations will be based on

aggregate experience for the reporting year

and the prior two reporting years (i.e., three-

year averaging will be used).

Rebates are

payable to customers in proportion to their

premiums, with allocation among employers

and enrollees in group plans depending on the

terms of employer/employee contributions.

As elaborated further later, the regulations

specify ‘‘credibility adjustments’’ to MLRs

for smaller plans for which claims experience

is subject to greater statistical variation. The

term ‘‘credibility’’ refers to the statistical

reliability of an insurance pool’s loss experi-

ence. Other things being equal, a larger

number of enrollees in a pool reduces

statistical variation in the average cost per

enrollee, producing a more stable MLR. The

regulations’ credibility adjustments make it

less likely that entities with relatively small

numbers of enrollees will have to pay rebates

for years when their MLRs fall below the

minimums due to chance (without giving

them the ability to add surcharges to premi-

ums when random experience causes their

loss ratios to go higher than expected).

The MLR calculations and rebates are

based on insurers’ claims and premiums

without deducting amounts for commercial

reinsurance, whereby a portion of risk and

premiums is transferred to one or more

reinsurance companies to reduce volatility.

Beginning in 2014, however, the calculations

will reflect payments and collections under

the ACA’s required risk adjustment program

and, for the period 2014–2016, payments and

collections under the ACA’s transitional

reinsurance and risk corridor programs.

The MLR provisions and regulations were

adopted in tandem with the ACA’s rate review

provisions and regulations. Section 2794 of the

ACA, ‘‘Ensuring that Consumers Get Value for

Their Dollars,’’ stipulates that the HHS secre-

tary, in conjunction with the states, establish a

process for annual review of ‘‘unreasonable’’

health insurance rate increases. Section 2794

does not require prior approval of rate changes

by state regulators or permit HHS to deny

increases.

But insurers must provide the HHS

secretary and relevant state regulators with

justifications of unreasonable rate increases

prior to implementation, and ‘‘prominently

post such information on their Internet web-

sites,’’ with public disclosure otherwise ensured

by the secretary. Insurers with rate increases

that are deemed unreasonable after state and/or

HHS review risk exclusion from the health

insurance exchanges in 2014.

HHS regulations implementing Section

2973 set 10% as the threshold for ‘‘unreason-

able’’ rate increases for a given product in a

state beginning September 1, 2011. Starting

in 2012, states could apply for state-specific

thresholds, based on the ‘‘the cost of health

care and health insurance coverage.’’ Insurers

that propose increases above 10% must file a

preliminary justification with the Center for

Consumer Information and Insurance Over-

sight (CCIIO) and the state, which then is

posted on the CCIIO website. If the state or

the CCIIO deems an increase unreasonable,

and if the insurer nonetheless implements the

Inquiry/Volume 50, Spring 2013

increase, the insurer must submit a final

justification to regulators and post it on the

insurer’s website. The CCIIO has thus far

identified a number of rate increases as

unreasonable.

While HHS and drafters of the law and

regulations regard the ACA’s minimum MLR

and rate review requirements as complemen-

tary (see the next section), there is some

conflict between the requirements. Rate review

focuses on whether proposed rates are ‘‘un-

reasonable’’ in relation to projected medical

costs, administrative costs, and profit at the

time policies are issued, including whether

projected rates are expected to satisfy the

minimum MLR requirements. The minimum

MLR provisions seek to limit realized margins

for administrative expenses and profits after

policies are in force. The combination creates

an environment where rates deemed reason-

able ex ante (at the time policies are issued)

may be viewed as unreasonably high ex post

(after medical costs have been paid).

Stated Rationales vs. Economic Aversion to

Price Controls

As noted earlier, the stated rationales for the

minimum MLR standards and associated

disclosure/reporting requirements are to pro-

mote transparency, consumer value, and great-

er efficiency by health insurers. According to

the CCIIO, the rate review regulations com-

plement the minimum MLR and its reporting/

disclosure regulations to help achieve afford-

able health insurance, in part by moderating

rate increases.

The traditional view of economic regula-

tion poses a three-prong test for efficient

regulation.

First, demonstrable market fail-

ure should exist. Second, there should be a

reasonable expectation that the benefits of

regulation will outweigh its direct and indi-

rect costs. Third, appropriate regulatory tools

should be matched with specific market

failures. Broadly construed, the MLR and

rate review regulations both represent forms

of price controls, which are subject to the

limitations inherent in such controls and not

easily reconciled with this view of regulation.

The economic rationale for price regulation

focuses on whether firms are able to charge

prices above marginal costs. If so, price

regulation has the potential to reduce welfare

losses by lowering prices and increasing

consumption. Given the direct costs of

regulation, potential distortions in incentives,

and other unintended consequences, however,

price regulation is generally viewed as a last

resort—to be used only in cases where

significant market power is inherent, such as

natural monopoly or near natural monopoly.

Otherwise, the preferred strategy is to pro-

mote more effective competition by, for

example, antitrust policy and/or improving

information disclosure.

Proponents of MLR minimums and de-

tailed disclosure of insurers’ claim costs and

administrative expenses argue that such rules

are an appropriate response to insufficient

transparency and competition in health in-

surance markets, which they believe have

resulted in excessive administrative expenses

and profits.

Administrative expense ratios

for individual and small group coverage in

particular are seen as providing prima facie

evidence of dysfunctional markets. Such

arguments notwithstanding, the use of mini-

mum MLR regulation as a means to make

health insurance significantly more affordable

overall is not readily reconciled with aggre-

gate trends in MLRs and insurers’ profit

margins. Using data from the National

Health Expenditure accounts, for example,

the estimated ratio of medical costs to

premiums (i.e., the traditional MLR calcula-

tion) for all private health coverage has

averaged 87.7% since 1965, with little or no

trend (see Figure 1).

Aggregate reported

profit margins for publicly traded health

insurers averaged 3.5% of revenues during

the period 1991–2011 and 4.1% during the

period 2002–2011 (see Figure 2), with gener-

ally lower margins for not-for-profit insurers.

Analyses of private health insurance mar-

kets have provided limited evidence of the

scope and effectiveness of health insurance

competition and little or no analysis of why

minimum MLR regulation would be an

appropriate vehicle for addressing market

imperfections. Health insurance market con-

centration is often high at the state and

metropolitan levels, especially for individual

insurance (e.g., Robinson 2004; American

Medical Loss Ratio Regulation

Medical Association 2007; U.S. GAO 2009;

Austin and Hungerford 2009; Cox and Levitt

2011; also see Scanlon et al. 2006), raising

concerns about market power.

But concen-

tration varies widely across states and market

segments (individual, small group, and large

group), the causes of such variation and the

nature and scope of possible barriers to entry

and growth are not fully understood, and

research has provided only mixed evidence of

adverse effects from increased concentration

(see, for example, Dafny 2008; Dafny, Dug-

gan, and Ramanarayanan 2012; Moriya,

Vogt, and Gaynor 2010; also see Conover

and Miller 2010, and Gaynor and Town

2011).

State regulation of health insurance rates

has received little analysis, in contrast to

research that has considered the effects of

state rate regulation of automobile insurance

and, to a lesser extent, workers’ compensa-

tion insurance, including numerous compar-

isons of loss ratios (ratios of claim costs to

premiums) in states with and without prior

approval rate regulation. The results general-

ly indicate that since the 1970s prior approval

regulation on average had no effect on loss

ratios, but periods of regulatory rate sup-

pression in inflationary environments in some

states were associated with reduced availabil-

ity of coverage and/or a significant increase in

insurer exits.

The implications for health

insurance are uncertain, in part because of

higher market concentration in many states’

health insurance markets compared with

property/casualty insurance markets.

Regulatory and compliance costs, incentive

distortions, and other inefficiencies and unin-

tended consequences ultimately transformed

federal regulation of transportation (airline

Figure 1. Estimated U.S. medical loss ratios for private health insurance, 1965-2010

(including premium equivalents for self-funded plans)

(Author’s calculations with nationa l

health expenditure data: National Health Expe nditure [NHE] Amounts by Type of Expenditure

and Source of Funds: Calendar Years 1965–2010 in PROJECTIONS format. Projections for 2010

based on the 2009 version of the NHE released in January 2011)

Inquiry/Volume 50, Spring 2013

and trucking) rates in the 1970s and 1980s.

Those problems have also contributed to a

significant emphasis on stimulating competi-

tion and consumer choice and to the adoption

of novel forms of regulation for utility services,

as opposed to the historic use of cost of service

rate regulation. In the case of regulated public

utilities, the drawbacks of traditional cost of

service (or ‘‘rate of return’’) regulation—

including, for example, weakened incentives

for cost efficiency, arbitrary allocations of

costs and assets across services, and difficulty

in setting an appropriate rate of return on

capital—ultimately led many regions to adopt

some form of ‘‘price cap’’ regulation, often in

conjunction with constraints on realized prof-

its over time (e.g., Braeutigam and Panzar

1993). Under ‘‘pure’’ price cap regulation, a

firm is permitted to raise the price of a given

service over time in relation to changes in a

price index, often with an efficiency adjust-

ment to reflect the potential for improved

productivity. The firm is otherwise allowed to

retain all profits, thus incentivizing efficiency

in production.

In principle, minimum MLR regulation

might be viewed as aiming to retain some

incentives for efficiency consistent with argu-

ments for price cap regulation in that, absent

potential restrictions on projected profits in

the rate review process, insurers are permitted

to earn and retain profits from improvements

in efficiency, provided that they meet the

minimum MLR standard. That potential has

to be weighed against the other consequences

of MLR regulation. Moreover, significant

differences between minimum MLR regula-

tion and basic price cap regulation include the

former’s focus on influencing specific types

and magnitudes of production costs and its

application without regard to the extent of

competition and potential market power in

different states or market segments.

Statistical Volatility and

Credibility Adjustments

Insurers’ projected (target) MLRs will vary

for different products and regions at time of

sale due to many factors apart from any

Figure 2. Quarterly net income as a percentage of revenues for publicly traded managed

care organizations, 4th quarter 1991 to 3rd quarter 2011 (four quarter moving average)

(Author’s calculations using S&P Compustat quarterly data.)

Medical Loss Ratio Regulation

potential variation that may arise from

market power, costly consumer search, or

other market imperfections. Those factors

include: the magnitude of an insurer’s fixed

vs. variable administrative costs; the number

of enrollees; the average morbidity and

medical care utilization of enrollees; the

average size of deductibles and other forms

of cost sharing; the degree of focus on

medical cost control; the types of relation-

ships with providers; enrollee growth and

turnover rates; and distribution methods

(e.g., Robinson 1997; Harrington 2010). This

complexity alone makes it difficult to predict

the outcomes of the MLR rules and increases

the likelihood of significant, unintended

consequences. The effects of the rules on

prices, coverage availability, distribution, cost

control, quality improvement, coverage de-

sign, and contractual relationships with pro-

viders will also depend on uncertain consum-

er responses to any changes in insurers’

offerings and strategy, as well as on the

extent to which insurers’ adjustments are

constrained by prior contracts and pricing

arrangements (such as guaranteed renewable

coverage).

The uncertainty and risk of unanticipated

consequences are amplified by an insurer’s

obligation to pay rebates on actual MLRs

that may differ significantly from those

projected when policies are issued (and by

amounts greater than any permitted credibil-

ity adjustments, which are described in detail

later). Health insurance premiums are based

on the projected costs of providing coverage

during the contract term, generally based on

data available some months before the term

commences. The variability between the

average costs realized during the coverage

period and the costs projected when coverage

was priced depends on random (chance)

statistical variation arising from the underly-

ing probability distributions of medical costs

and the unavoidable imprecision in estimat-

ing those distributions ( i.e., projecting trends

in medical costs).

As noted earlier, statisti-

cal variation in the average medical cost per

enrollee for a health plan diminishes as the

number of enrollees increases. Large enrollee

pools have less variation in average costs than

small pools. Even for very large pools,

however, risk remains due to the inability to

project precisely trends in costs. For example,

unpredictable changes in disease and illness

trends or in prices and utilization of medical

care can occur at the state, regional, or even

national level, regardless of the volume and

quality of data and analysis used to project

cost growth.

MLR Regulation Credibility Adjustments

The MLR rules authorize specific credibility

adjustments to reduce the likelihood that

rebates will be payable as a result of chance

statistical variation. The relevant credibility

adjustment, if any, is added to the insurer’s

MLR for the purpose of determining any

obligation to pay a rebate and the amount.

The eligibility for and magnitude of any

credibility adjustment depend on the entity’s

number of covered life-years in the state (the

total number of months of coverage provided

to enrollees divided by 12). If an insurer’s

experience is based on 75,000 or more life-

years, it is considered sufficiently reliable for

full application of the rebate requirements

without any credibility adjustment. If an

insurer’s experience is based on fewer than

1,000 life-years, its experience is considered

insufficiently reliable (‘‘non-credible’’) for

application of the requirements, and the

insurer is exempt from paying rebates. For

insurers with life-years ranging from 1,000

up to 75,000, a credibility adjustment that

declines with the number of life-years is

added to its MLR for the purpose of

calculating rebates.

The permitted credibility adjustments are

greater for issuers of plans that have higher

average deductibles because these plans ex-

perience more volatility in covered medical

claims (see, for example, Milliman 2010a,b

and Litow et al. 2012). Table 1 summarizes

the permitted credibility adjustments for

different numbers of life-years and average

deductibles.

The permitted credibility adjustments are

based on analysis by an actuarial consultant

under guidelines provided by the NAIC

(Milliman 2010a, b). The analysis used

statistical simulations of MLRs for plans of

different sizes and cost-sharing arrangements,

assuming: 1) an underlying distribution of

Inquiry/Volume 50, Spring 2013

enrollee medical costs based on the experience

of a large number of plans (21 million lives)

as of July 2010, and 2) a target MLR of 80%

for individual and small groups and 85% for

large groups. The process involved simulating

the annual medical costs paid for each

enrollee in a plan of a given assumed size

and then calculating the MLR for that plan-

year. The process was repeated 5,000 times,

producing an empirical MLR distribution for

a plan of that size.

The NAIC requested credibility adjust-

ments for two ranges, a ‘‘50 percent range,’’

where the adjustment is based on the 25

percentile of the generated MLR values, and

an ‘‘80 percent range,’’ based on the 10

percentile. Basing the adjustments on the 25

percentile implies that—under the assump-

tions of the simulation—a plan with a target

loss ratio of 80% would have to pay rebates on

average one year out of four as a result of

chance statistical variation in medical costs

(vs. one year in 10 if the 10

percentile value

were chosen). While there was concern that the

simulations produced too many ‘‘false posi-

tives,’’ the NAIC ultimately recommended—

and the HHS adopted—the credibility adjust-

ments based on the 25

percentile.

If the authorized credibility adjustments

were accurate, an insurer that covered be-

tween 1,000 and 75,000 life-years and had an

80% target MLR would face a 25% proba-

bility of having to pay rebates for any given

year due to chance alone (on average once in

four years). In addition, insurers with a target

MLR above 80% for individual or small

group coverage would face some probability

of paying rebates due to chance alone, with

the probability declining from 25% as the

difference between its target MLR and 80%

increased. Those insurers would likely con-

sider that possibility in their decision making.

The actuarial analysis underlying the cred-

ibility adjustments noted a number of limita-

tions, including several arising from the scope

of the analysis directed by the NAIC. Those

limitations included: 1) the assumed claim

probability distributions reflect nationwide

experience and do not necessarily apply to

any given insurer’s business, 2) the assumed

distributions need not apply to experience

following health care reform, 3) the analysis

did not consider variation that could arise

from the MLR formula’s dependence on

expenditures for quality improvement and

for taxes and fees, and 4) the analysis focused

only on ‘‘unforeseen statistical variation’’

rather than potential ‘‘pricing errors.’’

Related to the last limitation, and presum-

ably as directed by the NAIC, the analysis

and resulting credibility factors assume that

an insurer would know the underlying prob-

ability distribution of medical costs when it

established premiums. That assumption ab-

stracts from a central aspect of real-world

pricing decisions. Insurers do not know the

underlying claims distribution—it must be

estimated—and errors in projecting trends in

claim costs represent an inherent source of

risk in pricing, even for the largest insurers.

For premiums based on a given target MLR,

that source of uncertainty and resulting

forecast errors will cause variation in MLRs

above and beyond that contemplated in the

simulations supporting the authorized credi-

bility factors. An individual or small group

Table 1. Permitted credibility adjustments for medical loss ratios (MLRs)

Life-years

Credibility adjustment for different average deductibles

, $2,500 $2,500 $5,000 $10,000

, 1,000 Exempt from rebate requirements

1,000 8.3% 9.7% 11.6% 14.4%

2,500 5.2% 6.1% 7.3% 9.0%

5,000 3.7% 4.3% 5.2% 6.4%

10,000 2.6% 3.0% 3.6% 4.5%

25,000 1.6% 1.9% 2.2% 2.8%

50,000 1.2% 1.4% 1.7% 2.1%

75,000 0.0% 0.0% 0.0% 0.0%

The credibility adjustment for a given volume of life-years and average deductible is added to the insurer’s MLR for the

purpose of determining its obligation to pay rebates. Author’s calculation of factors for $2,500, $5,000, and $10,000.

Medical Loss Ratio Regulation

market insurer with a target MLR of 80%,

for example, might have a materially greater

likelihood of experiencing a lower MLR due

to chance than is implied by the simulations,

with correspondingly higher likelihoods that

insurers with higher target MLRs would have

to pay rebates.

Historical data provide

evidence consistent with this prediction.

Analysis of the volatility in annual, entity-

state level MLRs in the individual market

during the period 2001–2010 suggests mate-

rially greater volatility than implied by the

authorized credibility adjustments, with both

higher likelihoods of paying rebates and

higher than expected amounts.

Basing MLR and rebate calculations on

three years of experience, beginning with

2013, will reduce volatility but not eliminate

the risk of having to pay rebates due to

statistical volatility. MLRs based on three

years of experience will reflect roughly three

times as many lives. While three-year MLRs

will have correspondingly less volatility (e.g.,

American Academy of Actuaries 2010), they

will also receive lower credibility adjust-

ments.

An insurer with, for example,

50,000 lives over three years would expect

to have volatility roughly equivalent to an

insurer with 50,000 lives in a single year. Even

the largest insurers will still face volatility in

three-year MLRs due to unavoidable inaccu-

racies in forecasting claim cost trends.

Risk Adjustment, Reinsurance, and

Risk Corridors

The effects of the MLR rules will become

much more complicated in 2014 when three

other ACA provisions and attendant regula-

tions (U.S. HHS 2012b; 2013a, b) take effect:

1) a permanent risk adjustment program for

all non-grandfathered individual and small

group plans; 2) a three-year transitional

reinsurance program for high claim costs for

individual enrollees in non-grandfathered

individual market plans to be funded by

contributions from all issuers and third-party

administrators of group health plans; and 3) a

three-year transitional risk corridor program

for Qualified Health Plans (plans offered

through the exchanges). Insurer payments

and collections under these programs will be

added to, and deducted from, the numerator

when calculating MLRs and rebates, except

for contributions to the reinsurance program,

which will be deducted from the denominator.

Risk adjustment should primarily affect the

calculations and rebates based on whether an

insurer’s enrollees have above average or

below average ex ante risk characteristics as

incorporated in the risk adjustment models,

as opposed to unexpectedly higher or lower

realized costs for enrollees as a group. On the

other hand, insurers’ contributions to the

temporary reinsurance program would reduce

the denominator of the MLR calculation, and

collections for any enrollees with annual

insured medical costs exceeding the reinsur-

ance thresholds (attachment points) will

decrease the numerator. By reducing individ-

ual market insurers’ contributions in relation

to payments received, the contributions from

self-insurers will tend to lower individual

market MLRs, depending on premium ad-

justments in anticipation of those transfers.

The risk corridor program during the

2014–2016 period will provide payments from

HHS to Qualified Health Plans whose allow-

able costs (costs included in the numerator of

the MLR calculation) exceed target amounts

by specified percentages; it will require

payments to HHS from insurers whose

allowable costs are lower than target amounts

by specified percentages. Given statutory

language, it was originally anticipated that

the risk corridor calculations would be at the

plan level within a state, thus increasing the

statistical variation compared with perform-

ing calculations at the licensed entity (insurer)

level, as is done under the MLR rules. An

HHS interim final rule, however, would

essentially allow calculation at the insurer

level (U.S. HHS 2013a).

The risk corridor program will likely

reduce volatility in insurers’ MLRs for rebate

calculations over the 2014–2016 period,

making it less likely that an insurer will have

to pay rebates due to unexpectedly favorable

claims experience. Plans with unexpectedly

low costs below the thresholds in the risk

corridors will be required to make payments

to HHS, without any credibility adjustments,

which will offset or potentially exceed any

reduction in obligations to pay rebates.

Conversely, under the risk corridor program

Inquiry/Volume 50, Spring 2013

insurers will receive payments if unexpectedly

high medical costs produce allowable costs

sufficiently greater than the target amounts.

Potential Effects and

Unintended Consequences

Reductions in administrative costs that could

accompany rating reforms and the operation

of health insurance exchanges in 2014 and

later years could make it easier for insurers to

meet the MLR thresholds. On the other hand,

market dynamics during the first few years of

the new environment are unknown, and the

interactions between the MLR minimums,

risk adjustment, and transitional reinsurance

and risk corridors add another layer of

complexity. The effects of the regulations

generally will be greater for firms with lower

target MLRs, most obviously for any insurers

that have (or otherwise would have had)

targets below the 80% and 85% thresholds.

As stressed earlier, insurers with target MLRs

above the thresholds will also face the

possibility of having to pay rebates due to

unexpectedly low medical costs that cause

their actual MLRs to drop below the

thresholds, after including any credibility

adjustments.

Premium Margins for Non-Claim Expenses

and Profits

The MLR regulations are predicted to exert

downward pressure on overall margins for some

insurers’ administrative expenses and profits in

certain markets to reduce the likelihood of

having to pay rebates and the magnitude of

rebates if they are necessary. Consistent with

reports of reduced agent and broker commis-

sions, the requirements will generally lower

payments to agents and brokers, especially for

insurers that otherwise would be unwilling to

continue providing coverage.

For some insurers, expected profits will

likely decline compared with what would

have occurred without the MLR rules, at

least until they adjust their operations and

business models. Any firms that are unable to

achieve appropriate expected returns from

selling coverage will shrink and ultimately

exit. Arguments that lowering profitability is

an appropriate objective of the MLR rules

dismiss or ignore solvency considerations and

are not based on compelling evidence that

profit margins have been excessive. Other

things being equal, lower profits reduce

insurers’ financial ability to withstand unex-

pected increases in medical costs.

In response to the MLR regulations, some

insurers could choose to lower premium rates

vis-a-vis projected medical costs in certain

markets, but just how much of a reduction

may occur is unclear. It is possible that some

insurers instead might increase premium

rates. With that strategy, an insurer would

plan to pay rebates unless medical costs

turned out to be unexpectedly high, in which

case the higher premiums charged would help

fund the higher costs. To the extent that

occurs, the dynamics of pricing will shift

toward higher upfront premiums, with re-

bates expected in more years, from a pre-

regulation environment characterized by low-

er premiums but no rebates. That result

would tend to increase risk to customers. A

potential regulatory response would be to

deny or otherwise discourage rate increases;

over time, however, such action could create

solvency issues and inhibit innovation.

Spending on Cost Control and

Quality-Improvement Activities

The MLR requirements are likely to reduce

spending designed to lower the average cost of

medical claims per enrollee, thus increasing

medical costs and, other things being equal,

putting upward pressure on premiums. With-

out the MLR requirements, and for simplicity

ignoring possible effects on consumer demand,

a profit-maximizing insurer will invest in cost

control up to the point where an additional

dollar of spending reduces expected medical

costs by a dollar. Under the MLR rules,

additional spending on medical cost control in

many instances will also increase an insurer’s

expected rebate, thus reducing the marginal

benefit and amount of such spending.

That

prediction also holds for spending on fraud

prevention, which can only be counted in the

MLR calculation up to the amounts collected

from such efforts. The reduced incentive for

medical cost control with attendant pressure on

costs and premiums may represent a significant

unintended consequence of the regulations.

Medical Loss Ratio Regulation

Regarding spending on quality improve-

ment activities, without the MLR rules and

potential rebates, profit-maximizing insurers

will incur such expenditures to the point

where the marginal revenues from higher

prices and/or the attraction of additional

customers equal the marginal costs. In a

rebate environment, increased spending on

quality improvement activities for many

insurers will also reduce the expected cost of

paying rebates, thus providing additional

incentive to increase spending (as long as

consumers value the improved quality more

than the potential rebates).

On the other

hand, the requirement that quality improve-

ment activities demonstrate their effectiveness

over time creates uncertainty about the types

of expenditures that will ultimately be count-

ed as improving quality, and it fails to

recognize the fundamental challenge of dem-

onstrating the effectiveness of innovations in

care delivery to enhance quality.

The MLR requirements also create tension

between the concepts of ‘‘cost reduction’’ and

‘‘quality improvement.’’ Activities that im-

prove quality cannot be sharply distinguished

from activities designed primarily to control

costs. Attempting to draw fine distinctions

and requiring that quality-improvement ac-

tivities be shown to have measurable results

(even though initial demonstration is not

required) will likely discourage risky, but

potentially beneficial innovation and national

efforts to encourage experimentation.

Innovation, Insurer/Provider Contracting, and

Integrated Care Delivery

An important and specific goal of the ACA

and many private sector initiatives to control

medical costs while maintaining or enhancing

quality is to promote efficient delivery of

medical care, through, for example, innovative

models of care integration and coordination,

such as accountable care organizations, episode-

based payments, medical homes, and wellness

and disease management programs. Health

insurance companies are involved in numerous

initiatives along these lines, in addition to

traditional network and capitation arrange-

ments with providers and related organizations.

It is desirable for health insurers to invest

actively in innovation to develop new cover-

age arrangements, more cost-efficient provider

networks and delivery arrangements, and infor-

mation systems to guide consumer choice,

including evidence on medically effective and

cost-efficient care. Such investment requires

upfront expenditures, with a reasonable expec-

tation of earning returns over time at least

commensurate with the risk involved. Because

investment in innovation commonly has a high

failure rate, large potential returns from suc-

cessful innovations are often required to

incentivize investment. Although the MLR

regulations may stimulate some insurers to

reduce administrative expenses and the poten-

tial for rebates, the caps on potential returns

from innovation will likely reduce investment in

risky innovations that, if successful, could yield

large benefits. The MLR requirements add

another layer of uncertainty that health insurers

and parties that contract with health insurers

must confront when considering investment in

innovation to meet the challenges confronting

U.S. health care.

Considerable uncertainty exists concerning

the types of arrangements and levels of

‘‘administrative’’ expenses that might help

achieve efficient, integrated care, and thus

whether the MLR rules might discourage

efficient arrangements that otherwise would

be feasible. An important issue is the treat-

ment under the MLR rules of health insurers’

payments to providers and other entities in

integrated or managed care arrangements.

The framework and decisions regarding the

extent to which payments are considered

reimbursement for clinical services and thus

seen as incurred claims (or expenditures on

activities to improve quality)— which can be

included in the numerator of the MLR

calculation— versus non-claim costs— which

cannot be included— have important impli-

cations for the costs and risks of entering into

such arrangements and developing more

innovative ones.

Regarding this issue, Section 158.140(b)(3)

of the MLR Final Rule, and several rounds

of technical guidance issued by the CCIIO,

set forth detailed requirements and criteria

for identifying the amounts in health plan

payments to clinical risk-bearing entities

(such as independent practice associations,

Inquiry/Volume 50, Spring 2013

physician hospital organizations, and ac-

countable care organizations) and third-party

vendors that can be considered medical

claims in MLR calculations, as opposed to

administrative costs. Guidance issued on

February 10, 2012 (Cohen 2012), regarding

insurers’ payments to clinical risk-bearing

entities stipulates that ‘‘functions other than

clinical services that are included in the

payment… must be reasonably related or

incident to the clinical services, and must be

performed on behalf of the entity or the

entity’s providers.’’ If any administrative

functions are performed on behalf of the

health plan issuer, however, ‘‘that portion of

the issuer’s payment attributable to adminis-

trative functions may not be included in

incurred claims.’’

These provisions and guidance suggest the

difficulties and costs of crafting, enforcing,

and complying with applicable rules, and the

inherent complexity and uncertainty that can

arise in applying seemingly simple regulatory

requirements to complicated economic rela-

tionships. Regulators could fear that some

arrangements might be designed, at least in

part, to shift administrative costs to vendors

in an attempt to circumvent the MLR rules

and reduce the likelihood or magnitude of

rebates. Such concern notwithstanding, nar-

row construction of payments that qualify as

incurred claim costs under the MLR rules,

along with uncertainty about how payments

may be treated under existing or innovative

arrangements, could disrupt current and

future arrangements to better provide coor-

dinated, integrated care. That result would

undermine the key objective of achieving

more efficient spending. The trade-off favors

rules that err on the side of flexibly promoting

coordination and integration.

Coverage Design

Varying policy designs with respect to cov-

ered services, cost sharing, and plan differ-

ences in average medical costs (covered and

uncovered) for enrollees tend to produce

different target MLRs. Thus, the possibility

exists that the MLR regulations could lead to

changes in the supply of certain types of

coverage in different regions, reducing the

diversity of health plan choices. In the

extreme, the MLR’s sensitivity to different

plan types could make it difficult or even

infeasible to specialize in or even offer some

types of benefit and cost-sharing arrange-

ments. A variety of observers and commenta-

tors, for example, have expressed concern

about the future of high-deductible health

plans (HDHPs) under the MLR regulations

(with or without health savings accounts) and

whether HDHPs generally will be able to meet

the 60% actuarial value requirement for the

lowest cost (bronze) plans beginning in 2014.

Given some amount of fixed costs at the

policy level and with all else being equal, target

MLRs will be lower for plans with greater cost

sharing and thus lower actuarial values, or

with lower expected medical costs at any cost-

sharing level, or both. Litow et al. (2012)

provide detailed examples illustrating how

plans with lower actuarial values and/or lower

average medical costs for enrollees are likely to

have lower target MLRs and thus be more

likely to violate the MLR minimums, regard-

less of credibility issues. This could reduce the

prevalence of such plans and any associated

benefits from greater incentives for cost

control.

Consolidation, Concentration, and Capacity

The fixed costs of complying with the ACA’s

MLR and other insurance regulations will

weigh more heavily on smaller insurers and

increase the costs of entry by new insurers.

The MLR regulations also could make it

more difficult for new insurers to achieve

sufficient scale, even permitting temporary

deferral of experience on new business that

exceeds 50% of an insurer’s volume. The

MLR rules could encourage insurers to

consolidate to obtain product portfolios more

likely to meet the minimum MLR require-

ments (e.g., from pooling expenses or reduc-

ing statistical volatility in MLRs), or simply

to achieve additional economies of scale in

administration. The MLR rules are therefore

likely to increase market concentration above

and beyond the influence of exchanges and

other insurance market reforms. An associ-

ated reduction in the number of insurers and

increased market shares of larger insurers

would represent another unintended conse-

quence of the rules.

Medical Loss Ratio Regulation

Another possible unintended consequence

involves insurers’ investments in capacity to

meet growing demand. Health insurance

sector capacity will need to expand signifi-

cantly to meet the increased demand for

coverage from the ACA’s premium subsidies

and individual and employer mandates. The

MLR regulations could reduce some insurers’

incentives to build capacity to meet that

demand both inside and outside the exchanges.

The inherent caps on profitability, the expected

cost of rebates, and the actual payment of

rebates will likely shrink available resources,

make it more difficult for insurers’ to raise

additional capital, and potentially reduce the

number of insurers willing to participate in the

exchanges. To the extent this occurs, the

requirements would undermine the goal of

achieving orderly and vibrant health insurance

markets in 2014.

Alternatives

Accompanying development of the MLR

regulations was discussion of a variety of

methods to reduce the potential for unintend-

ed consequences. Among the examples were

permitting insurers to consolidate results for

subsidiaries and/or permitting greater use of

reinsurance to reduce MLR volatility, and

possibly allowing insurers to pool large

claims to help reduce statistical volatility

and the likelihood of having to pay rebates

due to chance statistical variation (e.g.,

American Academy of Actuaries 2010). Giv-

en the potential for significant unintended

consequences and other drawbacks, it would

be desirable to reconsider such proposals,

along with revisiting the adequacy of credi-

bility adjustments prior to 2014 and making

sure that appropriate credibility adjustments

are permitted in 2014 and later years.

More fundamental is the need for less

prescriptive alternatives that could help increase

transparency, efficiency, and consumer value

with fewer potentially adverse effects. An

overall strategy would promote more effective

competition, informed consumer choice, and

pro-competitive regulatory oversight of rates.

An important part of that strategy would be to

better understand and then reduce any artificial

barriers to entry and growth by new or smaller

insurers, especially in states with highly concen-

trated markets. That would require more

analysis of the reasons that some he alth

insurance markets are highly concentrated,

and the extent to which that concentration

primarily reflects efficiency, market power, or

other influences.

Regarding information disclosure, some

consumer advocates strongly pressed for and

endorsed the ACA’s required disclosure of

MLRs as a means to assist consumers in

identifying high-value coverage. Given the

MLRs’ dependence on insurers’ coverage

design, statistical variation, and other complex-

ities, however, providing reliable and meaning-

ful information on MLRs at the entity-state

level to guide consumers’ decisions is problem-

atic. Rather than convey detailed information

on MLRs and administrative expenses, infor-

mation disclosure should focus on reliable

metrics that determine ultimate value to

consumers, including: 1) premium rates, 2)

covered benefits, 3) cost-sharing and actuarial

values, 4) provider networks and specialist

access, 5) quality of care and claims adminis-

tration, and 6) insurer financial strength.

Given information on those attributes,

data on an insurer’s MLR in a particular

state is unlikely to enhance consumers’ ability

to make informed decisions, including help-

ing them evaluate trade-offs among the

various plan features. Because of statistical

variation, it makes sense at best to inform

consumers whether an insurer’s MLR is

significantly different from the average for

comparable products (as is done, for exam-

ple, in the Medicare Hospital Compare

system for hospital mortality rates).

Even apart from the statistical credibility /

reliability issue, comparing MLRs across

different types of products could just as easily

confuse as inform. The fact that an insurer

focusing on HDHPs, for example, might have

a lower target MLR than an insurer with

higher actuarial value plans does not imply

that the HDHP provides reduced value for

consumers given their individual needs and

preferences. It would not even imply that the

absolute dollar amount included in the premi-

um calculation for administrative expenses and

profits was higher for the HDHP. Further-

more, for plans with similar actuarial values

Inquiry/Volume 50, Spring 2013

and a similar network of providers, target

MLRs will tend to be highly and inversely

correlated with premiums, offering little, if any,

additional information beyond premiums—

that is, plans with low target MLRs will have

high premiums and vice versa. Finally, a higher

realized MLR, if not due to short-term,

statistical variation, might indicate poor oper-

ating performance and financial weakness,

rather than better overall value.

Conclusions

The MLR regulations established by the

ACA are designed to guarantee that a

specific, minimum percentage of health in-

surance premiums in a particular market be

spent on medical care and activities to

improve health care quality. The regulations

pose substantial risk of unintended conse-

quences, including those due to, or exacer-

bated by, the sensitivity of rebates to statis-

tical variation in medical costs. If medical

claim costs are lower than projected, the

regulations likely will expose many insurers

whose target MLRs are equal to or above the

specified minimums to a non-trivial risk of

having to pay rebates, despite the permitted

credibility adjustments. Insurers will not be

able to charge consumers additional amounts

to offset losses if costs are higher than

projected.

The risk of having to pay rebates due to

statistical variation magnifies the potential

for such unintended consequences as higher

upfront premiums for some insurers; more

limited consumer choice of coverage and

insurers; less innovation in products that help

align consumer, provider, and health plan

incentives; and increased consolidation and

concentration in health insurance markets. In

contrast to the traditional state regulatory use

of projected MLRs as a metric to help monitor

premiums in relation to medical benefits and

solvency considerations, and despite the in-

herent volatility of insurers’ MLRs and their

limitations in measuring value to consumers,

too little attention has been paid to the

possibility of such consequences. Policy-

makers should consider adopting alternatives

—or at a minimum modifications— to the

MLR regulations to help achieve their objec-

tives with a lower chance of adverse effects.

Notes

Thanks are due Gary Bacher and the editors for

helpful comments.

1 Earlier studies of insurers’ MLRs prior to 2011

had projected that rebates for 2011 experience

would exceed $1 billion (U.S. HHS 2010;

Abraham and Karaca-Mandic 2011; U.S.

GAO 2011b; Hall and McCue 2012; Herbold

2012; Cox, Levitt, and Claxton 2012).

2 Medicare supplemental coverage is subject to

minimum ratios of incurred medical costs to

premiums that must be met in rate filings and

that can trigger refunds to policyholders under

certain conditions.

3 Robinson (1997) provides early discussion of

this and related issues.

4 Denials of requested adjustments generally

concluded that exits were unlikely to occur in

the state even though some insurers would

experience operating losses after paying pro-

jected rebates. Details of the applications and

decisions are provided at http://cciio.cms.gov/

programs/marketreforms/mlr/index.html.

5 The Final Rule did not adopt a proposal

approved narrowly by the NAIC in November

2011 that would have allowed an insurer to

deduct agent and broker commissions from

premiums when calculating its MLR. Subse-

quent proposed legislation (H.R. 1206) would

exclude payments to agents and brokers from

the MLR calculation, require the HHS secre-

tary to defer to a state’s findings that applica-

tion of the MLR rules would destabilize the

individual market, and allow state waivers from

the MLR requirements for the small group

market in addition to the individual market (see

CBO 2012).

6 The numerator for the 2013 MLR reporting

year may include any rebate for the 2011 or

2012 MLR reporting year, and the numerator

for the 2012 MLR reporting year may include

any rebate for the 2011 reporting year if the

2012 MLR experience was not fully credible.

Whether prior rebates can be included in the

calculations in later years remains uncertain.

7 In addition, an insurer with 50% or more of its

total earned premium in a state attributable to

newly issued policies with less than 12 months

of experience may defer inclusion of the

experience for those policies from its MLR

calculation until the following year.

Medical Loss Ratio Regulation

8 There is an exception for ‘‘assumption rein-

surance,’’ where an insurer transfers all

obligations for a block of business to a

reinsurer.

9 State oversight of rate changes was (and is)

diverse across and within states for individual

and small group coverage. About half the

states required prior regulatory approval of

rate changes for individual health insurance in

2009 (NAIC 2009; Korlette and Lundy 2010).

10 The ACA authorized the HHS to assume

responsibility for rate review if it deems that a

state does not have effective rate review. The

CCIIO is conducting rate reviews in six states

(CCIIO 2011).

11 The CCIIO website (http://cciio. cms.gov/programs/

marketreforms/rates/index.html) provides ex-

amples where enhanced rate review is asserted

to have saved consumers money by reducing

insurers’ requested rate increases (also see

Korlette and Lundy 2010).

12 See, for example, the treatment by Associate

Supreme Court Justice Stephen Breyer in his

1982 volume on regulation and its reform

(Breyer 1982).

13 These views have a long history. See, for

example, the discussion in Robinson (1997).

14 The MLR equals the ratio of medical benefits

to premiums, including ‘‘premium equiva-

lents’’ for self-funded plans, which reflect

estimated fees to insurers and others under

administrative service contracts.

15 The limited federal antitrust exemption for the

‘‘business of insurance’’ has little effect on

health insurers. Insurers’ relationships with

medical care providers, such as the inclusion of

‘‘most favored customer’’ clauses in hospital

contracts, are not exempted. In contrast to

property/casualty insurance, health insurance

has no history of joint rate making that is

protected by the exemption. Health insurer

mergers have been subject to federal antitrust

scrutiny since at least the early 1970s, and

mergers and acquisitions of health insurers are

subject to approval by state regulators.

16 Potentially most germane to the MLR regula-

tions, Cebul et al. (2011) posit a model in which

search frictions can lead to high marketing

expenses and prices in health insurance mar-

kets. Based on comparison of premium distri-

butions for insured and self-insured employer

plans, they conclude that frictions significantly

increase premiums and that a public health

insurance option could improve efficiency by

reducing distortions in pricing and marketing

expenses. The theoretical model does not

consider the potential role of brokers in

reducing search frictions, and the empirical

conclusions depend on the authors having

adequately controlled for risk-related and other

factors that could produce premium differences

between insured and self-insured plans.

17 See, for example, Cummins (2002) and the

papers therein.

18 In practice, price cap regulation in the United

States generally has included some mechanism

for limiting firms’ profits over time in relation to

a benchmark, thus reducing its incentive effects.

19 The latter source of risk is known as ‘‘param-

eter uncertainty.’’ Wacek (2005) provides a

technical treatment of parameter uncertainty

for property/casualty insurance loss ratios.

20 For the 2013 MLR reporting year, the

credibility adjustment for partially credible

experience is zero if both: 1) ‘‘the current

MLR reporting year and each of the two

previous years included experience of at least

1,000 life-years,’’ and 2) ‘‘without applying the

credibility adjustment, the issuer’s MLRs for

all years were below’’ the minimum MLR

requirement.

21 An August 2010 letter to the Office of

Consumer Information and Insurance Over-

sight (later the CCIIO) by Rowen Bell, chair of

the Medical Loss Ratio Work Group of the

American Academy of Actuaries, explained

(American Academy of Actuaries 2010):

‘‘MLR volatility of small blocks of business

is also driven by uncertainties in setting

premium rates (in addition to the statistical

fluctuations of claims)…. Credibility factors

derived from an analysis of statistical fluctu-

ations only… would need to be set at a very

high confidence level in order to compensate

for other sources of volatility.’’ Bell’s comment

about uncertainties in setting rates also applies

qualitatively to large insurers.

22 Details are provided in the working paper

version of this paper (Harrington 2012).

23 Any positive correlation in annual MLRs would

increase the volatility of three-year averages.

24 In its budget score of H.R. 1206 (see note 5

previously), the CBO projected that the current

MLR rules will reduce premiums by ‘‘about one-

half of one percent, on average over the next few

years, declining to approximately one-tenth of

one percent by the end of the 10-year projection

period’’ (CBO 2012). McCue and Hall (2012)

report that nationwide administrative expenses

and profits per member for the individual

market declined in 2011 (the first year of

required rebates) vs. 2010. Administrative ex-

penses per member also declined for the small

group and large group markets, but higher

profits per member offset most or all of the

reductions. The study does not consider trends

in administrative expenses, medical costs, and

profits that could have affected insurers’ results

apart from the MLR regulations.

25 The effects could be smaller if consumer

demand depends on the magnitude of expected

rebates.

26 Any changes in spending on quality improve-

ment activities could also depend on the

Inquiry/Volume 50, Spring 2013

regulations’ effects on spending to control

medical costs. If declines in cost control

spending increase savings in medical costs

from certain types of quality improvement

activities, some increase in those types of

spending is likely. For example, the MLR

regulations classify prospective utilization

management, but not concurrent or retrospec-

tive utilization management, as a quality

improvement activity. If reductions in spend-

ing on concurrent or retrospective utilization

review increase the marginal benefit from

spending on prospective review, some increases

in the latter form of spending could occur.

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