Notes on efficiency

This is a post I submitted on February 17, 2016 on Peggy Chinn’s blog after following her posts on efficiency and productivity

…. and so we come full circle on the theme that first attracted my attention… efficiency. I was tempted to write these thoughts on the first post, but I figured it would be better to let that run its course…

and when combined with your mention of this political season I could no longer resist, one of my favorite topics: The efficiency of risk management, or “… all you wanted to know about insurance but were afraid to ask.”

Recent issues in the Democratic Party primaries have brought one of my favorite efficiency topics into view. What makes for an efficient insurer? Ask most lay people and they are likely to give a knee-jerk response: An insurer with a low loss ratio. But no, that is not the hallmark of an efficient insurer. That is the hallmark of an insurer that isn’t paying its policyholders’ claims.

Perhaps an insurer with a low, non-claims, expense ratio. That is certainly an important component of an efficient insurer, but not the most important component.

The hallmark of a perfectly efficient insurer is an insurer whose loss ratio (Total Claims Costs/Total Earned Premiums) is exactly equal to the loss ratio for the population from which it randomly selects its policyholders. No insurer is ever this efficient. The best any real world insurer can ever do is come close to having the loss ratio for the population insured.

Still, thinking about insurer efficiency can reveal a lot about one of the most important issues in the 2016 election: What is the best way to provide health insurance for the entire population of the USA? Is an incremental improvement in the proportion of Americans covered through the PPACA, as suggested by candidate Clinton, the most efficient approach, or is a single payer, Medicare for All, as suggested by candidate Sanders, the most efficient approach?

First, the landscape. We hear a lot about some of our biggest insurers/health benefit plans: AETNA, Humana, United Healthcare, Kaiser Permanente, etc. We have also heard about some colossal insurer failures: AIG, Reliance Insurance Company etc.But the real issue of inefficiency has to do with the hundreds of smaller health insurers/health benefit plans we have. Most of these hundreds of insurers are terribly inefficient, often paying only a small portion of their premiums in the form of policyholder benefits, nowhere near the loss ratio appropriate for the population insured.

So, what is the magical ingredient in efficient insurance? Volume, Volume, Volume. The more policies an insurer issues, the closer its loss ratio falls to the expected loss ratio for the population insured. The importance of this proximity to the loss ratio for the population is critical. The more accurate an insurer’s loss ratio the easier it is to convert premiums into health care benefits. If an insurer knows exactly what its claims will be, year after year, it faces little or no risk of adverse operating results. The lower the insurers risk, the less need there is to reward investors with profits and the lower the “risk premium” it should have to charge for its risk management services. As these two items decrease, the insurer can convert more of its premiums to policyholder health benefits.

Now the thing about insurers, as I suggested above, is that the more policyholders, the more efficient the insurer becomes, the higher the benefits it can offer, the lower the premiums it can charge, and the lower the risk of bankruptcy.

For every population there is ever only one maximally efficient, risk managing, insurer. The largest insurer possible, or a national health insurer. Let’s imagine we have an “efficient enough” health insurer, insuring 1,000,000 Americans and converting 75% of its premiums to health benefits, having a profit goal of 5% of its premiums, charging a risk premium of 5% for its service as a risk manager, and having non-loss operating expenses of 15% of premiums. This insurer can reliably convert 75% of its premiums to policyholder benefits.

Year after year, in some years it will have lower losses than expected and it will earn higher profits than expected. In other years it will have higher losses than expected and it will incur operating losses, using up the 75% of its premiums earmarked for policyholder benefits, eating through its 5% risk premium and eliminating its expected profits. In really bad years it may lose all the money it has, it will become insolvent, shut its doors and deprive some policyholders of their benefits. This happens fairly rarely for insurers with 1,000,000 policyholders, but it happens quite often for insurers with 5-10,000 policyholders.Precisely because they are inefficient risk managers, small insurers earn excessive profits, or incur crippling losses, fairly frequently.

But we are interested in efficiency, not inefficiency. So we need to look the other way. While an insurer with 1,000,000 policyholders may be efficient enough, it isn’t going to be efficient enough for people like us who want to see real efficiency. So, lets think about the relative efficiency of an insurer covering all 323,000,000 Americans, the Bernie Sanders solution.

I specified the 5% profit margin and 5% risk premium for a reason. Together with understanding the Central Limit Theorem, these assumptions are based on the notion that the standard error for the loss ratio for our insurer with 1,000,000 policyholders is 5% of its premiums. In about 95 years out of 100, our efficient enough insurer will have a loss ratio between 0.65 and 0.85. That is ok but it should be clear that a 20% spread in how much of the premiums will be left each year will make life difficult for everyone.

How would our insurer covering 323,000,000 policyholders compare? Well, to calculate the risk management efficiency of a national health insurer, we invoke the Central limit theorem and we find that the standard error for the loss ratio for our insurer with 323,000,000 policyholders is not even close to 5%, it is only 0.002782%. Our largest possible insurer will have loss ratios that vary between 0.74722 and 0.75278, about 95 years out of 100. This insurer is so efficient that it will never go bankrupt because its losses never exceed its premiums. On the downside it also has very few years when it makes substantially higher than expected profits.

It is this very efficient insurer that lies at the heart of the current political season. Will America be better served by 323 “efficient enough” insurers that cannot plan to provide benefits of more than 75% of their premiums as benefits, or would America be better served by a maximally efficient insurer that could pay almost 85% of its premiums as benefits? Most would probably pick the insurer that pays the most benefits. Yet, all but one Republican party candidate, and one Democratic party candidate tell us that a national health insurer is the wrong choice for America.

This is, of course, only a teaser. A glimpse at some of the ways in which insurers can be efficient. I have a nice little paper that covers all the turf, covered by my book “Standard Errors: Our Failing Health Care (Finance) Systems And How To Fix Them” that I am distributing gratis as my contribution to rational discourse on the topic of how to achieve universal coverage. For a free copy pick the small paper up from my website: http://standarderrors.org/WorkingPapers/2012/JSM073111PaperFinalWorkingPaper09262012.pdf.

In 2016 everyone should understand how insurance really works or we will blindly face the Woody Allen Dilemma in the balance of the primaries and throughout the election year:

“More than any other time in history, {wo}mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.”

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