Managed Care: Because I'm A Scorpion, And It's In My Nature - An Editorial On Health Reform

Carl McDonald is a Managing Director at Oppenheimer & Company. He is one of the most followed health insurance industry analysts who can regularly make stock prices rise and fall with his comments. Today, he and colleague James Naklicki offer an "editorial" on the current health care proposals pending in Congress. I will suggest that their analysis of the impact of potential "reform" on consumers, the states, and the health insurance industry are well worth your time.

Managed Care: Because I'M A Scorpian, And It's My Nature - An Editorial on Health Care Reform
by Carl McDonald and James Naklicki

The current health reform legislation has a lot of objectives, but two key goals are to provide coverage to all Americans and to control the growth in health care cost trends. The legislation currently pending in Congress would achieve partial success in covering more people, but we think it will fail miserably in slowing health care costs. Because there's so little in the bill that actually deals with cost, we wouldn't be surprised if reform actually caused health care trends to accelerate more than if we'd done nothing. And so while health reform is laudable for its efforts to cover more people, it just isn't a very good outcome for the country.

Key Points

In this piece, we look at where the health reform discussion will turn to in the final few months of debate, with the focus likely on the consumer groups that stand to lose the most, and the issues the legislation will have working in the current health care market.

Seniors in the Medicare Advantage program will face higher premiums and lose valued benefits, while younger people (a key Obama demographic in the last election) will have to pay significantly more for their health care, since they will now be subsidizing the older sicker members of the population.

The relatively modest subsidies to help people buy insurance and the very minor penalties for not having insurance, coupled with a significant illegal immigrant population, mean that the uninsured population will still number 10-20 million even after this legislation, raising the question of whether we should be spending almost $1 trillion on reform.

The taxes levied on health insurers will ultimately be passed onto employers and consumers, raising premium rates by over 1% each year, meaning that the middle class will be funding at least a portion of the coverage expansion.

In addition, states will be covering a large chunk of the Medicaid expansion. Because states have to balance their budgets each year, this will likely result in higher state income, sales, and property taxes, which will have a disproportionate impact on the middle class.

The Scorpion and the Frog

One day, a scorpion looked around at the mountain where he lived and decided that he wanted a change. So he set out on a journey through the forests and hills. He climbed over rocks and under vines and kept going until he reached a river.

The river was wide and swift, and the scorpion stopped to reconsider the situation. He couldn't see any way across. So he ran upriver and then checked downriver, all the while thinking that he might have to turn back.

Suddenly, he saw a frog sitting in the rushes by the bank of the stream on the other side of the river. He decided to ask the frog for help getting across the stream.

"Hellooo Mr. Frog!" called the scorpion across the water, "Would you be so kind as to give me a ride on your back across the river?"

"Well now, Mr. Scorpion! How do I know that if I try to help you, you won't try to kill me?" asked the frog hesitantly.

"Because," the scorpion replied, "If I try to kill you, then I would die too, for you see I cannot swim!"

Now this seemed to make sense to the frog. But he asked. "What about when I get close to the bank? You could still try to kill me and get back to the shore!"

"This is true," agreed the scorpion, "But then I wouldn't be able to get to the other side of the river!"

"Alright then...how do I know you won't just wait till we get to the other side and THEN kill me?" said the frog.

"Ahh...," crooned the scorpion, "Because you see, once you've taken me to the other side of this river, I will be so grateful for your help, that it would hardly be fair to reward you with death, now would it?!"

So the frog agreed to take the scorpion across the river. He swam over to the bank and settled himself near the mud to pick up his passenger. The scorpion crawled onto the frog's back, his sharp claws prickling into the frog's soft hide, and the frog slid into the river. The muddy water swirled around them, but the frog stayed near the surface so the scorpion would not drown. He kicked strongly through the first half of the stream, his flippers paddling wildly against the current.

Halfway across the river, the frog suddenly felt a sharp sting in his back and, out of the corner of his eye, saw the scorpion remove his stinger from the frog's back. A deadening numbness began to creep into his limbs.

"You fool!" croaked the frog, "Now we shall both die! Why on earth did you do that?"

The scorpion shrugged, and did a little jig on the drowning frog's back.

"I could not help myself. It is my nature."

Then they both sank into the muddy waters of the swiftly flowing river.

The parallels between this story and health reform are so good it requires no further explanation.

Investment Thesis

Health reform has a lot of objectives, but two key goals are to provide coverage to all Americans and to control the growth in health care costs. The legislation currently pending in Congress would achieve partial success in increasing insurance coverage in the country, but it will fail miserably in slowing health care costs. In fact, because there's so little in the bill that deals with health care costs, we think there's a greater probability that reform will actually have the opposite effect, and cause health care costs to rise faster than would have been the case without the legislation. So while health reform is laudable for its efforts to cover more Americans, it just isn't a very good outcome for the country.

Let's get my biases out of the way. I follow health insurance stocks for a living, so naturally I'd prefer that the health insurers continue on in their current form. But since all of the provisions that would have put the industry out of business (like a government run health care plan with significant competitive advantages over existing insurers) seem dead and buried, a seismic shift in how the industry does business over the next few years doesn't seem to be in the cards, even if the group's current valuation multiple says differently. So with the group sticking around for the foreseeable future, my job as an analyst is to objectively predict what future stock prices will do, and I can be just as right with a call that reform will change little and that the group's multiple will return to 10x as I can with a view that the legislation will seriously inhibit the ability of health plans to ever earn a margin again. In other words, as long as the group is still around, I don't have a particular bias on whether it does well or not.

But this piece is about the bigger picture, not stock prices, and my friends in politics tell me that negative advertising always gets more attention, so with that in mind, in the list below I've run through some of the issues I have with the legislation, and the consumer groups that stand to lose the most from it. Some of these topics have been discussed extensively in the press over the past month, while others are the stories I suspect will be receiving a lot more attention in the weeks to come. It's not an exhaustive list, to be sure, but it does provide an overview of what the major challenges will be for the health reform legislation in its final few months of debate. The figures cited below are largely derived from the latest Baucus legislation in the Senate Finance Committee, since this bill has the highest likelihood of serving as the framework for the final legislation.

The legislation will put an enormous amount of pressure on the federal budget, because it does almost nothing to control medical cost trends. The current legislation kicks the cost question down the road, and it will ultimately mean that either significant tax increases or painful benefit reductions will be necessary to cover the cost of what will be the country's third significant underfunded entitlement program. When health reform legislation was first being discussed during last year's election, I thought that if it happened, everyone in the health care system would have to share the pain. Consumers wouldn't get as much and would have to pay more, while all the health care industry groups would have to give up their pound of flesh.

As I sit here today, that is not at all the case. Consumers are being told that not only will they receive better and more efficient care, it will also be less expensive. And all of the industry are giving up a little bit, but what the pharma, med device, and health insurance industries are losing is more of a flesh wound than a pound of flesh. Because of all the unnecessary care that is delivered in the country, it is theoretically possible to improve the quality of care without significant benefit reductions or major cuts. But there isn't much in this health reform bill that really goes after that problem, so it just doesn't seem logical that everyone can get more (or least keep the same) and that no one pays the price without the federal deficit ballooning.

To pay for health reform, Congress is proposing a somewhat equal split between Medicare payment reductions and increased taxes. We'll get into some of the taxes below, but let's be clear on the Medicare payment reductions. Reducing what a hospital or doctor is reimbursed by Medicare does not save any money. Numerous studies and examples show that two things generally happen when Medicare rates are reduced. The first is that providers shift additional costs onto paying commercial customers. This is one of the major reasons why commercial medical cost trends always rise at a significantly faster pace than Medicare trends. Second, providers tend to utilize more. In other words, it seems like providers have a revenue target in mind, and they tend to be fairly agnostic as to whether that goal is achieved through unit cost or through utilization. So cutting Medicare rates does reduce federal government expenditures, but from an overall cost perspective, nothing changes. Health care costs simply get moved from the federal bucket onto employers.

It will be years before we have to deal with the cost question, but that doesn't make it any less important. With most of the reform initiatives not implemented until 2013, it will take at least a year or two to see what the true cost of the new entitlement program is. Whatever the year of atonement turns out to be, it will ultimately mean either that the subsidies to purchase insurance will shrink, the benefits provided reduced, or taxes increased.

The tax on plans with rich benefits will ensnare an increasing number of people each year, because the threshold is set to rise at the rate of inflation, while health care costs grow significant faster than inflation. One of the major revenue generators of the health reform bill is a 40% excise tax on health insurance plans with rich benefits that exceed $8,000 a year for singles and $21,000 for family coverage in 2013. Note that the threshold includes health insurance coverage as well as dental, vision, and other supplementary health insurance coverage.

This provision isn't a big deal today, since $8,000 a year works out to $667 per month, and most people don't have policies that cost anywhere near that much. The key to understanding this excise tax is that the threshold only grows at the rate of inflation plus 1%, and health care costs grow at a significantly faster pace. So it won't be long before many people in the country have plans worth more than $8,000 a year and become subject to the excise tax.

There are some policies out there today that will exceed the $8,000 threshold. These tend to be union health plans, or for employees of city and state governments, or policies for those who work in high risk professions. The latter group appears to be spared some relief along with retired individuals over age 55, since the threshold amount for these two groups will be increased by $1,850 for individuals and $5,000 for family coverage under the latest version of the legislation, but it still isn't clear to us that union leadership will be willing to go along with this provision, since the costs of the excise tax will be passed onto their members.

The taxes on insurance companies will be passed directly onto consumers and employees, resulting in higher premiums that will impact the middle class. The excise tax noted above will technically be assessed to the health insurers, but much like the premium taxes that some states currently charge, the excise tax will be passed onto employers on a dollar for dollar basis. This will result in higher premiums, and in response, employers will likely either slim down the benefit design, or pass on more costs to employees in the form of higher copays and deductibles.

There is a separate assessment of $6.7 billion on the health insurance industry that will also be passed onto consumers in the form of higher premiums. The industry generates around $500 billion in premiums on an annual basis, by our estimate, so a nearly $7 billion annual tax would increase premium rates by about 1% a year, by our calculation. If the tax applies only to commercial insurance (and excludes Medicare and Medicaid), then the impact on premium rates will be even more significant.

If the $6.7 billion tax is implemented in 2010, it will create capital issues for a number of smaller plans in the industry, pushing market share to the larger plans in the industry. As noted above, while this tax will ultimately be passed onto employers and consumers, there is a nuance in the timing. Since this reform bill won't pass until very late in 2009 (if it does at all), most 2010 plans will have already been re-priced by the time companies know whether the tax will be in effect next year. As a result, most plans would be unable to pass the tax onto employers next year, and have to absorb the hit themselves. It would be a pretty meaningful impact, considering that industry profitability is probably about $15 billion or so on an annual basis. Moreover, the tax is not deductible.

Plans like United or WellPoint clearly have no interest in paying the tax, and will do what they can to avoid it, mainly by arguing that it should be pushed until at least 2011. However, in the worst case, United and WellPoint certainly have the capacity and the capital to pay the tax. The same cannot be said across the entire group, as there continue to be a number of smaller non-profit plans with thin operating margins and capital levels that are just above regulatory requirements.

Take Blue Cross Blue Shield of Rhode Island. The company seems pretty well capitalized at the end of 2008, with a risk based capital level of almost 745%, well above the Blue Cross industry average of 700%. However, on a dollar basis, the excess capital held by the Blue amounts to only about $205 million relative to the minimum capital allowed by the Blue Cross Blue Shield Association. In 2008, the Blue generated about $1.76 billion in premiums, or about 0.35% of the total estimated revenue for the industry. That implies that the Blue in Rhode Island would be responsible for paying about $23.5 million of the $6.7 billion tax. With this legislation, over 10% of the excess capital of the Rhode Island Blue would be wiped away.

And that's for a plan that's extremely well capitalized relative to the rest of the industry. Coventry just bought a plan in Kansas this week called Preferred Health Systems. If we look at the larger of the two subsidiaries that was bought, called Preferred Plus of Kansas, it had a risk based capital ratio of 320% at the end of 2008, as it held about $11.6 million of excess capital at the end of the year above the minimum 200% RBC ratio requirement. With $285 million in revenue, Preferred would be responsible for 0.06% of the $6.7 billion tax, or almost $4 million. So the legislation would eliminate about a third of the excess capital of the plan, and reduce its RBC ratio to 280%.

So while paying the tax in 2010 probably wouldn't put many smaller plans out of business, it would create some capital issues that would have to be rectified through higher premium rates in the ensuing years in order to build the capital base back up, which would likely result in further market share gains by the larger plans in the market, resulting in less competition, a direct contradiction to one of the goals of the legislation.

The penalty for not having insurance coverage is too low, and it will result in many people choosing to just pay the fine rather than purchasing insurance coverage. The individual penalty is $750, which is too low, but it will also be phased in over many years. In 2013, for example, there is no fine for not having insurance. By 2014, the penalty is $200, and it rises to $400 in 2015, $600 in 2016, and $750 by 2017. So there really won't be an individual mandate in 2013, but plans will still be required to issue a policy to anyone that wants one, and charge premiums based on community rating, rather than individual underwriting. This is a recipe for adverse selection, which will raise premium costs across the entire health care system. In 2014, when the penalty is $200, the decision to not buy health insurance will be pretty easy for most, since consumers will be faced with paying the $200 penalty once, or paying over $200 every single month to buy insurance. Individuals will be exempt from the excise tax if the premium of the lowest cost option available exceeds 8% of their adjusted gross income.

This decision will be particularly easy for the younger, healthier segment of the population with few health care costs. They will see little value in buying an expensive health care plan, and many will gladly pay the penalty. However, for community rating to work with any reasonable degree of success, young and healthy people are necessary to subsidize the cost of coverage for the older and sicker. Otherwise, you end up with a situation that New York currently suffers through, as the cost of a real individual policy in the state can exceed $1,000 per month because of the guaranteed issue, community rating requirements without an individual mandate.

Along these lines, because of community rating, young people in the population (a demographic that was a major supporter of Obama in the last election) will be forced to pay significantly higher premiums for health care coverage, because they will now have to subsidize the costs of older, sicker workers in the population. Aetna has been particularly vocal on this topic, which is likely because it is one of the newer entrants to the individual market, and likely has one of the youngest and healthiest books of individual business in the market. Senator Jon Kyl, a Republican from Arizona, noted in a Senate Finance hearing that a family of four, including two 35-year-old parents and two children, currently could buy a CIGNA PPO plan in Phoenix for $512 per month. Under the reform plan being pushed by Senator Baucus, Senator Kyl claimed that the price of the policy would nearly double to almost $1,000 a month. While the premium figures may not be exactly correct, directionally, the comment makes a very important point.

The subsidies provided to enable people to purchase insurance through the exchange are not large enough, and will result in a number of people being forced to buy insurance that they can't afford, or pay a penalty. Individuals with modified gross incomes up to 300% of the federal poverty level would be eligible for what the legislation calls a premium credit. The subsidy available will be determined on a sliding scale based on income. For someone with an income at 100% of poverty, premium costs would be capped at 2% of income, while someone at 300% of poverty would have premium costs capped at 12% of income. Those with income between 300-400% would also have premium costs capped at 12%.

The federal poverty level for a family of 4 today is $22,050, so at 400% of poverty, that works out to $88,200. Using the 12% of income threshold works out to nearly $10,600. That's not to say a family of four would need to buy a policy that expensive, but they wouldn't receive any federal assistance or exemption from the penalty, unless their insurance costs exceeded that amount. The point here is that this family of four in our example that is today uninsured will receive almost no assistance from the government in paying for their health care coverage, and it seems unlikely that most families in this situation will have the resources to come up with the $6,000 ($500 per month) it would take in most states to purchase a reasonable family policy.

The result of the small penalty for not having insurance and the relatively small subsidies means that tens of millions of people will remain uninsured following this legislation, so it isn't wise to believe that the uninsured problem will disappear with this bill. Keep in mind that of the 45 million uninsured today, something in the neighborhood of 10 million people are illegal immigrants who will receive no coverage under this legislation. Add to that the millions of people who will choose to go without insurance and pay the penalty, or simply won't be able to afford the cost of the premium, and the uninsured issue will remain a major problem. We suspect this will be a major focus of the Congressional Budget Office (CBO) as they review the changes made by the Senate Finance Committee during the mark-up process, and it will raise the question of whether we should be spending something around a trillion dollars on a health reform bill that could still leave 15-20 million people uninsured.

States will incur significant new costs covering the expanded Medicaid population, forcing them to raise taxes, which will impact the middle class. One of the reasons the Senate Finance bill is less expensive than some of the prior versions is because the SFC chose to push more of the costs of Medicaid expansion onto the states. The legislation would establish 133% of the federal poverty level as the new mandatory minimum Medicaid eligibility level, beginning on January 1, 2014, which would increase the Medicaid population by around 10 million by most estimates. Beginning in 2014, additional assistance would be provided to states to cover the cost of all newly eligible beneficiaries, with states that currently offer no coverage for the newly eligible population receiving more assistance than states that already have programs in place. Between 2014 and 2018, that additional assistance would be adjusted so that by 2019 all states would receive the same level of additional assistance. Additional payments would be made to "high need states" that would cover the full cost of the new eligible population for five years between 2014 and 2018.

For states that are already struggling to pay for their Medicaid programs today, the idea that they will be responsible for covering a huge influx of new members seems impossible. In addition, states are concerned that people currently eligible for Medicaid but not enrolled in the program will come forth in greater numbers. The state of Tennessee has estimated the bill would add about $1 billion in extra Medicaid costs for the first five years after expansion, while California has estimated the expansion could cost around $8 billion each year.

Because states are required to balance their budgets, these additional Medicaid costs will result in major funding cuts to other areas, or more likely tax increases that will cause income tax, sales tax, and property taxes to rise. On this point alone, it's hard to argue that the middle class will be spared from paying for a big portion of the health expansion.

Seniors, particularly those enrolled in the Medicare Advantage program, will see premiums increase and benefit reductions because of the funding cuts proposed in the legislation. While it has been a favorite saying of the Administration to note that seniors will not see benefits reduced because of the proposed Medicare cuts, even the Congressional Budget Office concedes that Medicare Advantage premiums will rise and benefits will be reduced as a result of the funding cuts proposed in the legislation. While it's certainly reasonable to question whether it is fair that seniors enrolled in the Medicare Advantage program receive extra benefits, the fact of the matter is that those benefits will be reduced or eliminated over the next five years if the health reform legislation passes.

With all the focus on providing health insurance coverage to beneficiaries, no one seems to have focused on whether we have the infrastructure and provider access to actually provide care to all these newly insured members. Massachusetts appears to have had some issues with provider access after passing their health reform legislation, as an Urban Institute report earlier this year found that one in five adults reported being told in the past 12 months that a physician or clinic was not accepting new patients or would not see patients with their type of insurance. Lower income residents had greater difficulty finding a physician, according to the study, as 24% of residents enrolled in state-subsidized health plans were told a doctor didn't accept their insurance, compared with 7% of residents with private coverage. So while the legislation may be successful in adding 10 million people to the Medicaid rolls, reducing the uninsured rate through health insurance exchanges, it isn't clear that physicians have the capacity and willingness to serve all the newly insured members, particularly if they are being paid at Medicaid reimbursement rates.

All in, if the health reform legislation currently pending is enacted, it seems the goal of expanding health care access will achieve limited success while making health insurance more expensive for many.