Establishing a Medical Loss Ratio
States may set a minimum percentage of premium dollars that must be spent on medical care (as opposed to administrative costs), called a medical loss ratio. When insurers initially set their premiums, they must estimate what they will spend on medical claims over the course of the year. In some states, if an insurer’s expenses for medical claims are lower than anticipated and it does not meet the medical loss ratio, the insurer must refund the excess premium dollars to consumers at the end of the year.
Example: New Jersey requires individual and small group insurers to spend at least 75 percent of premium dollars on medical care. At the beginning of the year, when insurers set their premiums, they file a certification that medical claims will exceed 75 percent of premiums. At the end of the year, if the amount spent on medical claims is less than 75 percent of collected premiums, they must issue refunds to enrollees in their health plans to make up the difference.
The New Jersey Insurance Department reports that this is an easy system for the state to administer—insurers know whether they have met the standard, and they process refunds when they do not. What’s more, in recent years, the small group market has been competitive, and on average, insurers actually have a higher medical loss ratio than the minimum 75 percent—they spend about 80 percent of premium dollars on medical care. However, not all carriers meet the threshold, and some carriers do issue refunds in the small group market.
The individual market is less competitive, so the medical loss ratio has therefore helped control premiums, largely by requiring insurers to set premiums to meet a loss ratio of 75 percent. Also, some insurers have been required to issue refunds.¹
¹The Actuary further explains, “In the SEH [small employer health] market, prices are set by competition. Currently, competition seems to set the price at a loss ratio of about 80 percent. [Insurance] Carriers can still pay claims and administrative expenses and make a nice profit at an 80 percent loss ratio. But some carriers may set their loss ratio closer to 75 percent, giving up market share for more profit on each policy. Because claims are not predictable, the loss ratio may fall below 75 percent because claims are less than expected. The refund formula in this case limits the extra profits that the carrier gets in this good year. The carrier (involuntarily) shares its good fortune with the policyholder.
The IHC [individual health coverage] market is not as competitive. If there was not a 75 percent minimum loss ratio requirement, a carrier might set its premiums higher, to attain a loss ratio of 70 percent or 65 percent. Frankly, many carriers do not care whether they sell any individual policies or not. And, with a lower loss ratio, they might get a higher profit on each policy they sell. So, the 75 percent loss ratio requirement actually establishes a maximum that the carrier can charge in this non-competitive market. This is what we mean when we say that the loss ratio keeps premiums down in the IHC market. Refunds in the IHC market are just a natural consequence of this pricing—if a carrier is pricing to have a loss ratio of 75 percent, it is likely (under simple assumptions, a 50-50 chance) that experience will be better than expected and a refund will be paid.” (Source: Personal correspondence with Neil Vance, Chief Actuary, New Jersey Department of Insurance, August 3, 2006.)