Here at the Institute, we’re conducting research on business model innovation in health insurance. As part of this effort, we’ve learned a lot about the intricacies of the Medical Loss Ratio, or MLR, and its influence on industry outcomes.
It’s worth discussing because, as Clayton Christensen outlined in The Innovator’s Prescription, industry regulations and standards significantly impact an innovation’s ability to succeed.
The MLR is often discussed as a “given” in the US health insurance business model. Therefore, it’s a core factor influencing insurers’ profit formula. It’s also a critical concept for innovators and entrepreneurs seeking to create change in the industry and policymakers striving to make regulation more effective at improving health.
Today, it does the opposite.
How might we change that?
How the MLR works
With the passing of the Affordable Care Act in 2010 came the federal requirement for insurance companies to pay out at least 80-85% of premium revenues for medical care. This is known as the MLR. If the MLR is unmet, insurers incur a penalty and must issue rebates to plan enrollees. The equation is shown below.
MLR = (Total medical spend + Total quality improvement spend) / Total premium
For the purposes of the MLR calculation, “medical care” consists of clinical services and quality improvement efforts. Since the MLR must be 80-85%, there is an incentive for insurers to spend more, up to a certain point, on medical care and “quality improvement.” Prior authorizations, where an insurance company must approve a proposed medical service before the provider executes it, count as quality improvement. However, there is little evidence that the majority of prior authorizations result in higher quality care or improved health outcomes, and in fact, many providers believe it does the opposite.
Conversely, there is a disincentive for insurers to reduce the cost of care or to limit the risk of poor or substandard care. That is because they gain no financial benefit if they do so.
Additionally, if insurers spend money on programs to support non-clinical drivers of health (DOH), also known as social determinants of health, these are generally considered administrative expenses. Therefore, they don’t usually count toward the numerator of the MLR. While this is both a point of confusion and a current flaw in the calculation, DOH leaders are advocating to correct it.
While some have attempted to address this in the past, the most recent ruling leaves ambiguity concerning whether DOH investments can be included in the “quality improvement” category. As a result, the lack of clear inclusion of DOH in the MLR numerator disincentivizes insurers from investing in activities that can improve health and reduce the total cost of medical care.
The requirement to spend a given percentage of premium dollars on medical services, combined with disincentives to reduce the cost of those services or invest in DOH, puts insurers in a conflict-of-interest position. With the MLR’s approach to cap margins, growth can’t occur by reducing costs. Therefore, insurers must look elsewhere for growth.
MLR heavily influences insurer behavior, resulting in unnecessary spending
One of this regulation’s unintended consequences was that it further fueled vertical integration and incentivized insurers to acquire and/or establish provider organizations. By integrating provider organizations into their parent companies, insurers can retain a portion of their medical “costs” as revenue for another line of business.
Most large insurers have executed this vertical integration and revenue flywheel strategy, which is evident from UnitedHealth Group’s Optum division, CVS Health’s acquisition of Oak Street Health, Humana’s Centerwell offering, and more. Clearly, this further exacerbates the conflict-of-interest position insurers find themselves within, as there is an additional disincentive to reduce care costs and poor or substandard care when one receives revenue for providing that care.
This directly conflicts with the desired outcomes of demand-side stakeholders (e.g., government and employer plan sponsors and consumers), who want the best care at the best cost.
Based on these characteristics, the MLR calculation needs reevaluation and change. Specifically, it should clearly include DOH expenses in the numerator to incentivize insurers to invest in health-promoting, non-medical factors for members.
Regulation influences business model innovation
Given MLR’s impact on insurers’ profit formulas and business models as a whole, does this mean innovation in the field isn’t possible?
No.
The regulation is simply a constraint that innovators must acknowledge and consider as they develop new business models to bring about change.
In our report, due later this year, we accept the current MLR regulation as a given in today’s environment, and therefore, our business model innovation recommendations consider it.
Even with the MLR, business model innovation and industry transformation are possible.
Change will just occur faster if the MLR is reevaluated and altered to eliminate insurers’ current conflict-of-interest position.
