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Commentary

Avik Roy, 05.07.10, 6:00 AM ET

One of the quirks of ObamaCare is that most of its key provisions don't go into effect until 2014. But in any 2,300-page law, there are bound to be provisions that have immediate and unintended consequences. One such provision is Section 2718, entitled "Bringing Down The Cost Of Health Care Coverage."

If only. Section 2718, at a mere 802 words, goes into effect first thing next year and will have a huge impact on the private insurance market. It is the section that converts private insurers into regulated utilities by effectively placing a ceiling on their already-low profit margins. Depending on how the law is implemented by Kathleen Sebelius, the Health and Human Services secretary, it could end up driving many insurers out of business.

It all hinges on a regulatory technicality: In the context of insurance, how do you define "profit"?

One of the key metrics for comparing the financial performance of different insurance plans is what is called the "medical loss ratio," or MLR. The MLR is the percentage of an insurer's premium revenues that are spent on actual medical care. The largest insurers typically have MLRs in the low 80s: In 2008 Aetna's MLR was 81.3%; Humana's was 79.3%; UnitedHealth's was 81.5%; and WellPoint's was 83.6%. After insurers spend on beneficiaries' health care, whatever money remains is used to pay for labor, expenses and taxes and, if anything is left over, to generate a small profit.

There are three large markets for health insurance sold in the United States: large group plans for companies with 50 or more employees (ObamaCare increases this to 100), small business plans and individual plans. Due to economies of scale, large-group plans cost less to administer than small-group plans, which in turn cost less than individual plans. In addition, large employers have more negotiating power with the insurance companies than small groups or individuals, and thus can bargain for lower premiums.

All this means that in the large-group market, insurers can spend relatively more on health-care expenses. For example, UnitedHealth's 2008 loss ratio was 81.5% overall and 82.7% for large groups. But for individuals, it was 67.8%.

Now enter the world of ObamaCare.

Section 2718 requires that from Jan. 1, 2011, onward, MLRs in the small-group and individual markets must be above 80%, and above 85% in the large-group market. Many companies will need to lay off employees or use other cost-cutting measures in order to meet these congressional targets. Some important services offered by insurance companies, such as 24-hour nurse hotlines and disease management programs for preventive care, are classified as administrative costs, and not medical expenses, solely because of the technicality that they are not payments to a third party. These programs, if they cannot be reclassified to count as part of the MLR, will get shut down--to no one's benefit.

Given that the typical profit margin for a health insurance plan is under 5%, there isn't much fat on the bone. It may well be impossible for United to move its individual-market MLR from 67.8% to 80%; instead, the company may decide to exit the business altogether.

The worst-case scenario--the one with dire consequences for the insurance market--revolves around how exactly Secretary Sebelius decides to calculate these medical loss ratios. Since health insurers are already regulated at the state level, national insurers like WellPoint have discrete plans in each of the states in which they operate. The loss ratios of these plans can range from 30% to 170%, depending on how well or poorly each plan is established in its respective state. Averaging together these disparate performers allows the insurer to keep its ill-performing plans in operation.

Will Sebelius allow insurers to meet ObamaCare's MLR mandates on a national basis, or will she require that each discrete, state-based entity to jump through the hoop?

If she decides the former, private insurance market can survive by raising premiums. If she decides to calculate loss ratios on a state-by-state basis, it will cause massive dislocation. Insurers will exit the states in which they have high fixed administrative costs (due, say, to low market share), in order to keep their units in other states in business. In essence, it will reward well-established incumbents in each state and reduce competition. The likely outcome: more insurance monopolies at the state level, which will doubtless be decried by the very people who caused them.

Over the next few months, Secretary Sebelius and her staff will work around the clock to plug the various regulatory holes in the Affordable Care Act. It is a massive undertaking. Sebelius and her White House compatriots seem to enjoy demonizing insurers. Will they spend enough time on a few sentences in Section 2718 to avoid blowing up the private insurance market? Would that even bother them? We will find out soon enough.

Avik Roy is an equity research analyst at Monness, Crespi, Hardt & Co. He is a regular contributor to Forbes' The Science Business and blogs on health care policy at The Apothecary. He has no rating on any of the HMOs mentioned in this story, although he regularly writes about the sector.