Experience Rating, Medicare, Medicaid, and ERISA
The insurance functions of Blue Cross and Blue Shield plans were pretty simple in their early years. The plans engaged in community rating. This simply meant that all of the subscribers of a plan were in one large risk pool. Insurance premiums were determined essentially by projecting the growth of insurance claims and dividing by the number of subscribers. Commercial insurers began to challenge this in the 1950s through experience rating, and by the 1960s, experience rating had driven out community rating.
Suppose an insurer is able to identify a group of people who are reasonably healthy and, therefore, low utilizers of care, relative to others. Teachers or bank employees may be good examples. The insurer could approach these groups and promise them an insurance premium that reflected their likely lower claims experience. This is experience rating. While community-rated plans, such as Blue Cross, include low-, medium-, and high-cost sub- scribers, the experience-rated plan disproportionately includes low-cost sub- scribers. As a result, it can provide the same coverage at a lower premium and still make money. Moreover, the community-rated plan will experience cost increases simply because it loses its low-cost subscribers.
This was the commercial insurers’ approach. They offered lower premiums to groups with low claims experience. Blue Cross and Blue Shield were forced to switch from community rating or face a future in which they were the insurer of only the highest-cost subscribers. In the 1960s, the last Blue Cross plan gave up community rating.
The 1960s saw the enactment of the Medicare and Medicaid programs, during the Lyndon Johnson administration. Medicare provided coverage for hospital and physician services to those over age 65 who were covered by Social Security. With the lens of today’s private health insurance plans, Medicare looks strange. This is because, as Congress cast about for an insurance model to follow, it focused on the Blue Cross and Blue Shield models of the time. It created separate hospital (Part A) and physician (Part B) coverage that reflected the nature of the coverage under each type of plan. It also followed Blue Cross and Blue Shield in paying hospitals based on costs and physicians based on their allowable charges.
Medicaid is a joint federal-state program designed to provide coverage to the poor. It was essentially an expansion of the 1960 Kerr-Mills Act. The federal government specified the nature of coverage and eligibility across broad parameters, but allowed the states considerable flexibility in deciding how much of each type of service was to be covered and what income threshold was to be used for eligibility. The federal contribution was pegged to the relative poverty in a state and ranged from 50 percent in the most affluent states to 83 percent in the poorest.
The key event in the 1970s with respect to private health insurance actually was triggered in December 1963, when the Studebaker Corporation closed its U.S. automobile plant in South Bend, Indiana, and left an under- funded pension plan. Congress responded to this and other pension concerns in 1974 with the Employee Retirement Income Security Act (ERISA). This large piece of legislation was designed to protect defined benefit pension plans. It did this largely by providing tax incentives to encourage employers to prefund their pension plans and by requiring participating pension plans to contribute to a government-affiliated reinsurance fund to bail out future pension plan defaults. The legislation also included a relative handful of provisions dealing with “welfare plans”—that is, health insurance plans.
Employer health insurance plans that were self-insured under the terms of ERISA were subject to the federal ERISA statute and not subject to state insurance regulation. Large employers had argued that they often had plants in several states and that trying to provide consistent and uniform coverage was made difficult by the differing insurance regulations that the states imposed. Moreover, efforts to self-insure their workers were hampered by state insurance regulations that were not designed for such efforts. Under ERISA, self-insured plans were not subject to state insurance regulations dealing with reserves or coverage requirements, and they were not subject to state premium taxes.
ERISA resulted in a quiet revolution in the health insurance industry. Heretofore, large firms were usually experience-rated through an insurer. This meant, in essence, that a firm was responsible for its own claims experience and paid the insurer to administer the plan. If such a plan was “fully credible,” meaning that its premiums were based solely on its own claims experience, the move to self-insurance was a no-brainer. The firm bore the same claims risk, but now it could shop for a less costly claims administrator, or it could undertake those activities itself and, in the process, avoid state premium taxes of 2 to 4 percent. Moreover, somewhat smaller firms could incur the claims risk over some range of losses and buy stop loss coverage for big individual claims or for aggregate claims that exceeded some threshold. Medium- and even small-sized firms could be self-insured.
These events happened at the same time that mainframe computer processing was rapidly dropping in price. In the 1960s, large conventional insurers had comparative advantages in both bearing claims risk and in claims processing. They lost both in the 1970s. ERISA meant that there was potential entry into the risk-bearing segment of the business. Efforts to extract more than competitive returns from this segment would lead to the entry of many self-insured employers providing their own coverage. The advent of low-cost mainframe computing meant that the claims-processing segment was also competitive. If the large insurers attempted to charge more than competitive processing fees, new providers would appear and undercut them. Indeed, a new industry emerged—third-party administrators (TPAs) that handled the claims processing of self-insured firms. Insurers opened new lines of business as well, such as ASOs (administrative services only). Through these lines, they also provided claims-processing services to self-insured firms. By 2001, 50 percent of insured workers were in a self-insured plan (Gabel, Jensen, and Hawkins 2003).
Ironically, ERISA also spurred more state insurance regulation. Prior to 1974, there were virtually no state insurance coverage mandates (Jensen and Morrisey 1999a). However, by the close of 2005, there were over 1,800 individual insurance mandates (Council for Affordable Health Insurance 2006). Providers and concerned citizens often ask the state legislature to require insurance companies operating in the state to include specific coverage. They may, for example, demand that in vitro fertilization be covered like other procedures. In the period prior to ERISA, proponents of such legislation faced opposition, typically from large employers. However, after ERISA, larger employers were unaffected by such laws, and the legislative scale tipped toward the proponents.