What goes into the cost of health insurance?

There are many common misconceptions about the cost of health insurance. One of those misconceptions is that health insurance premiums are comprised mostly of profits and administrative costs (e.g., executive salaries). While profits and salaries indeed factor into premiums, the single largest component of your health insurance premium is medical costs. In order to show you exactly how much medical expenses drive the cost of health insurance, consider the following, which is based on premium data taken from taken from the OHIC’s December 2006 report, “The Effectiveness of the Small Employer Health Insurance Availability Act in Promoting Rate Stability, Product Availability, and Coverage Affordability.”

What costs factor into the price of health insurance?

The price of health insurance can be separated into three broad components:

(1) medical costs—sometimes referred to as “claims expense,” medical costs are the costs incurred by the insurance company when it pays claims for medical care. These costs often include indirect costs associated with the provision of medical care, such as quality assurance monitoring, case and disease management programs, and utilization review.

(2) administrative expenses—these include all non-medical costs incurred by the insurer, such as salaries and benefits for employees, commissions and fees paid to brokers, advertising, rent, marketing, enrolling members, billing, processing claims, provider contracting, network management, legal costs and all other services required to maintain and keep the insurer operational. Essentially, these are all the non-medical operating expenses of the insurer.

(3) profit or contributions to surplus (or reserves)—insurance companies typically build profit and/or contribution to surplus (i.e., the company’s retained earnings) into their proposed rates. To the extent that expected profits and surplus are built into rates, the insurer must also include an amount to cover income taxes (and other premium taxes, if applicable). An offset for investment income is also typically reflected in the rates.

What percentage of my health insurance premium is each of these components?

Medical costs—The medical cost component is by far the costliest part of your health insurance premium. A recent study of the Rhode Island small employer market (employers with 1 to 50 employees) revealed that medical costs for Blue Cross & Blue Shield of Rhode Island (“Blue Cross”) were approximately 84% of total premium. This means that in the small group market, 84 cents of every premium dollar paid to Blue Cross goes toward medical expenses. At UnitedHealthcare of New England, Inc. (“United”), the same study showed that approximately 77% of total premium went to pay for medical costs.

Administrative expenses—In the small employer market, United’s administrative expenses are approximately 18% of premium. At Blue Cross, approximately 14% of the premium is required for administrative expenses.

Profits/contribution to surplus—In the small employer market, United’s administrative contributions to reserves and profits are approximately 5%. Blue Cross’ contribution to reserves is approximately 2%.

How does this breakdown translate into dollars and cents?

These percentages can be seen in the following 2005 small employer market premium data. In 2005, Blue Cross’ small employer base rate was approximately $399/month. United’s was approximately $392 during the same period.

These premiums break down as follows:

Blue Cross—$399 ($335.16 for medical expenses, $55.86 for administrative costs, and $7.98 for contribution to surplus)

United—$392 ($301.84 for medical expenses, $70.56 for administrative costs, and $19.60 for profits/contribution to surplus)

The real culprit here is medical costs. Even if Blue Cross and United had slashed their 2005 small employer market administrative costs and profits by one-third, their base rates for 2005 would have still been quite high. Blue Cross' rate would have been $377.30/mo. and United's would have been $361.35/mo. It is the cost of medical services that is driving the cost of health insurance higher, not administrative costs.

In my next few blog entries, I will discuss the issue of rising medical costs and current approaches to medical cost control.

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