Insurance costs and health-care reform: Are health insurers making huge profits?

Are health insurers making huge profits?

Mar 5th 2010, 14:15 by M.S.

YESTERDAY Barack Obama dropped in on Kathleen Sibelius‘s meeting with executives of America’s top five health insurers and read a letter from a constituent. Natoma Canfield, a self-employed house cleaner, had carcinoma 16 years ago; it has been in remission for 11 years. Last year Anthem Blue Cross, who provide her with a high-deductible ($2,500) individual plan, raised her premiums 25%, to $6,075. This year they’re raising them another 40%, to $8,500. Ms Canfield  closes her letter, “Please stay focused in your reform attempts as I and many others are in desperate need of your help.”

There’s no doubt that the Obama health-care reform bill would help Ms Canfield; she’s exactly the kind of person (low-income, pre-existing condition, self-employed) it’s designed to help. But in their report ABC’s Jake Tapper and Sunlen Miller quickly segue to the related issue of whether insurance companies are greedy monsters who hurt policyholders by raking in big profits. They say no.

Certainly no one can easily defend the health insurance industry policies of denying coverage to those with pre-existing conditions or dropping coverage for individuals once they get sick. But Dr. Mark J. Perry, a professor of economics and finance in the School of Management at the Flint campus of the University of Michigan, has noted that, according to data from Yahoo business, the health insurance industry, with an average profit margin of 3.3 percent, is the 86th most profitable industry.

As the Washington Post’s Ezra Klein notes, that’s a lower margin of profit than many other players in health care, such as the pharmaceutical industry (16.5 percent), “health information services (9.3 percent), home health care (8.4 percent), medical labs and research (8.2 percent), medical instruments and supplies (6.8 percent), biotech firms (6.7 percent), and generic drug manufacturers (6.6 percent).”

It’s commendable that Mr Tapper and Ms Miller take the time to present the underlying issue. But there are a couple of things that are off here. The main problem is that “profit” isn’t the right measure to use in this context. Profit is a deceptive measure when used with insurance, because the amount of money that flows through insurance companies is vastly disproportionate to the work they do or the value they add, just by the nature of the business. To put it more simply: private insurance companies’ “costs” are probably about half of all the healthcare spending in America, since that’s the proportion they cover. And their revenues are somewhat higher than that (currently about 4.3% higher, according to Yahoo business). But it’s not as if they’re actually doing half the work in America’s health-care system; they’re just collecting premiums and paying bills, plus a lot of administration and advertising. If I had a business that consisted of people giving me $100 bills and me paying them back $96, it would be silly to describe that as a very low-profit industry.

This issue was well treated in a thread on Tyler Cowen’s website last fall. As commenters suggested, the better measurement is not profit, but return on invested capital (ROIC). ROIC measures how much money it takes to set up and run an insurance company, versus how much profit it brings in. Unfortunately it’s not so easy to find good ROIC figures. The closest equivalent Yahoo business has is return on equity (ROE), but that can vary according to whether firms are financed through equity or debt. Still, across the entire industry this hopefully evens out a bit, and what it shows is that ROE in health insurance is about 16.1%, roughly the same as for the health-care industry as a whole, and a good deal higher than the average ROE in most sectors of the economy.

If what you’re interested in is how much we can cut health-care spending by eliminating insurance-company profits, then what Ezra Klein says is true: it’ll help, but not too much. But it’s misleading to use the industry’s low apparent profit margins to make it appear as though insurance executives are selfless folks who are just trying to eke out a little profit while doing their best to help people. The health-insurance industry provides very healthy returns to investment, and its executives want to make sure it continues to do so. The question is whether their efforts to pursue healthy returns to investment are good for Americans as a whole. Last year Wellpoint, which owns Ms Canfield’s insurer (Anthem Blue Cross), showed profits of 18%, far above the industry average; its ROE was 27%. Ms Canfield paid them over $5,000 more than they paid out in claims in 2009, and the following year they hit her with rate increases so punitive they seem designed to push her, and her pre-existing condition, off their rolls, so they can book their profit and drop her risk. These are the incentives that exist for Wellpoint; this is how our system works. It’s broken. And with regard to these particular problems, Obamacare would help fix it.

(Photo: “Dollar Sign” by Andy Warhol. Source: Christie’s Images via Bloomberg)

Insurance costs and health-care reform: Are health insurers making huge profits? | The Economist.