- Blue Shield of California (BSC) has committed to keeping profits at 2% of revenues or less (and returning any excess).
- The commitment is economically meaningful: $180M of 2010 revenues will be returned; just a few years ago, BSC made 4.9% net income and, under its promise, would have had to return 2.9% of revenues.
- However, given BSC’s very large reserves, it has plenty of capital to fund investments or, if necessary, absorb losses.
- While the PR aspects of the move are interesting, it seems unlikely that this is an attempt to defuse public support for rate regulation in California. Other insurers would have to make the same commitment and that is not plausible for the for-profits (they have historically not followed BSC leads in any case); also, BSC unilaterally reduced pricing before in the recent rate hike controvery without doing much to blunt pressure for the legislation.
- On the other hand, there are several industry scenarios (e.g., permanent flattening of the underwriting curve or the public utilities hypothesis) for which the BSC move could an attempt to secure advantage by being a first-mover in profit targeting.
- Another view is that BSC is trying to push out some competitors who are close to throwing in the towel in loss making markets in California (e.g. individual). By committing to lower profits, BSC is signaling its firm intention to make California a tough market through aggressive pricing. Getting another player to withdraw now would be attractive because the pie is going to get a lot bigger with the reform “big bang” in 2014.
This week, BSC said it would limited its net income to no more than 2% of revenue. Income earned above 2% will be returned to its customers or donated (e.g., to promoting accountable care or to their Foundation). For an industry accustomed to managing underwriting cycles by using the profits in fat years to cover losses in lean years, imposing a unilateral profit ceiling sounds bold!
The ceiling is meaningful. BSC made less than 2% in 2008 and 2009 and expected the same for 2010 (per a quote up on BSC FAQ site: “As a not-for-profit health plan, Blue Shield of California had net income of less than two percent of revenue in 2008 and 2009 and we expect similar results in 2010”. I quote in full because presumably the FAQ will be updated at some point). But if 2010 earnings over 2% were a surprise, it remains a large amount of money to return especially given emerging rate regulation. Also, 2008-2009 was the bottom of the latest underwriting cycle. At the previous peak of 2004, BSC earned 4.9% net income. No more of that going forward!
One interpretation is that this is a Hail Mary promise to defuse AB 52, looming California legislation to implement health insurance rate regulation. By committing to keep profits low, the theory might go, BSC is seeking to reduce the pressure on law makers to pass the legislation. This seems unlikely: real success would require more than just BSC (with its 9% of the market) making such a move and it is hard to imagine that the big for-profits would voluntarily match it. Besides, insurers agreeing to lower rates has typically been taken as evidence that they were overcharging in the first place (see the end of this press release from the California Insurance Commissioner). If this was the intent, I would argue that, at best, BSC will accrue some limited PR gains (it certainly needs some) but not, on its own, deflect AB 52.
Other strategic hypotheses seem more likely:
(1) The underwriting cycle has been mastered; time to reflect that in the economics. Take a look at the chart in this report from Goldman showing underwriting margin for the BCBS system and the for-profits over past forty years. Of note: the most recent down-cycles have been short and dipped less deeply, while the upswings have lasted longer. Implication: health insurance is not as risky as it once was (one reason reserves are going up); therefore, you do not need to extract as much cushion in the up years to weather the down years. Generally, profitability should flatten out. If true, then BSC’s promised profit ceiling is simply an attempt to get some early marketing mileage from what will be an inevitable for all. It is also important to note that BSC’s very strong reserve position (1344% as of September 2010 compared with a minimum 375% under Blues system rules) provide it with plenty of cushion to be a first mover.
(2) Public Utility Model will become a reality, let’s make sure we are one of the last ones standing. The idea that health insurers will become public utilities with regulated profit margins has been circulating for a while (see Covert Rationing Blog for a great discussion of the concept). The MLR floors do not quite get there, because profits aren’t directly controlled, nor are premiums or medical costs. But a few other moves underway would “lock in” profits through arithmetic: California’s closer regulatory scrutiny of premium rates is one step. And other states are exploring options to set rates for providers (e.g., see proposed cost control legislation in Massachusetts). Fix a few of these variables and the profit margin will simply become a consequence of the math…and public utility economics are born. So, under this scenario, what might BSC be up to? In public utilities, scale is critical. Only the big will remain in business. Right now, BSC is a pretty distant fourth vs. its fraternal twin Blue Cross California / Wellpoint (~25% share), Kaiser (~20%) and United (~13%). Holding profits (and prices) down now will help BSC bulk up on market share and then have a better shot at being one of the big utilities at the end of the day.
(3) Competing plans are losing their stomach for losses, let’s push them out of the market before the 2014 newly insured “land grab” begins. The California individual market has be costing the major players a lot of money at the same time they have been blugeoned in the press for rate increases. BSC played a very interesting role in those discussions:
- Initially, it looked like BSC tried to “lead a resistance” against further regulatory review from a newly elected insurance commissioner. Back in January, 2011, the California DOI asked each of the major insurers (on 1/6 and 1/11) for 60 days to review proposed rate hikes. BSC was the first to officially react and said no (on 1/14); shortly thereafter, competitors all said yes (1/27) and BSC was forced to change its mind and follow suit (1/31). BSC certainly felt left out in the cold on that one!
- After that, BSC turned the tables on the competition: As the DOI was reviewing proposed rate hikes, BSC decided (3/15) to withdraw its requested rate increase unilaterally and promised no more increases for the rest of the year (despite saying they would lose money on the business). The other insurers quickly made agreements (3/21) to reduce rate hikes and delayed implementation. If it is true — as most players say — that individual is a loss market, these compromises only made that market less attractive.
Under this interpretation, BSC’s profit ceiling commitment is upping the ante on the individual market: Wellpoint, United, Aetna can continue to play in a loss-making market by cross-subsidizing from group. BSC’s reduced margins will put pressure on group pricing and BSC’s competition will have a harder time squeezing out enough group margin to pay for the individual losses. Something will have to give. And once a player withdraws from individual, they will have a very hard time getting back in. This strategy is particularly intriguing given the emerging view that the Exchanges will be a lot bigger than was originally thought because a lot more employers will opt out of providing coverage and people will end up on the individual market starting in 2014.
By the way, there is an additional competitive benefit: the pay-outs by BSC occur in the year following the profit gain above target and will be paid to customers signed up in the following year. Consider it a little reward to increase stickiness. In a world of challenging customer acquisition (driven e.g. by reduced broker commissions under MLR rules), increasing stickiness is good business.
It is hard to say which hypothesis guided BSC’s decision; but a clever strategy is one where the move you make is the right one under several different scenarios. And BSC might have done just that.
- Insurers who stick to the core business are going to see profits erode as more high-reserve players like BSC put pressure on pricing. Business models must continue to evolve towards specialty products and adjacencies.
- Competitive moves should be evaluated from the view of what they mean under the reform 2014 “big bang”. Players may be trading off short-term unattractive economics to secure bigger gains in the long run – especially if they have the strong reserve positions that grant them medium-term strategic flexibility.
- Look for more public pressure on non-profit Blues in other markets to make similar commitments.