How Are Health Insurance Premiums Calculated?

how are medicare premiums calculated

If you thought that everything you heard from the politicians and press about health insurance was correct, you got the wrong impression.  Whether they lean Democratic or Republican makes no difference.  You probably only heard the facts that best fit their own agendas.

During the Health Care Reform debates of 2009-2010 the politicians and press implied that “evil” health insurance company executives picked premium levels that would ensure them the biggest bonuses possible.  They implied that insurance company executives could be replaced with a chimpanzee and a dart board.

In actuality, premiums are calculated with more in mind than profits and executive bonuses.

Perhaps the most important person in the premium calculation process is called an, “Actuary.”

An actuary is a specialist in statistics.  By using the “Law of Large Numbers ” and assuming that everyone has the same chance of needing medical care during the year, the actuary can come pretty close in predicting how much the insurance company will have to pay to medical providers for its policy-holders.

Unfortunately, the actuary will not be able to predict who will need medical care.  He will only be able to say how many will get sick out of the group and how much their medical bills will be.

The actuary’s job is to tell the CEO how much money will be needed to be collected from policy-holders during the year to pay for medical expenses.

A CEO is not a greedy boogey-man looking for ways to scam people.  He is responsible for everything the insurance company does.  The CEO may delegate duties to other people but ultimately, he is responsible.

The CEO is very similar to the President of the United States.  He considers everything that is brought to him and either returns it as not acceptable (veto) or approves an idea.  Premiums are just one of the many decisions the CEO must make.

After the actuary has completed his predictions, the CEO, or his staff, will add the operating costs and desired profit margin to the premiums that the actuary recommends.  The result is the premium that you must pay if you want health insurance.

What the federal politicians did not stress during the Health Care Reform debates is that each state already has laws on the books to regulate insurance premiums.  According to state laws, the insurance company is required to collect enough money from policy holders to pay for all of their anticipated medical bills.

The insurance company must be able to pay when 9-year-old, Johnny has

to see the doctor because of an ear-ache.  The insurance company must also pay the bill when grandpa has heart surgery.

In addition to medical bills, an insurance company is the same as every other type of company.  It must pay employees wages and benefits.  It must also pay for other operating expenses like office buildings, utilities and supplies.  The insurance company must also collect enough premiums to pay these overhead expenses.

If there is any money left over at the end of the year, the profits are either paid out in the form of executive bonuses, dividends to stock-holders or placed in reserve for future emergencies.

State law is not the only thing that must be considered.  The PPACA added a new restriction to the premium calculation.  The new Medical Loss Ratio requires that insurance companies spend 80-85% of the money they collect through premiums on medical bills.  If they do not, they must give every policy-holder a pro-rated refund.

Our economy is built on competition.  If a consumer does not like the price of a product, they are free to either not buy it or purchase the same product at a lower price from someone else.

In spite of what politicians say, health insurance executives are not “stupid.”  They understand that if they inflate the price of health insurance too much, their healthy policy-holders will elect to either do without health insurance or buy from a different insurance company.

If that happens, the insurance company will be left with only policy-holders who are sick.  The insurance company’s only options would be to increase the premiums they charge already sick fold or use the money they are required by state law to hold in reserve for emergencies.

If they elect to use the money in their reserves and the balance dips below what the state law requires, the insurance company will have no option but to go out of business.

Health insurance company CEOs have a difficult balancing act to do.  By law they must make certain that premiums are high enough to pay the doctors, hospitals and pharmacies what they want.  However, they cannot make them so high that people cannot or refuse to pay their premiums.

I am not an apologist for health insurance executives.  I am certain that there is some truth to the accusations that politicians have made against them.  I do, however, understand that their job is not one to be envied.  Much like our national CEO, Barack Obama, they have to make some unpopular decisions.


Category: Insurance

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