How Do Medical Insurance Companies Make Money

The question on the profitability of health insurance companies, ironically, comes to me when a consumer (or friend) realises that he's been paying too much in premiums over the years without making a single claim. I wonder whether to be happy for him or sad for him. But one thing is clear, health insurance companies make money exactly the way all other insurance companies earn i.e. through the difference between premium received and claims paid

In this article, I will show you finer aspects of this interplay of money-in and money-out including how health insurance companies make more money with small tweaks, how they control losses and how products are smartly designed to improve the health insurance company profits.

How Health Insurance Companies Calculate Premium

Recently I published an article on how to calculate insurance premiums that focused on the end user. Now, I'll turn the picture upside down and give you sights on how health insurance companies make money.

Let's start with a quick summary of what we learnt on the science of computing insurance premiums

Step 1 – Determine the Frequency

Frequency is the probability of the event actually happening.

Since insurance is for future events which have to be forecasted, the actuaries in a health insurance company lay down predictions based on historical data, existing risk pool, channels of sourcing new business and underwriting rules. A combination of these can give a fairly good idea of what percentage of the policyholders are likely to claim for particular procedures.

For example – let's say we want to establish the frequency for cataract treatments in our medical insurance plans.

We start by examining the chances of cataract (event) happening which is split by multiple factors like age, gender, location, occupation, income, race, medical history etc. We are using only age in our study and we find the following table for our consideration:

Age Group	Incidence of Cataract (average of 10 years)
0 to 20	0.3%
21 to 40	0.8%
41 to 60	2.0%
61 to 80	64%
81 and above	47%

Now, let's say a large part of sourcing thus far has been from consumers who are in the age group of 25 to 40 years. For this risk pool, a frequency of over 2% for cataract treatment is anywhere from 20 to 30 years away and hence, the actuaries will assume a frequency for cataract at not more than 2%.

However if our policyholder base has a high senior citizen bias, then we would have certainly assumed a frequency upwards of 60%, given the historical data available with us. We shall study more about this when we discuss the senior citizen plan from Star Health.

Recommended article: 8 Easy Steps to Compare Senior Citizen Health Insurance plans

Step 2 – Determining the Severity

After estimating how likely an event (i.e. some treatment/procedure that leads to a claim) will happen, it is time to estimate the claim cost when such an event happens.

Severity is the term used to estimate the average claim per event.

Here too a lot of data is used to understand the average claim amount. In my opinion, this is even more difficult than estimating frequency because this is a function of many variables of hospital used (government v private), location (metro v Tier 1 v Tier 2), plans sold (sum insured), medical complexity (related to age and pre-existing diseases) etc.

Insurance companies try to limit severity in cases where the frequency risks and claim amount are too high. For example – total knee cap replacement is often excluded in group health insurance policies where parents are included. If not, there is a sharp sub limit that is applied so that the cost of claim (severity) can be controlled.

Step 3 – Calculating Health Insurance Premium

A major part of the health insurance premium calculation is the Frequency x Severity model.

Normal Loss = Frequency x Severity

Normal loss is the bare minimum premium that health insurance companies will charge to ensure that they don't make underwriting losses.

The most profitable health insurance companies in the world are the ones who earn an underwriting profit. An underwriting profit is what remains when losses on account of claims and administrative expenses have been deducted from the earned premium. This does not include any investment income earned on held premiums. We'll learn more about this in the next section

Let's go back to our cataract example.

Age Group	Frequency	Frequency	Normal Loss
0 to 20	0.3%	₹27,000	₹81
21 to 40	0.8%	₹27,000	₹216
41 to 60	2.0%	₹27,000	₹540
61 to 80	64%	₹40,000	₹25,600
81 and above	47%	₹40,000	₹18,800

We see in the above table that the normal loss for different age groups is different with the highest normal loss going as high as ₹25,600 for a policyholder in the age group of 61 to 80 years who has crossed the 2 year waiting period.

Ofcourse, it is possible that the actuaries might reduce the normal loss assuming that some senior citizens might have already had their cataracts done before but they can also increase the normal loss, if they feel the price of cataract surgery is going to increase in the coming 2-5 years. This is also the process that is used by health insurance companies to decide what to cover.

Now, a health insurance policy does not just cover cataracts. It covers a range of illnesses, treatments and conditions. The process remains exactly the same. The actuarial team will create frequency charts for different treatments, mesh it with other variables and apply the severity on top of it to find the normal loss.

Step 4 – Apply the Additional Health Insurance Pricing Parameters

There are five elements to pricing of health insurance policies:

1. Normal loss
2. Cost of Acquisition
3. Operational Expenses
4. Investment Income
5. Profit Margin

We just learnt about how normal loss is calculated in a health insurance scenario.

Very briefly, here's what the others mean:

Cost of Acquisition is the expenses related to advertising, branding, printing brochures, sponsoring events, commission to agents, online marketing etc. As per IRDA's remuneration structure, agents can receive a commission of 15% on health insurance premiums.

Operational Expenses includes expenses for operating branches, printing renewal reminders, printing forms, technology systems, customer service teams, claims staff, operations staff etc.

Investment Income Margin is the yield (returns) received as interest income on the premiums advanced by policyholders. The premiums received by policyholders are invested by the health insurance company in safe instruments (generally AAA rated bonds and papers) on which they make 8 to 9% per annum.

Finally, the profit margin is the percentage of profit that the health insurer makes for all his efforts. The profit margin is computed by using the other four factors that we discussed earlier.

Here's how the health insurance premium is calculated

Let's do some quick math.

An insurance company is about to launch a health insurance product and here are the specifications. Your job is to calculate the premium.

1. Normal Loss for the health insurance policy = ₹10,000
2. Cost of Acquisition = ₹2,500
3. Operational Expenses = ₹1,000
4. Investment Income Margin = 8%
5. Profit Margin = 12%

And when we plug it into our formula, here's what we get.

Premium = (₹10,000 + ₹2,500 + ₹1,000) divided by (1 – 8% – 12%)

Premium = ₹13,500 divided by 80%

Hence, premium (exclusive of taxes) = ₹16,875

The GST (goods and services tax) in India is 18%, so the final premium comes to ₹19,912

And that's how the health insurance company computes the premium of the mediclaim policy

Recommended article: How Health Insurance Works in India

What are the risks in health insurance premium pricing?

Well, there are many risks towards the health insurance company earning money because almost everything (other than the desired profit margin) are scenarios.

1. The frequency might be different than predicted. The severity might be completely out of whack. And therefore the normal loss might be an incorrect prediction

Case in point is the recent Covid19 benefit policies which were issued by some general insurance companies for as little as around ₹100 to ₹200 for a ₹25,000 sum insured. Unfortunately for them, most of them got the frequency wrong and they ended up making losses on these policies.

2. The cost of acquisition might be more than predicted (generally assumptions are made on MS Excel)

A popular distribution channel experimented by almost every general insurance company is the direct sales team (DST) i.e. employees of the insurance company who sell policies based on leads passed by their call centre and through referrals. While it all starts well, over time, the cost of managing this channel and the cost per lead starts sagging the profitability of the direct sales team. Eventually most companies reduce or close down the DST channel.

3. The investment income margin is lower than assumptions.

The interest rates and bond yields tend to fluctuate quite a bit especially at times when the economy is booming or repressed. Infact the below graph shows that RBI interest rates have dipped to almost 4% thrice in the last 15 years. Interest rate risk is always there in predictions.

And finally there is the black swan event from the coronavirus which has laid the waste any best laid plans. Just yesterday I read an article which says that the premiums for health insurance plans are set to increase as the loss ratio for many companies has jumped from an estimated 105% to 120%.

Thus, with always so much happening around, it is the health insurance company too that takes the risk of any of its assumptions not panning out as predicted

How Health Insurance Companies Make Profits

The title of this section is a little sensational because most insurance companies in India don't make underwriting profits. Infact, it became news when Bajaj Allianz for FY16-17 emerged as the only insurance company to turn underwriting profits (article)

Of the material you have read so far, it would be clear to all that a health insurance company makes money by keeping some part of the premium and investment income after paying for claims, selling expenses, operational and administrative expenses.

So what techniques does a health insurance company use to make some money?

Here are some.

1. Smarter Product Development

Traditional health insurance products were simple and would cover inpatient hospitalization, day care treatments, pre-hospitalization, post-hospitalization, domiciliary hospitalization, organ donor expenses and ambulance charges. There was hardly any innovation.

Then about a decade back and aided by some standalone health insurance companies, a lot more innovation started entering the market. And with him came creative product development teams which converted a mediclaim into a health & wellness product.

One stand-out feature that was introduced is the "restore" feature in health insurance plans.

A restore (or recharge or reload) benefit is the reinstatement of the policy sum insured after you have consumed the entire original sum insured for any illness other than the one for which you took the original claim.

The math below will help understand this:

1. Chance of a policyholder making a claim in a policy year = 5%
2. Chance of the claimant consuming 100% of the sum insured = 10%
3. Chance of the claimant filing for another claim of a different illness = 10%

In numbers, this means:

1. For every 10,000 policies, only 500 are likely to claim (5%)
2. Of these 500 policies, only 50 will consume the entire sum insured (10%)
3. Of these 50 policyholders, only 5 policyholders will file a claim for a different illness (10%)

Hence, the restore feature will benefit only 5 out of 10,000 policyholders who have it in their plan benefits. That's just 0.05% of policyholders !

In other words, the pricing of the restore feature in a ₹8,000 health insurance policy is just about ₹40 but when Apollo Munich first introduced the Optima Restore health insurance plan, it's marketing team made sure that the feature was worth a lot more than ₹40.

2. Policy Terms and Conditions

The terms and conditions on every aspect of the health insurance policy is available in the policy wordings.

Most policyholders never read the policy wordings out of laziness or a general apathy towards the rules. Or maybe they get overwhelmed by a document running into 20 pages. (I'll let you in a secret – the 80/20 rule applies on the policy wordings too where 20% of the document contains 80%of what you need to know about your health insurance policy)

A health insurance policy has many inclusions, exclusions and in-between conditions. These conditions are most important because this is what is used by health insurance companies to control claims and earn profits on their plans.

Let's take a few examples here.

1. Sub limits and copayment

Earlier in this article, we discussed cataract treatment and the high frequency of senior citizens claiming for it due to higher prevalence at those age groups.

The Star Health Senior Citizen Red Carpet policy is a popular parent medical insurance plan and is likely to get a number of claims for cataract. To control the claims, the Star Health underwriting team has put in many stipulations which include :

1. A 24 month waiting period before any claims for cataract (this is common condition in most health insurance policies though)
2. A capping on cataract treatment i.e. the maximum allowable claims for cataract procedures for a ₹10 lakh sum insured policy is just ₹25,000 (both eyes included)
3. Additionally a copay of 30% shall be applied on all claims. So, if your cataract treatment cost ₹25,000, then Star Health will apply a your-share copay of 30%.

Related article : What is copay? And how does copay affect health insurance claims?

Let's apply point 2 and point 3 above in an illustration. So, you submitted a hospital bill of ₹35,000 for cataract operation on both eyes. Here is the process followed under the Star Health Senior Citizen Red Carpet health insurance policy:

• Hospital bills : ₹35,000
• Apply step 1 i.e. sub limit > The admissible amount is now ₹25,000 which is the sub limit applicable for cataract operations for a policy year for a ₹10,00,000 plan
• Apply step 2 i.e. copayment > On the ₹25,000, a copay of 30% is applied for all claims under the policy terms & conditions. This comes to a copay of ₹7,500.
• Therefore, the final eligible claims for payout is ₹17,500

We see above how the Star Health senior citizen plan was able to reduce the claims on account of cataracts done to 50% of the actual hospital bill for the cataract operation. This is why I suggest you use a good health insurance agent who can clearly explain all these nuances without you having to ask him/her everything.

2. Copayment or Sublimit when not using Insurer's Preferred Partner Network

Health insurance companies allow unrestricted use of private and government hospitals under their plan except for some handful of hospitals which are blacklisted due to fraudulent activities. Of these, some medical institutions are preferred hospital partners.

Case in point is the Religare Smart Select program where they have designated some hospitals as "preferred" and if you agree to go to only these institutions then a 15% discount shall be given in the premium. I really like this option because when I checked out the Delhi hospital list, I found that 58 out of 75 cashless network hospitals were a part of the Religare Smart Select program.

Related article: Which Top Hospitals in Delhi & NCR are part of Religare Health cashless hospital list?

Coming back. This came as a surprise for me when I observed that some mediclaim policies actually apply sub-limits if you were to take treatment in a non-preferred partner network.

This is the case in the National Insurance Varistha Mediclaim Policy for Senior Citizens that pays only 25% of the hospitalization claims if treatment is taken at a medical institution outside the insurance company PPN. And the Bajaj Allianz Silver Health Policy for Senior Citizens applies a copayment of 20% on admissible hospitalization claims when treatment is taken outside their PPN.

3. Using Deductibles

Another common practice especially in hospital cash insurance and travel insurance policies is to use deductibles.

A deductible is the number of days or an amount that one first spends or incurs before the insurance company starts paying any claim. Let's understand with an example.

The SBI Hospital Daily Cash Insurance Policy is a popular policy which offers a payout of upto ₹2,000 per day for every day you spend in the hospital. However they apply a deductible to 1 day which means 1 day will be deducted from the calculation of number of days spent in the hospital. So, if you spent 1 day – you will receive nothing i.e. 1-1 = 0. And if you spent 6 days, you will receive ₹10,000 i.e. 6 minus 1 day = 5 days * ₹2,000

Related article: What is a Hospital Daily Cash policy? And Should You Buy One?

You might be wondering that a 1 day deductible is hardly a big deal for the consumer. But it is for the health insurance company.

That's because more and more Indians are being discharged earlier by hospitals on two counts – 1) improvement in technology allows for faster discharge and 2) the more a patient occupies a day in post-operative recuperation, the hospitals (and their business mindset) think of the patient as a liability and try to clear him/her quickly.

For the health insurance company, this is a good sign as it means the policyholder will be paid less claims if he/she moves out of the hospital sooner. And money saved is money earned and more profits for the health insurance company

3. Select Preferred Lives

• 35 year old
• Married with children
• Earns over ₹1,00,000
• No history of medical illness
• No history of illnesses in family
• Opting for high sum insured (i.e. pays high health insurance premium)

The above 5 points represent every health insurance company's most preferred target market. Why? Because this is the segment of the population that is least likely to claim for the next 10 years or more i.e. this is a low-risk segment

Different health insurance companies approach the market differently. While some companies are conservative and only target the sub-45 year segment, others create products for different age groups.

One good way for health insurance companies to make money is by targeting preferred lives which means less claims and hence more profit. Ofcourse, it goes without saying that this segment will have the maximum competition because all 31 general & health insurance companies in India are targeting this same population.

4. Reduce Operational Expenses

Insurance companies are often slower to adapt as compared to a lot more industries. It may be something to do with being a legacy business and a conservative mindset towards business. As a result, the costs for insurance companies are bloated with the cost of maintaining branches, printing of forms and thousands of call-centre executives working in operations & customer services.

Technology is a fine way by which health insurance companies can reduce costs and some insurers have started to take big strides in this area. Some examples of how technology is being utilized by health insurers include:

• Sell policies online
• Replace physical forms with digital application forms
• Offer work-from-home services to non-customer facing staff (becoming a reality in this pandemic situation)
• Reduce storage capacity by scanning & saving documents in digital mode
• Instead of sending surveyors to inspect vehicle, ask the policyholder to do that using the insurance company mobile application especially for small claims
• Use artificial intelligence in claim assessment
• Utilize drones for site inspection rather than sending surveyors
• Use data sciences and machine learning to detect frauds

The use of technology allows insurance companies to temper down their cost structures and convert themselves into a lean and progressive institution. The savings go directly back into the profit pool of the health insurance company.

5. Preferred Hospital Network

In an earlier section, we referred to the preferred hospital network promoted by Religare Health Insurance under the Religare Smart Select program. Per the terms, if you agree to take treatment only in Smart Select network providers then you are eligible for a discount of 15% on the premium. This does not mean that you can't access the non-Smart Select providers but then, you'll have a 20% copay when you do that.

In other words, the health insurer wants you to stick with the PPN. But why?

Two reasons:

1. Health insurance companies negotiate rates with the hospitals for all major and minor treatments. This ensures that hospitals don't overcharge the policyholder and insurance company which is a thorn in these relationships. Here are some articles in Business Today (link) and Times of India (link) which shows how consumers are getting suffering because of this institutional quarrel.
2. Insurance companies get better control over their losses due to claims as having standard rates allows for better assessment of severity and hence, higher predictability of insurance premiums to be charged from consumers.

But all this does not seem beneficial to the hospital. Why would they agree to be a part of this preferred hospital network?

Hospitals agree to be part of the preferred hospital network for many reasons which include:

1. As more consumers adopt health insurance, they start showing a preference for hospitals which are in their insurance companies cashless network list. For example – a friend (without my knowledge) recently ported his policy from ICICI Lombard to a different insurance company merely because BLK Super Specialty Hospital in New Delhi (which is very close to his residence) was not in the ICICI Lombard network hospital list for Delhi.
2. Insurance companies, via their call-centre, push more policyholders to take treatment at these preferred hospitals so this becomes like an acquisition channel for the hospitals.
3. Hospitals get faster service from the insurance company such as a faster settlement of dues. Generally insurance companies take 15 days to pay the hospital but in case a hospital is in the preferred network list, then the insurance company promises to settle the bills in just 7 days which improves the medical institution's cash flow.

If you want to evaluate your existing health insurance policies on the basis on cashless network, coverage, sub limits, copay, premium, exclusions, pre-existing diseases etc., then feel free to set up a free health insurance consultation session with me at a date/time per your convenience.

And if you are keen to switch health insurance providers, then make sure you read my article on How to Port Health Insurance in India which entails the process of applying for switching with your existing health insurance provider to the new providers while retaining your benefits which include waiting periods and cumulative bonuses.

Overall, the PPN is a win-win for all constituents including the customer who gets the advantage of affordable premium as there is better control of expenses at the insurance company end. Over the next decade, you can expect to see the insurance companies becoming more powerful and getting more & more hospitals in their PPN. You'll also see more insurance products being developed which are based on PPN access.

6. Avoid Group Mediclaim Policy (atleast the non-profitable groups)

In July 2020, the Government of India made a list of demands to three PSU general insurance companies (Oriental Insurance, National Insurance and United India Insurance) as conditions for a ₹12,450 crores capital infusion. The most prominent of these were a reduction in loss-making group mediclaim business (article)

What is wrong with group health insurance profitability?

All group health insurance policies are not loss making. Actually most of them are profitable. The issue arises with large groups i.e. more than 3,000 lives i.e. about 1,000+ employee companies. Here, all insurers bid for these businesses because of the big-fat-cheque that the company needs to hand over to the insurer.

In other words it is a case of too many people chasing the same target which leads to cut-throat competition. And exactly the reason why the most aggressive companies often are the ones who make a loss on this portfolio. The case of the PSU insurers is important because for all three of them, more than 66% of their health insurance book is from such group mediclaim contracts.

Related article: Contribution of Retail and Group in Health Insurance book of Insurance Companies in India

Some insurance companies are very selective about picking up the group mediclaim business. Companies like Max Bupa, Star Health, Apollo Munich (now HDFC Ergo Health) and Cholamandalam MS have a group business contribution in health insurance of less than 30%.

Conclusion

The profitability of a health insurance company is a function of many factors like category of policyholders targets, sourcing channels, premium charges, product terms & conditions, claim efficiency etc. The good part is that most of these elements are in the control of the health insurance company.

In the above article, in addition to explaining how health insurance companies make money, I have put forward a lot more information on how health insurance companies can play around with the variables with positive or negative implications on sales, market share and earnings.

I hope you liked this article and I'll appreciate it if you can share this content with your friends and connection at LinkedIn, Twitter and Facebook

If you have any questions or if you feel I can be of any assistance to you with regards to identifying the best health insurance policy for your parents or family members, then do connect with me at [email protected] or set up a free health insurance advisory session where we can discuss this and a lot more.

Thank you for taking the time to be here.

How Do Medical Insurance Companies Make Money

Source: https://www.arogyasanjeevani.in/how-health-insurance-companies-make-money/

Posted by: gilesotinsilly.blogspot.com

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