Cash Flow is King
17 January 2011
How to Make a Killing
in the Insurance Industry
Without Really Trying
Suppose you ran a business and you could get the government to force people to buy your product or service under threat of penalty. That would be really sweet, wouldn’t it? Well, health insurance companies in the US are now in this enviable position. One could say that anyone who doesn’t go right out and set up shop in the insurance industry is a fool, except that there are significant barriers to entry to the industry. It takes a lot of money to be in the insurance industry. You have to sit on a mountain of cash, and you have to have a lot of cash flow to make it work.
Sometimes people in the business world say, “cash flow is king.” Even a business that isn’t doing so well can leverage its cash flow for its benefit, if it has a cash flow to leverage. Small businesses routinely do this in minor ways by, for example, charging their business purchases on credit cards that give them benefits. So if you have a lot of cash flow but not much profit, you can still get something out of the cash flow. It’s sort of like juggling money.
Big businesses leverage their cash flow in big ways. Indeed, some industries make their money not from sales of goods and services, but from the management of their cash flow. The insurance industry is one of these industries. It is not usual for an insurance company to pay out $1.06 in claims for every dollar it takes in from premiums. How do they stay in business? They sit on so much cash, that they invest the cash they sit on and they make some money from capital gains. An ADP representative once told me that this is how they make their money too.
The pending individual mandate to force the uninsured to purchase health insurance is a promise of even greater cash flow to the insurance industry. During the run up to the passage of health care legislation in the US, the insurance industry lobbied hard for the mandate and for penalties that would really bite: “AHIP objected to the version of the penalties in the original Senate leadership proposal as insufficiently strict to induce many people to become insured.” The insurance industry was never fooled about this, though the popular press persisted and still persists in characterizing this legislation as “reigning in” the healthcare insurance industry and calling them to account. This behavior has been encouraged by the Kafkaesque title of the legislation: Patient Protection and Affordable Care Act (ACA).
“Three important goals of reform are to increase health insurance coverage, to eliminate discrimination by health status in the sale and maintenance of health insurance, and to increase the affordability of coverage. Without an individual mandate, these would all be affected by the natural tendency for people to want to pay for health insurance only when they believe they will need health care services. Since those currently without insurance have significantly lower costs on average than those paying for insurance, the mandate will bring lower-cost people into the insurance risk pools. This would lower the average cost per person covered and thus lower premiums.”
When you read the insurance industry treatments of the problem you find formulations like “a diverse risk pool of enrollees.” This sounds very nice, but what does it mean? In the context of health insurance, it means health diversity. In other words, some people are weak and sickly, and some people are strong and healthy, and the insurance industry, as well as a lot of politicians, want the strong and the healthy to subsidize the weak and the sick. Failure to do so they call “adverse selection.” You know what adverse selection is in evolutionary theory? It is extinction. This is a debate about extinction. Go figure. I can say things like this bluntly and honestly because I don’t have to care what other people think of me, but politicians and politically visible persons (like CEOs of major companies) can’t be honest. They cannot afford to be honest.
How much cash flow are we talking about as a result of the individual mandate? I did some very rough calculations — literally on the back of an old envelope — and if we take the frequently cited figure of 47 million Americans without health insurance, and divide this by average household size of 2.59, we get more than 18 million uninsured households. I found figures cited between $46,000 and $50,000 as the median US household income in 2010. I took the lower number of $46,000, and found estimates between 7.5 and 12.8 percent of household income to be spent on healthcare (the Urban Institute’s report cited above gives a rate of 2.5 percent, but this is not to be taken seriously). If we pick a number between the two percentages cited, between the high and the low figure, we get about $4,650.00 annually for health insurance per household. This is an unrealistically low number, but I’m doing a conservative calculation. With these conservative numbers, we find that the individual mandate would funnel another 83.7 billion dollars into the coffers of the insurance industry annually. This is cash flow that they can leverage even if they have to pay out a little more than 83 billion in claims.
Now, if I were an insurance executive, even if I had to operate under government regulations (what industry does not have to deal with regulators?), I would be very pleased indeed to hear that the government was going to force people to spend another 83 billion dollars in my industry. Even if I didn’t get all of it, I could count on getting a portion of it. And we all know that an expanding industry is an industry in which the established players don’t have to fight over scraps. A bigger pie means a bigger slice for everyone invited to the table.
But the business model of profiting off investments has weaknesses. Sometimes no profits are to be had from investments. Sometimes investments lose value. This can create a crisis. During the last stock market plunge prior to the 2008-2009 debacle, insurance companies were hit quite hard. Policy prices spiked as the industry sought to make up their losses. My business policy increased significantly. Nothing could be done about it. You pay the bill, you accept the fact that you may have lost your profit for the year, and you hope that next year will be better. C’est la vie.
What happens when everyone is forced to buy insurance, the insurance companies have their money invested, and the stock market tanks, threatening the industry as a whole? After all, we do live in a capitalist economy (more or less, granting exceptions like the nationalization of the airport security industry following 11 September 2001), and no one has figured out how to have a free market without a business cycle. The business cycle is a fact of life in a market economy. It will happen again, like it or not. We can do our best to smooth out the business cycle, but we won’t eliminate it.
When this eventuality comes to pass, and premiums must spike sharply across the board, for everyone, the politicians and the insurance company executives will say that there is nothing they can do about it. And they will be right. Honestly, under these circumstances, there is nothing that can be done except to raise everyone’s premiums, or to let a few companies go bankrupt, or a combination of the two. But it is one thing to understand this, and another thing entirely to explain it to more than 300 million people with an attention span shortened by the cleverest spin doctors in the business. Maybe there will be congressional hearings. Maybe heads will roll. But the one thing that is sure is that the money has to come from somewhere. The politicians could turn to the expedient of printing money, thus creating inflation, but that has been made more difficult by the same measures that have been introduced in the attempt to minimize the business cycle.
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