By JONATHAN HALVORSON

The Affordable Care Act was intended to usher in a new era of competition and choice in health insurance, and at first it succeeded. But increasingly, provisions in the law are undermining competition and wiping out start-up after start-up. If something isn’t done soon, the vast majority of new insurers formed in the wake of the ACA will fail, and many old-line insurers that took the opportunity to expand and compete in the new markets will leave. It’s a classic story of unintended consequences and the difficulties of regulation.

Flush with optimism after the ACA passed, dozens of new insurers formed to take advantage of the environment created by the law. Twenty three of these were co-ops given start-up funding by the ACA. In most states the new plans only grabbed a small share of the market, but enough to put pricing pressure on larger incumbent plans. In a few states, like New York, the start-ups and other new entrants grabbed over half of the business on the exchanges.

To the surprise of many, price increases in health insurance remained low by US historical standards even as the recovery continued and people who had been without insurance were finally able to get it. How much of that modest cost trend is due to an improved competitive marketplace on the exchanges is speculation, but what is clear is that the doomsayers about the ACA were wrong. Costs did not explode, and even with higher 2016 rate increases we are not back to the bad old days (yet).

One of the cornerstones of the ACA, however, has had the opposite effect intended, and it is now threatening the destruction of much of the good that has happened to health insurance competition and choice. The ACA had three measures to stabilize the exchanges and improve competition—reinsurance, risk corridors and risk adjustment. Reinsurance has worked largely as intended to mitigate the effect of unexpectedly high claims. Risk corridor payments were similarly intended to soften the highs and lows of bad guesses about medical costs, but were dramatically reduced by Congressional Republicans. This played a role in forcing about half of the co-ops to close by the end of 2015. It was a deliberate political outcome rather than a regulatory misjudgment. In any case, both of those programs were intended to be temporary until insurers could gain experience in the new post-ACA environment. They end in 2016, so their benefits and harms have essentially been delivered, unless Congress is willing to reverse course and fully fund the risk corridors before time runs out.

On the other hand, the risk adjustment payments are permanent, and their scope expands beyond the exchanges to all individual and small group health insurance. These risk adjustment payments are having a large and surprising impact on insurers across the country for reasons that sometimes have no real competitive justification, making some companies that are already dominant and profitable even more dominant and more profitable.  The point of giving a bonus to plans with higher than average risk and penalizing plans that enroll members with lower than average risk is to prevent the business strategy of skimming the market to find the lowest risk enrollees. The idea is to prevent health insurers from profitably pricing below their competition because their products attract members who use fewer health care services, and force insurers instead to compete on the quality and efficiency of services delivered. Is that happening?

Take New York, where I live and work. UnitedHealth, the largest insurer in the US, is also one of the largest players in the NY individual market and is by far the largest player in the small group market (under the name ‘Oxford’). It is profitable locally and nationally, and has been for some time. In the small group market, it did not participate in the new exchange at all, yet it was due a net $281 million in risk adjustment payments. In the individual market, it had limited participation and was due a net $86 million in payments in 2015. The next highest beneficiaries of payments received $13.5 (small group) and $48 million (individual).

In the small group market in New York, about 9 of every 10 dollars paid in risk adjustment went to United/Oxford in 2015, largely for clients that United had before the ACA took effect and that it continued to serve off the exchange. There is no change in these payments based on profitability, so a company breaking even or losing money because it priced aggressively to grow is still forced to pay, while a profitable company will still receive money so long as it has members in higher risk demographics or with higher risk diagnoses.

A key feature of the way the risk adjustment program works is that the payments come from other plans in the same state. It is a zero sum game. So, other plans in New York gave their largest competitor a total of about $367 million dollars in 2015. This was also the year that the fastest growing ACA co-op in the nation, HealthRepublic of NY, went bankrupt owing its competitors $191 million in risk adjustment payments, because the formula determined that its members had health risk that was too low. It owed about 37% of its total 2015 premium revenue. Even if HealthRepublic did not have other problems, it could not have long survived these kinds of payments in a business (health insurance) that, despite its reputation, typically has a profit margin of around 5%. It could easily have taken a decade for Health Republic to make back in profit what it lost in one year’s worth of risk adjustment. Of that $191 million owed in risk adjustment payments, the vast majority was slated for United and its Oxford subsidiary. Similarly, other smaller plans trying to expand the small group market have been paying out millions.

In New York’s individual market, the second and third largest recipients of risk adjustment funds have been venerable Blue Cross/Blue Shield plans (Excellus and Empire, a subsidiary of Anthem). Blues plans in many states are the ones getting the best shake out of the risk adjustment program. In contrast, those paying out the large sums have mostly been smaller competitors that are either start-ups, or non-profit Medicaid plans that expanded into the individual commercial market. The companies that are paying are often losing money even before the payment. How is this helping competition or stability?

The problem is by no means isolated to New York. On August 1^st, New Mexico Health Connections (NHMC) and Minuteman Health of Massachusetts sued the federal government, charging that the risk adjustment program unfairly penalizes new entrants and advantages old line insurers that have long dominated the individual and small group markets. For 2015, NMHC was required to pay out 15% of its total premium in risk adjustment payments. In the case of New Mexico, and many other states, the primary beneficiary is the local Blue Cross/Blue Shield plan.

Similar scenarios (and in some cases, lawsuits) are playing out in Maryland, Washington, Oregon, California and other states.

What Went Wrong?

Risk adjustment works relatively well in other nations and in the Medicare program, so why does it seem to be failing here? I don’t think anyone has the full answer at this point, but a few trends seem to be emerging.

Risk adjustment requires an insurer to report on the health risk of its members, and to do that it needs good data. Plans that played the game better from the start set a high priority on collecting and reporting on that information. However, it is much harder to get good data if a member just joined than if you have had that member enrolled prior to the ACA exchanges and can mine your data warehouse for all those ICD codes that boost the risk score. The dominant pre-ACA players had more years of member data, and mature analytics capabilities, to help them maximize their risk scoring. This has created a serious penalty for new entrants in the first few years which CMS has not addressed.

The Maryland co-op suing the federal government has taken this concern a step further and alleges that incumbent insurers actively encouraged their members to seek services in order to be diagnosed as higher risk so that the plan would receive increased risk adjustment payments. This may be straying into tinfoil-hat territory, but the potential for some gaming is there.

More important than the reporting issues, some of the difference in member risk between insurers is also real, but it is not clear that the difference is well-captured in the risk adjustment model, or that it should always generate a payment.

For example, another advantage of incumbency is that older, higher-risk people are more likely to want to stick to names they have known for years in health insurance (e.g., the local Blue Cross/Blue Shield plan) and not want to take a chance on upstarts. Brokers in the small group market may steer clients towards the companies they have long been most comfortable doing business with. These forces of inertia create a barrier to newcomers, which is normal, but it gets compounded as an issue because for each sicker person who doesn’t switch to a new or less-known brand, it contributes to the financial transfer payment the upstart plan owes under the risk adjustment program.

It’s also not clear if some plans are being penalized for being too good at preventive health. The CMS model does not seem to be able to tell the difference between a plan that has low risk people because they enrolled that way, and one that has low risk people because it works more effectively to prevent chronic diseases and cancers. It’s unlikely this is a major factor, just because so few health plans actually seem to be able to move the needle on preventive health care. It may, however, be an issue in some cases and certainly could become a bigger issue down the road.

Finally, and this is the real wild card, products that attract sicker patients have historically tended to be those with richer benefits, larger networks, lower penalties for going out of network, and fewer approvals to get care. That’s understandable, but having people gravitate to such plans will make controlling costs harder. And by rewarding plans with less cost-control that attract higher risk patients, the ACA may be inadvertently incentivizing health insurers to promote such products because they can predict that the plans with worse cost control will be subsidized by the stricter cost-control plans that attract healthier people. That’s a scary thought for the future of premiums on the exchanges, and doesn’t seem to have been accounted for in the policy papers outlining the risk adjustment goals and methodology.

With the ACA’s risk adjustment, it is possible that there will be a perpetual skew of risk towards products that are less well-designed to control it, which is reinforced by the risk adjustment mechanism in a manner that doesn’t allow more tightly controlled products to compete well, with the result that certain products are pushed out of the market, competition is lessened, and premiums have less pricing pressure.

All of the issues described above are fixable, but time is rapidly running out to do so after the damage of the risk corridor reductions, and now these large and ongoing risk adjustment payments. The seven remaining co-ops are hanging by a thread, with one or two exceptions. Firms that expanded into new markets with the ACA have had to retrench or reconsider further expansion. Even well-capitalized start-ups can’t continue forever to hemorrhage dollars through risk adjustment payments to their competitors. It’s hard for David to win in a fight against Goliath when you risk-adjust the rock out of his slingshot.

All that said, it is true that the Goliaths are not all standing tall. While United has done well in New York, it made headlines a few months ago when it announced it was losing about $500 million annually on the exchanges and was pulling out of most states. Aetna and Cigna, other insurance giants with well known brands, have also experienced losses and are pulling back on expansion plans. The Blues, including Anthem, have generally been winners, but even adding profits from the Blues and the few others that have stayed in the black, the average plan had a net loss of 4% on the individual market in 2014. The small group market has remained profitable at about a 3% margin overall, though as the example of New York shows there are big winners and losers hidden in the average.

The data is clear that insurers have been playing an aggressive game on pricing, especially on the individual exchange. This can’t continue much longer, and plans will need to price to maintain a margin of 3-5%. With the current risk adjustment model giving such large and hard to predict results, achieving pricing discipline to yield a stable margin will be a challenge, to say the least.

A fix to the risk adjustment model can’t wait. It will have to be thoughtful to minimize gaming and to achieve the objectives of bringing stability and encouraging competition based on quality and efficiency rather than actuarial risk selection. Perhaps a solution in the short term is to lower transfer amounts so their impact is lessened until the reporting and methodology can be ironed out. For a longer term solution, one of the more simple refinements may be to add a restriction that plans that are already profitable or have medical loss ratios below a certain percent (say 85%) should not receive these payments, or payments should be made on a sliding scale related to MLR. Similarly, unprofitable plans could be removed from some or all obligations of making risk payments. Likely, more radical changes are needed.

CMS is well-aware that there are problems. Let’s hope it makes enough changes before the innovations and competition among insurers that sprang up with the ACA whither and blow away.

Jonathan Halvorson edits the New Economy section for THCB. FD: As a consultant Jonathan works with startups, providers and health plans, advising clients on policy issues, strategic direction and related topics.