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Is the Insurance Company At Fault?

March 15, 2010

From Baseline Scenario:

So, let’s try to answer two questions:

1.  What do we achieve by trimming “wildly excessive” profits of health insurers?

2.  Are these profits “wildly excessive,” when compared to other industry segments?

It was actually Professor Reich’s article that initially sent me looking for information, as his billions of dollars of health insurance profits were a meaningless factoid unless one placed them in the context of the actual revenues of the five top insurers.  In order to have a solid foundation of comparative data, I reached for the 2009 Fortune 500 rankings (based on 2008 financials), easily accessible on the CNN web site.  The Fortune numbers are somewhat different from Professor Reich’s data, as they represent prior year results, but one also gets an unbiased comparison with other industries.

In 2008, the top 10 health insurers combined had $264 billion in revenue and profits of $8 billion.  A little bit of arithmetic shows that the combined profit margin for this group was 3.1%.  The highest profitability among the top 10 was reported by Aetna: 4.5%.

Thus, even if we regulate all health insurers to eliminate all their profits, as Senator Feinstein would have it, we can only reduce health insurance spending by 3.1%.  So much for the boatloads of savings that Professor Reich talks about – the impact on our health insurance costs would be minimal.

Now, one might say that turning the health insurers into true non-profits would also free up the sums currently spent on sales and marketing.  While this is mostly true, the sums saved still do not present a panacea for rising health care costs.  A spot check of annual reports shows that the cost of sales for top 10 insurers is about 3-4%.

So, let’s move to the second question.  We cannot make a dent in health insurance spending, but perhaps it’s worth bashing health insurers because their 3.1% profits are obscenely high when compared to other industries.

Well, it is not quite so.  The same source shows that top 10 pharmaceutical companies reported 18.4% profits in 2008 ($49 billion profit on $269 billion revenue).  Interestingly, the top pharmaceutical company – Johnson & Johnson – earned ($13 billion) more than all top 10 health insurers taken together.  Other “pharma” players were not far behind.  Both #2 (Pfizer) and #4 (Merck) earned $8 billion each, or as much as the 10 top health insurers taken together.  The highest profit was 37.7%, reported by Gilead Sciences.

Similarly, the top 10 companies in the ”medical products and equipment” segment had 10% profit ($6 billion profit on $64 billion revenue).  It actually would have been closer to 15%, if not for the disastrous year experienced by the #3 player, Boston Scientific.

Once you internalize these numbers, it becomes clear that any meaningful reduction of health insurance costs can only be achieved by reducing the underlying health care cost structure.  We cannot hold health insurance rates flat if we allow pharmaceutical companies to average 18.4% profits and to grow their revenues.  That would be akin to freezing the price of cars while allowing price increases for steel, rubber, etc.

As I was thinking about what health insurance profitability would not be deemed “wildly excessive,” I also looked at other areas of the economy where we spend significant amounts of money without complaining too loudly.  Interestingly, the top 10 Computer Software companies reported 23.6% profits on average.  The top 10 in Household and Personal Products (ranging from hammers and batteries to toothpaste and lipsticks) averaged 11.2%. Even the regulated Gas & Electric Utilities earned10.3%.

So, the 3.1% profitability that health insurers reported in 2008 pales in comparison with other industries and, even if totally eliminated, will not make a significant dent in our spending.  Any meaningful cost reduction will require a disciplined approach to modify the way we consume and price health services, ranging from doctor and hospital fees to pricing of medications, equipment, and supplies.

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