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Commentary: Are Healthcare Co-ops the Next Fannie Mae?

Ian Duncan, September 30, 2009

Congress attempted to achieve a social objective—higher homeownership rates—on the cheap by using Fannie Mae to acquire mortgages. The subsidy, in the form of an implicit guarantee of Fannie Mae's capital, meant that Fannie did not need to hold the levels of capital required to support the explosion in mortgage lending that resulted. The results are plain for all to see.

Fast forward to the healthcare debate: Congress is now proposing to repeat the trick with health insurance cooperatives. Health insurers are regulated by state insurance departments, who, over time, have built up a wealth of experience of the levels of capital needed to support an insurance enterprise. After all, if a health insurer should default, it is the state insurance department that is left to protect policyholders. This has led to what is called risk-based capital (RBC) requirements for health insurers.

The minimum level of free capital (also called surplus) that an insurer needs to hold is somewhere between 8% and 11% of premiums in most states (New York is an exception, and its rule is 25%). If an insurer's capital falls below this level, the state insurance department can step in and take action that could ultimately lead to winding-up the insurer.

Prudent insurance companies—for example, members of the Blue Cross Blue Shield Association, which has its own (higher) guidelines for its members' capital—hold considerably more than the minimum required by the state. Typically, well capitalized insurers hold anywhere between 15% and 40% of premium income in the form of free capital.

Capital, of course, is not free. An insurer with 100,000 members could well have $500 million in premiums, and require the backing of between $50 million and $200 million in capital.  Assuming a 10 % return on capital pre-tax, this requires between $5 million and $20 million in profits, pre-tax, to service the insurer's existing capital, or an additional charge to the monthly member premium of between $4 and $17.

Because of healthcare inflation, an insurer has to constantly increase this capital. The additional capital can be provided by investors (in which case the return on capital scenario above applies) or, more likely in the case of insurance co-ops, it will have to be provided by insured members. A 10% increase in premiums ($500 per year) could require an additional charge (to increase its capital) to the member's premium of between $50 and $200 per year.  These additional charges are offset somewhat by earnings on an insurer's capital, but the rules for what counts as admissible assets for RBC purposes tend to result in conservative investments and (relatively) low yields.

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