#2 How Do Risk Contracts Align Incentives?

How Do Risk Contracts Align Incentives?

Risk contracts align incentives by focusing insurers and providers on common objectives. Historically, the most important objective has been managing medical costs.

When actual costs exceed expected costs, the responsible party experiences a pro forma loss. The chance of this loss reflects the negative connotation of medical cost risk. When the reverse is true, however, the responsible party experiences a gain and can decide the disposition of any surpluses.

Many factors influence the accumulation of expense such as member health status, provider behavior, and available technologies. Because of these, insurers often need to engage care providers to influence spending choices and closely monitor its aggregate level against expectations. As a result, the balance of expense to revenue must be monitored.

How is Expense to Revenue Monitored?

The most common measure of actual aggregate medical cost vs expectations is the Medical Loss Ratio, MLR (sometimes called the Medical Benefit Ratio, MBR). The numerator is the total accumulated cost for a period of time for a population, and the denominator is the expected value for the same. Often the expected value is also the revenue provided by the sponsor for the period. When the denominator is total revenue available, to remain solvent, insurers must manage the MLR to a level that also provides surplus for running their own operations.

Health plans with MLRs (MBRs) in excess of 100% for extended periods devour their reserves and fold or are closed by regulators before catastrophic financial failure can adversely affect the beneficiaries they represent. When the MLR exceeds 85% for an extended period, it is still often difficult for the insurer to remain in business because it cannot afford to pay the staff and provide for the systems necessary to administer itself and the benefits it offers for its membership. Conversely, plans with lower than expected MLRs often profit from the favorable revenue to expense performance to the benefit of their sponsors and shareholders.

How Are Incentives Aligned?

Insurers align provider organizations with their own MLR objectives by engaging them to oversee it for the subset of the overall membership that they manage. Each risk contract includes the language to accomplish this through a target MLR percentage. If, over a defined period of time, a panel managed by a provider group for a health plan (colloquially a “risk group”) experiences a MLR percentage that is below the target, the risk group could be eligible for a surplus. Conversely, if the MLR for the panel managed by the risk group exceeds the target, the risk group could be required to provide funds to the insurer to offset the excess expense.

The amount of payment or repayment required depends on the type of arrangement, but in the simplest framework, full risk contracts, the full up and downside risk is transferred, thus perfectly aligning incentives. There are a number of exceptions for later discussion.

To learn more about how risk contracts align incentives, stay tuned.