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How health insurers should handle this Obamacare reversal

November 15, 2013: 12:53 PM ET

Allowing customers to keep their non-ACA compliant plans for another year is an actuarial nightmare that could inspire customer loyalty. But at what cost?

By Cyrus Sanati

President Obama speaks to reporters about the ACA.

President Obama speaks to reporters about the ACA.

FORTUNE -- Health insurance providers may end up taking a hit to their bottom lines thanks to the Obama Administration's decision Thursday to allow some people to keep their so-called inferior health insurance plans for another year. But don't cry for the big insurers like Aetna (AET), UnitedHealthcare (UNH), Cigna (CI), Blue Cross, and others just yet. The government has built into the new health care law a number of risk-mitigating safeguards to limit downside risk for the insurers so that they don't end up losing that much money. The majority of the cost associated with this change will most likely end up being absorbed by the government -- raising health care cost for everyone down the road.

"Insurance is complicated to buy," President Obama told reporters yesterday at a special White House press conference on the troubles connected with the launch of the new online health care exchanges. "Buying health insurance is never going to be like buying a song on iTunes," the president lamented as he was grilled over technical glitches with the main health care exchange website. The President had called the press conference to announce that his administration would "allow" for health insurance companies to offer their customers the option to renew their current health care plans, even if they didn't meet the minimum level of care prescribed under the Affordable Care Act (Obamacare).

When the President initially made the promise that those who were "happy" with their health insurance plans could keep them after the ACA went into force if they wanted, he was somewhat correct. Health care plans offered before 2010, when the ACA was passed in Congress, were "grandfathered," meaning that health insurance companies could continue selling those plans even after the ACA's individual mandate went into effect in 2014. But the logic here was flawed. Health insurance plans are essentially contracts for service that generally last only one year. While the plan may have the same name from year-to-year, there was almost always some sort of change to its structure, whether it be in the plan's premiums, co-pays or deductibles. In the individual market, plan costs and benefits would shift radically from year to year forcing people to change providers often.

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For those few who didn't have the (unfairly untaxed) benefit of corporate-subsidized health coverage, the individual market worked well, as they generally had greater choice, allowing them to pick a plan that was tailor-made for them. For those on a budget, there were the so-called bare bones or catastrophic type plans that carried low premiums, but offered limited levels of care. No matter what plan a person chose, generally, the younger and fitter you were, the less you would pay upfront in premiums. If you were older or got sick too much in the previous year, chances are the insurance company would either raise your premiums so high it was financially crippling or would just simply drop you all together. And since other insurers didn't cover so-called preexisting conditions many of those forced into finding new coverage, as a result of being dropped for an illness, chose to simply go uninsured.

The ACA was set up, in part, to mitigate this volatility in the individual market by forcing all insurers to provide a minimum level of care and accept everyone who applies for coverage, regardless of age or preexisting condition. People would then pay the same price for the same coverage, again, regardless of age or preexisting condition.

So the insurance companies sent out cancellation notices telling customers to go on to the health care exchange website for new options. Unfortunately, the bugs on the website prevented many people from seeing their new options, causing anxiety levels to rise. For those who were able to see their options, many were shocked to discover they would have to shell out more money than they did in the past for health insurance. They were now forced to pay for levels of care they didn't need or want. Essentially, people had been forced into a group plan, similar to a corporate-subsidized group plan, except in this case the group consisted of millions of people, and the government was the one subsidizing it.

Well, for some, those who are expected to make more than four times the poverty limit in 2014, there was no government subsidy at all, forcing them to pay premiums that are in some cases several times more than their old individually tailored plans. People were understandably upset, leading to the chaos, which forced the President to act yesterday in allowing people to continue on with their old plans for another year.

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Insurance companies are now trying to ascertain what all this could mean for their bottom lines.

The shift in policy has created an actuarial nightmare as they had priced their 2014 plans thinking that everyone from the old individual market, plus all those who had been priced out in the past or who simply didn't have health insurance, would purchase one of the new government-subsidized plans.

To be sure, President Obama's decision to allow the insurance companies to offer those old individual plans again doesn't mean that the insurance companies must do so. There is nothing the government can legally do to force them to re-offer the old plans. Nevertheless, some might do it anyway.

"The larger carriers who were in the individual market, such as the Blues [Blue Cross], will now probably reinstate their plans," Mark Argosh, managing principal at Sterling Healthworks, a consultancy, told Fortune. "They will be compelled to do so as they want to retain their customers as much as they can."

Indeed, Aetna, one of the largest health insurance companies, confirmed to Fortune that it was already talking with state insurance regulators about refiling and re-rating their old plans. The key thing here is "re-rating." How they price those old plans given the new insurance market mix will be critical to figuring out how large of a hit, if any, they will end up taking to their bottom lines.

The assumption is that people who can pay lower premiums with their old plans will stick with them for as long as they can. Those people are going to be generally healthier and younger, thus their absence from the exchange market will lower the profitability of the Obamacare plans. But while the health plans on the exchange are government-subsidized, there is still competition amongst health insurers. Aetna and the other big insurers may think it could be worth the headache and the actuarial mess to reinstate those old plans at fairly low rates so that next year when people are forced onto the exchanges for good they would be more inclined to stick with their old carrier, even though it means higher premiums and a totally different level of coverage.

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This could be a significant advantage, one that will be hard to quantify when assessing plan profitability. But the insurers really don't have to worry that much about losing money with their plans on the exchange, at least not for the next three years. The government anticipated that the first few years of the marketplace would be difficult for insurers as it would very difficult for them to assess in advance how healthy their client pool might be.

As such the government created what is known in the industry as "risk corridors" in order to protect insurance companies from major losses early on in the program. Under the ACA, larger insurers must pay out a minimum of 85% of their premiums toward care. That only leaves a 15% margin to account for all SG&A costs. Say it is 10%, which only leaves 5% left for profit. You might ask why anyone would want to be in the insurance game given such low margins, but this is a matter of scale -- that 5% could be billions of dollars -- or at least that is what insurers are hoping. If by chance -- and it is a pretty good chance -- that insurers are wrong and they lose money in the first three years, then the government will step in and mitigate their losses.

For example, JP Morgan estimated that Kentucky Medicaid, which paid out 120% of its premiums to care last year, would have had its losses subsidized to a point that would push that number down closer to the mid-90s. In this case, the insurance company would readjust the rates it was offering on the exchange upwards so they would fall below that 100%.

Putting aside the obvious moral hazard issue, the point is that insurers will be protected if they lose a bunch of money the next year. The Center of Medicaid and Medicare tried to calm the industry yesterday by noting in a letter to state insurance commissioners that, "the risk corridor program should help ameliorate unanticipated changes in premium revenue."

So the big insurers are bound to get hit now that some of their healthiest candidates will be out of the market. The biggest issue here isn't the potential loss money; rather, it is the loss in data about the potential market. By allowing people to essentially opt out for next year, the government has essentially polluted the data results. This means insurers will again next year be taking a stab in the dark in ascertaining their premiums. Given all this, it won't be surprising if they ask the government to add another year to the risk corridor program.

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