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Why Aren’t State Exchanges Embracing Prudent Purchasing Strategies?

March 19th, 2012
by William Kramer

In the design of health insurance exchanges, one key issue is whether exchanges will offer improved value to people buying insurance in the individual and small group markets.  A lot depends on whether the exchanges act as prudent purchasers – making design decisions that keep quality high and costs low.  It appears that many states, however, are pursuing a different approach – one that allows virtually any licensed insurance carrier to participate and does not use effective purchasing strategies that are widely used by large employers.  If this approach is used, we will have missed an opportunity to reduce costs and improve quality for exchange participants.

The limited embrace of prudent purchasing in the exchanges is somewhat surprising, especially since other state-level entities are active purchasers for health benefits.  Many state employee benefit plans have been trailblazers in setting high standards for participating health plans and rewarding those that deliver high quality care at a low cost.  In addition, most state Medicaid programs have been very active in trying to find ways to save money, e.g., by contracting with managed care plans and setting low provider payment rates.

Why are most state exchanges not pursuing a prudent purchaser strategy? One reason, of course, is that some health insurers and provider organizations have expressed opposition.  These groups often have significant political influence, and they have been successful in some states in getting legislation that prohibits the exchanges from being active purchasers.  There is, however, a deeper explanation for the fact that most state exchanges are not pursuing prudent purchaser strategies.  In the exchanges, the premiums are paid by participating individuals and small employers, and the subsidies for low-income individuals are paid by the federal government.

In contrast, the premiums for state employees are paid fully by the state; any savings in the program come back directly to the state. Likewise, the costs of a state Medicaid program are shared by the federal and state government; when the state acts as a prudent purchaser, it saves money.

From one perspective, it makes sense for states to operate the exchanges while the federal government pays the subsidies.  The first element gives each state the flexibility to design its exchange to fit the unique characteristics of its individual and small group health insurance markets, and the second element shields the states from costs that they simply cannot afford in the current fiscal climate.  Unfortunately, these two provisions in combination create a situation in which the state does not have a strong motivation for saving money.  Using prudent purchasing strategies in the exchanges is likely to happen only in the states that consider it “the right thing to do” unless we can find ways to build stronger financial incentives for states to do this.

Shouldn’t something be done to encourage states to use prudent purchasing strategies?  Surely it would be better for the exchange’s beneficiaries – individuals and small employers – if the exchange were able to offer lower costs and better quality. In addition, an exchange’s efforts to improve affordability and quality could be a catalyst for broader improvement throughout the health care system.  From the federal government’s perspective, an exchange acting as a prudent purchaser would help to keep the cost of government subsidies lower.

Ideally, we could find a way to align the accountabilities, i.e., the authority to design the exchanges would be more strongly linked to financial incentives to do it better, but creating a theoretically ideal design probably isn’t practical at this point.  This isn’t an easy task, but there may be some measures that would provide support and strengthen the incentives to states to pursue prudent purchasing strategies. For example:

  • Federal requirements.  The federal government could, of course, simply set high standards for state exchanges and require them to pursue strong purchasing strategies, using the authority under PPACA to certify state exchanges.
  • Financial incentives. Short of shifting the costs of subsidies to the states – which is not practical in the current climate — there are a variety of ways that they could be given stronger financial incentives to be effective purchasers.  For example, the federal government could offer innovation grants and technical assistance to states that want to pursue prudent purchasing strategies.  An even stronger incentive would be provided if the federal government were to offer rebates to states in which premiums in the exchanges were lower than a defined benchmark, e.g., expected premiums based on historical trends or averages of other states.  The rebates would be financed by the reduced cost of federal subsidies in those states in which premiums were lower than expected.  This “shared savings” approach would provide a tangible reward to states that used effective purchasing tools in their exchanges.
  • Alignment with other purchasers.  For other state purchasers, i.e., Medicaid and state employee plans, it would be valuable for the exchange to use similar purchasing practices.  If all state-level purchasers, including the exchanges, were to use common performance measures, consistent standards for participating health plans, and common purchasing strategies, it would send a clear and consistent message to the state’s health plans and their affiliated providers.  If the other state purchasers were to speak up about the value of alignment, it might influence the design of the exchanges.
  • Report cards.  If states were evaluated on their use of effective purchasing practices and the results were published, it might encourage more states to use stronger purchasing practices.  The positive recognition for those with good outcomes (lower costs, higher quality) and the potentially uncomfortable visibility for those with poor outcomes might move the latter group to make changes.  The use of report cards might also be a stimulus for the sharing of best purchasing practices among the states.
  • Consumer and purchaser voices.  Individuals and small employers could speak up and insist on good value in the exchanges.  In some states, they have potential influence through participation in the exchange’s governing board.  If consumers and purchasers were to make a strong and unified case for a prudent purchaser strategy, they might be able to influence legislators and governing boards as they make design decisions about the exchanges.

In the end, we will need to address this issue.  If exchanges do not pursue effective purchasing strategies, we will have missed an opportunity to reduce costs and improve quality for individuals and small employers and to be a catalyst for improved performance of the health care system as a whole.  States would benefit from stronger financial incentives to pursue effective purchasing strategies in the exchanges.  In recognition of this fact, we should pursue some or all of the above approaches to recognize and reward states that design and implement the exchanges in ways that create improved value.

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2 Responses to “Why Aren’t State Exchanges Embracing Prudent Purchasing Strategies?”

  1. sonyaschwartz Says:

    Hi Bill, Your blog made me realize it wasn’t clear if information about the status of health insurance exchanges and “active purchasing” was readily available to people interested in this topic. So, I responded in a blog on State Refor(u)m ( The blog is available here: I analyzed existing exchange legislation and executive orders, and compiled what we know so far with links to all relevant sources.

    In a nutshell, six states—almost half of states with exchange legislation or executive orders—have already given a “green light” to what I call “active purchasing” strategies. I defined active purchasing, for the purposes of my analysis, as using selective contracting to negotiate better prices and higher quality from plans, or setting certification criteria beyond the federal floor that reflect the state’s goals.

    Best, Sonya

  2. Thomas Cox Says:

    It is easy to miss the real problems with the state exchange model. When this happens it is comforting to think that we might tweak a system a bit that was, in what will be the final analysis, guaranteed to fail from the start. Under the tweak approach we can fix a few isolated problems in much the same way that Copernicus fixed a few of the problems with the geocentric universe.

    The problem, unfortunately, is that in insurance markets there actually is a single best, most efficient, and least problematic design. The optimal size for an insurer is the largest possible portfolio possible. In the case of health benefits this would entail eliminating hundreds of smaller, less efficient health benefit plans and insurance policies in favor of a single insurer covering all 309,000,000 Americans.

    This single insurer, with a single set of benefits, a single set of forms, a single set of standards for evaluating the costs and outcomes of interventions, is the most mathematically efficient insurer possible.

    By efficiency I refer, of course, to the proximity the insurer’s loss ratio to the population loss ratio for the population served. No smaller insurer will have loss ratios as close to the population loss ratio as the single largest insurer possible. In fact, simple applications of the Central Limit Theorem will allow us to specify how much further from the population loss ratio a smaller insurer’s loss ratios are likely to fall.

    If a relatively large and reasonably efficient insurer, our Paradigm Insurer, has a loss ratio that wobbles around the population loss ratio of 0.7500 from year to year, in a manner that suggests that about 95% of years will produce loss ratios of 0.6500 to 0.8500, how far from 0.7500 would our national health insurer’s loss ratio be likely to fall over the same number of years if it is insuring 309,000,000 and offering identical benefits?

    The answer is that the national health insurer’s loss ratio would lie between about 0. 7443 and 0.7557. This assumes that the standard error of the estimate of the population loss ratio for the Paradigm Insurer is 0.0500 and multiplies this by the square root of the ratio of the size of the national health insurer’s portfolio to that of the Paradigm insurer. In short, the standard error of the estimate of the population loss ratio for our national health insurer is about 0.0028, far lower than the Paradigm Insurer’s standard error.

    Among the advantages of this largest possible insurer are that it would have a higher probability of achieving reasonable profits, it would have a far lower probability of incurring solvency threatening losses, it would provide higher benefits per premium dollar than any smaller insurer, and it would need far less surplus to assure its solvency. From a purely mathematical viewpoint there is no number of insurers greater than 1 that can compete with these operating characteristics.

    No amount of political ranting and intentional misinformation can overcome the obvious advantage of a national health insurer yet this does not stop either the ranting or the intentional misinformation.

    Even beyond the mathematical superiority of a single, optimally sized national health insurer, is the elimination of all the inefficiencies that accrue with hundreds of insurance companies, thousands of specific benefit benefit plan inclusions and exclusions, the resulting uncertainties about benefit eligibility, and the massive litigation over benefits, not to mention the waste and inefficiencies involved in insurance underwriting, rate making, reserving, and capitalizing all these inefficient insurers.

    So, given that there actually is a mathematically, single most efficient insurer, we must focus on why we continue to look everywhere else but there for solutions to our problems, with all too predictable results.

    In the final analysis the answer seems clear enough. Our current system of hundreds of health insurers and health benefits companies accomplishes something that the national health insurer will never be able to accomplish. We succeed in rationing care, limiting access to health care, delaying and denying potentially expensive health care services at arm’s length through our current system.

    If we implement a national health insurer we will actually have to decide, and explain in detail, what benefits everyone will be eligible to receive. Politicians and benefit overseers will have to go on record and state that certain kinds of services will not be paid by the national health insurer. Perhaps we will not provide liver transplants to life long alcoholics. We may not provide tube feeding for near comatose patients in their 90s who have not communicated with anyone for years, but are lying in nursing homes because some entity is paying for their care.

    This enormously successful ability to ration care, at arm’s length, with the notion of “Plausible Denial” about what we are doing, is the most obvious benefit our fragmented and fractured health care (finance) systems bestow at this point. Unfortunately, our fragmented and fractured health care (finance) systems provide this cover at far greater cost to individual patients, health care providers, payors, and the public at large, than would be the case with an optimally sized national health insurer.

    So, the answer really is that the efficiencies the authors suggests could be achieved by combining state health insurance exchanges purchasing with better, more efficient benefit plan purchasers is exactly what our policy planners, researchers, and politicians are working so hard to avoid – a coherent, well documented, health benefit plan that would equally well serve everyone in the United States, where everyone would know what benefits were available, and in which those benefits would actually be provided.

    Combing purchasing would eliminate the finely orchestrated system of inconsistent benefit entitlement determinations that have been finely tuned by insurers and insurance risk assuming health care providers, who are motivated by the increased profitability that denying and delaying services provides to them.

    This finely tuned health care rationing system saves trillions of dollars each year compared to any imaginable system in which everyone would have the same exact access to health care services whether they were active duty military personnel, homeless veterans struggling with war zone injuries and PTSD, senior citizens, the poor, transients, college professors, or factory workers.

    Apparently almost nobody in America really wants an efficient health care finance system or we would already have one since the mathematical basis for such a system is abundantly clear.

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