Let the (Accounting) Games Begin!

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Igor Volsky at WonkRoom has just discovered that when you arbitrarily set restrictions on what sorts of expenses companies can take, they will arbitrarily reclassify those expenses as something else.  Specifically, government officials think it would be nicer if insurance companies spent a higher percentage of their revenues on medical care rather than administrative overhead.  Without particularly investigating whether this was sound, or even possible, they enacted a rule dictating that the "medical loss ratio" had to be a fairly high percentage of revenues.  Predictably, companies are reclassifying administrative expenses as medical in order to make their numbers.Now, maybe this is an example of evil companies struggling to hold onto their profits.  But you certainly couldn't prove it by Volsky's post.  He seems to confuse administrative overhead with profits, and further seems unaware that overhead (apart from profits) is usually higher when dealing with a lot of small clients rather than a few big ones.  He refers to the MLR rules as "one of the few ways to prevent insurers from earning outrageous profits before most of reform's provisions kick in", even though the health insurance industry isn't particularly profitable.

It is true, of course, that profits are part of the overhead targeted by the medical loss ratio rules.  But it does not therefore follow, as night to day, that if you raise the percentage of money that you spend on treatment, you lower profits.  It certainly doesn't follow that you lower profits the way you want to--by taking money from greedy executives and giving it to nice folks seeking treatment--rather than, say, by forcing companies with high overhead out of the market entirely. 

He seems blind to the other obvious way to meet your MLR requirements:  stop searching for fraud on either the customer or provider end, and let costs balloon.  If you stop paying attention to controlling costs, your overhead goes down, especially relatively to your costs.  Normally, this is a recipe for bankruptcy, as your competitors undercut you.  But when your competitors are all subject to the same rule requiring them to let this happen....

Given how much focus reformers put on controlling health care costs, reclassifying administrative costs as medical expenses is probably a positive development.

I'm generally annoyed by conservatives who claim that Washington is full of pointy-headed wonks who have never held a "real job" . . . but I do think that the most dangerous weakness on the pro-reform side is a broad ignorance of how companies actually work.  There seem to be a lot of assumptions that are intuitively satisfying, but blatantly silly to anyone who has ever managed a company (or spent much time talking to those who do).  The assumption that lower overhead is invariably better is one of these, but not the only one.  Others include a fairly persistent confusion about how companies make investment decisions, and how capital markets work; the belief that price rationing and government rationing are somehow economically equivalent because they both contain the word "rationing"; and the belief that having more the one product in a market is obviously wasteful "me-too" competition which is bad for consumers.

It's a dangerous weakness because it leads them to an extremely simplistic model of how companies work, and I think it makes them believe that they can mandate a lot more than they really can.  The pro-reform side has been at its best in describing market processes that look a lot like what happens in government programs--things like adverse selection, and bargaining with providers.  But when you have to add in processes that don't look much like what the government does--things like capital costs and investment decisions*, competition, and price discovery--their mental models often seem suspect.

I suspect that's going to be a big problem as we go forward, particularly when it comes to controlling costs.

*Before you rush to tell me that the government does too make capital investment decisions, let me just say that the government capital investment process simply looks virtually nothing like what happens in a company. Just try to imagine calculating an IRR on a highway. 

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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