The Affordable Care Act's Impact On Health Insurance Ratings Is Neutral Now, But Pressure Could Build Over

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Primary Credit Analyst: Neal I Freedman, New York (1) 212-438-1274; neal.freedman@standardandpoors.com Secondary Contacts: Hema Singh, Hightstown (1) 212-438-7254; hema.singh@standardandpoors.com Joseph N Marinucci, New York (1) 212-438-2012; joseph.marinucci@standardandpoors.com Lawrence A Wilkinson, New York (1) 212-438-1882; lawrence.wilkinson@standardandpoors.com Research Contributor: Caitlin Weir, New York (1) 212-438-5669; caitlin.weir@standardandpoors.com

Table Of Contents
Adverse Selection, Morbidity, And Pricing Issues At The Blues Will Risk Mitigation Work? Capital, Earnings, And Accounting Issues

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The Affordable Care Act's Impact On Health Insurance Ratings Is Neutral Now, But Pressure Could Build Over Time
The Affordable Care Act (ACA) is the most far-reaching legislation to affect the U.S. health insurance system since the enactment of Medicare and Medicaid in 1965. The federal ACA exchanges, where residents of 36 states can buy health insurance, have experienced significant operational difficulties since launching on Oct 1. Operations at the 14 state-run exchanges and in the District of Columbia have experienced varying levels of difficulty, though the California and Kentucky exchanges have been among the more successful. Although crucial parts of the ACA are just beginning to go into effect, Standard & Poor's Rating Services foresees that the law's immediate impact on our rated health insurers will be neutral. Over the intermediate to long term, however, we believe the ACA could diminish the financial strength of some health insurers, especially some in the Blue Cross and Blue Shield system, potentially resulting in downgrades. Overview We believe that the Affordable Care Act will generally have a neutral impact on health insurance company ratings in the near term. The potential for negative ratings actions for insurers, however, will grow over time, particularly at some Blue Cross and Blue Shield plans that we see as especially vulnerable. The efficacy of the ACA's risk-mitigation provisions, which were put in place to protect health insurers, have never been applied to such a broad population with such a comprehensive set of benefits. ACA provisions will introduce new and complex accounting issues that will complicate our analysis of the health insurance sector.

The rollout of ACA affects our analyses of health insurers in a number of key ways. In particular, the potential for adverse selection--the tendency for larger numbers of people in poor health to buy health insurance--could result in elevated morbidity (defined here as the overall health status of the risk pool). This would contribute to diminished operating performance and reduced risk-adjusted capitalization for a health insurer. Our analyses will also be complicated by new and complex accounting issues the ACA has created, most notably the difficulties in estimating claim reserves and the potential for large receivables between health insurers and the federal government. Finally, the legal and regulatory issues concerning the ACA remain quite fluid. We will continue to monitor changes and incorporate them into our analyses as events unfold. The scope of this article is the rating impact of the ACA exchanges, and we'll consider the other major provision of the ACA--the expansion of Medicaid coverage in a number of states--separately in a later report.

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The Affordable Care Act's Impact On Health Insurance Ratings Is Neutral Now, But Pressure Could Build Over Time

Adverse Selection, Morbidity, And Pricing Issues At The Blues

Blue Cross and Blue Shield plans (the Blues) are the largest participants in the state and federal health insurance exchanges set up under the ACA and often have significant leading market shares in their designated territories. In most cases their products offered on the exchanges are the least expensive (or close to it), though they have been, in our view, priced to generate a small profit. But being the low-cost provider will likely generate adverse selection, though this risk is somewhat mitigated by many of these plans having strong risk-adjusted capitalization resulting from medical costs rising more slowly than expected over the past few years. However, because of the exchanges' operational difficulties, those in poor health are more likely to persevere through these difficulties and purchase a policy, resulting in greater adverse selection and higher morbidity. Finally, the recent decision to allow the sale of noncompliant health insurance policies though 2014, subject to approval by state regulators, further exacerbates the problem of adverse selection. So far, 13 states have granted approval, and 10 have refused. Individuals who choose to stick with their noncompliant policies are likelier to be in good health because these policies were typically medically underwritten (that is, they took into account subscribers' health status). So, when these people stay with their policies, it means fewer healthy people buy insurance on the exchanges, elevating the morbidity of the exchange risk pool. With policies that were not priced to include this additional morbidity, we believe that some of the Blues, in particular, will likely see diminished operating performance and as a result, request large rate increases for 2015. That could prove problematic because these requests could make it difficult for regulators to maintain a balance between the affordability of health insurance and the need to keep insurers financially strong. The large, national health insurers, by contrast, don't have as much at stake because they are less heavily involved in selling policies on the exchanges. United HealthCare, Aetna, and CIGNA, for example, are participating on a limited number of exchanges. Furthermore, their policies are also generally priced higher than the Blues, giving them somewhat more of a cushion.

Will Risk Mitigation Work?

Because health insurers may become financially weakened through adverse selection, the ACA includes three provisions to reduce that risk: The first is a three-year (2014-2016) reinsurance plan that provides funding to insurers that incur high claim costs for enrollees. The federal government will collect premiums from all insurers to be disbursed among certain insurance plans when an individual's claims exceed a specified attachment point in a given year ($45,000 in 2014). The second is risk corridors, which limit insurer losses and gains. Like the reinsurance plan, these corridors will be in effect for three years. Under them, the federal government will share an insurer's exchange underwriting results based on the size of the variance between the insurer's underwriting results and a formula-based target amount. Insurers with results that are significantly worse than the target amount will receive payments from the federal government, while insurers with underwriting results that are significantly better will make payments to the federal government. The third is risk-adjustment, which transfers funds from insurers with lower-risk enrollees to insurers with

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The Affordable Care Act's Impact On Health Insurance Ratings Is Neutral Now, But Pressure Could Build Over Time

higher-risk enrollees. Unlike reinsurance and risk corridors, this provision is permanent. The risk-adjustment program provides payments to insurers that disproportionately attract higher-risk populations, such as those with chronic conditions. Unlike the reinsurance and risk corridors provisions, this transfer of funds is not between an insurer and the federal government. Rather, it is from insurers with lower-risk enrollees to insurers with higher-risk enrollees. These risk-mitigation techniques have never been attempted before on a scale as large as what the ACA envisions with regard to such a broad population and such a comprehensive set of benefits. In our view, this attempt to mitigate risk on such a large scale could be a risk in itself. However, these techniques do have some history in the Medicare Advantage (risk adjustment) and Medicare Part D Prescription Drug programs (all three provisions), which focus on senior citizens. But it's too early to know how effective they will be in offsetting insurers' risks under the ACA, and we will continue to monitor how these efforts play out. Given the pricing and morbidity issues, we believe it's more likely than not that reinsurance and risk corridors will result in large payments from the federal government to insurance companies. With the ACA still controversial among many Americans, these payments, which should help reduce earnings volatility, also raise the possibility of a political backlash.

Capital, Earnings, And Accounting Issues

Uncertainty about the the efficacy of the risk-mitigation provisions, combined with the potential for diminished operating performance through adverse selection, could erode an insurer's risk-adjusted capitalization, as measured by our risk-based capital model. In such cases, we would lower an insurer's capital and earnings scores, which would likely lower its financial risk profile and potentially resulting in a downgrade. The ACA will introduce several new accounting issues that will affect our analysis. How the potentially large receivables from the federal government under the reinsurance and risk-adjustment portions of the ACA will be accounted for on profit/loss statements and balance sheets will be of particular interest to us. We will also be looking closely to see how health insurers account for new actuarial estimates, the risk corridors, and reinsurance transfers. In addition, because of the large number of newly insured individuals expected to buy exchange policies, we foresee a likely change in claim payment patterns, which will make claim reserve estimation more difficult. And because different insurers have different claim-reserving practices, comparing health insurance companies will likewise become a more challenging part of our analysis. Moreover, because claim reserves are a critical input to determining the level of incurred claims, they affect nearly every important calculation included in the ACA, such as the medical loss ratio (the share of premiums spent on medical care) and the risk corridor calculation. Although the main provisions of the ACA have been clear for some time, the legislation itself is a complex law that has generated thousands of pages of additional regulation that insurers must be knowledgeable about to stay in compliance. They must also meet the requirements and approval of state regulators where they operate. It is a massive undertaking for them, and we will monitor the process as it moves along. Currently, we see little ratings impact. But the potential for negative ratings actions, especially among Blues, is likely to increase as the ACA is fully implemented.

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The Affordable Care Act's Impact On Health Insurance Ratings Is Neutral Now, But Pressure Could Build Over Time

Writer: Robert McNatt

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