Building a National Insurance Exchange: C A L I FOR N I A Lessons from California H EALTH C ARE F OU NDATION Introduction In 2007 and 2008, California launched a major Among the deliberations now taking place in the push to expand insurance coverage to all citizens nation’s capital regarding federal approaches to of the state, an effort that was initiated by expanding health coverage, virtually all incorporate Governor Schwarzenegger and vigorously pursued the idea of an insurance exchange — an entity to by a number of legislators and stakeholders. An which people can go to select a health plan from insurance exchange was a central element of all Issue Brief a broad range of offerings. Over the past 15 years, of the proposals. Ultimately, however, agreement California gained extensive experience in designing on some key aspects of the reforms could not be and operating just such an exchange, an effort that reached, and the effort collapsed in 2008. ultimately proved unsustainable. Exchange Models This issue brief draws heavily on interviews with The basic concept of an insurance exchange is not eight individuals who were either at the forefront new, but there are several variations on the idea: of shaping the California exchange concept or ◾◾ Active purchaser. The model for this played key roles in its design and operation, right approach is large employers who negotiate through to its ultimate demise. The hope is that and selectively contract with insurers that the lessons learned at the state level will prove offer a high-value product in exchange for useful to federal policymakers as they construct a a large volume of enrollees. Where this viable plan for reform on a national scale. exchange model has operated in the past, there has been a market both within and Background outside the exchange seeking to attract the California’s effort to create an effective insurance same customers. The Health Insurance exchange began in 1993, when the Health Plan of California (HIPC) and its successor Insurance Plan of California (HIPC) began PacAdvantage are examples of this model. offering small employers several standardized health insurance products being sold by several ◾◾ Passive clearinghouse. An exchange built on different health plans. Although initially a govern­ this model is merely a “price taker” willing ment entity under the auspice of the Managed to accept all health plans, a place where Risk Medical Insurance Board (MRMIB), the employers and individuals can go to find a authorizing legislation called for the exchange to range of coverage offerings and compare price, be privatized. Accordingly, in 1999, operation quality, and service levels. Participating plans was turned over to the Pacific Business Group compete for exchange enrollees on the basis on Health, where it became PacAdvantage. At of cost and quality. The Federal Employees its peak, the California exchange enrolled about Health Benefit Program is an approximate 150,000 people. Nonetheless, it encountered example of this model. major problems and ultimately closed in 2006. J uly 2009 ◾◾ Hybrid market organizer. An entity built on this year (upon initial enrollment and again at annual model does not directly negotiate prices or selectively renewal), they would be forced to compete on the contract; however, it may define standard benefit basis of price, quality, and service — an approach packages, provide some degree of endorsement, and known as “managed competition.” otherwise indirectly encourage health plans to offer 3. Enhance portability of coverage. Once individuals high-value coverage. The Massachusetts Connector is selected a health plan through the exchange, they could an example. keep the same coverage if they changed jobs to work for another participating employer. The California Exchange The Reality The Expectation The actual experience of the California exchange taught The founders of the California exchange designed it to be some hard lessons. It showed that none of these objectives an active purchaser. They, like others across the country is easily achieved. who were attracted to this exchange model, hoped to achieve a number of important objectives: The history of the California experiment can be summed 1. Provide an easy-to-navigate single point of entry where up in a single rule: Any exchange that seeks to be an people could go to choose among several health plans. active purchaser will have a very difficult time achieving The exchange would contract with a number of health its objectives if it is not the exclusive source of coverage plans and then provide objective information about for some populations, such as small employers or price, benefits, and plan performance to help people subsidized individual purchasers. compare plan value and make wise choices. If there is competition for the same customers inside and 2. Reduce the cost of coverage, using three primary outside the exchange, the exchange will be unable to offer mechanisms: lower prices on a sustained basis, for at least four reasons: ◾◾ Reduce administrative costs by achieving 1. Some health plans may refuse to participate. economies of scale. The exchange would centralize some marketing functions, enroll individuals 2. Economies of scale in administration are hard to in their chosen plan, and collect and distribute achieve. premiums to health insurers. For people who 3. Participating health plans will not give the exchange choose not to use insurance agents, it would a lower price. reduce the premium to reflect the savings from not having to pay a commission. 4. The exchange is likely to attract higher-risk enrollees. ◾◾ Command lower prices. Just as large employers Moreover, without sufficient numbers of health plans, do, the exchange would negotiate with health the exchange cannot offer meaningful choice or enhance plans, offering contracts to only a selected few portability. plans that offered favorable prices in exchange for a significant market share. ◾◾ Foster market competition. Because insurers would be required to offer standardized health plans from which individual employees could choose every 2  |  California HealthCare Foundation The Participation Problem The Elusiveness of Savings An exchange can serve as a convenient place for people to Achieving lower prices over the long run also proved choose among health plans only if a significant number unworkable in California, for three reasons: the exchange of popular plans are willing to participate. However was not able to produce administrative savings, it could the attempt in California, as elsewhere, demonstrated not negotiate lower premiums, and it became a victim of that as long as the exchange is not the exclusive source adverse selection. of coverage for some populations, health plans may be reluctant to participate, including some of the largest Few administrative efficiencies. Administrative plans. economies of scale are not achievable without large enrollment. At its peak, the California exchange enrolled Insurers do not particularly like the head-to-head about 150,000 individuals — a tiny percentage of the competition that is a feature of the exchange concept, small-group market. For each individual health plan, the in part because they could lose any given enrollee to a business generated from the exchange was such a small competitor in any given year. Moreover, the people most proportion of the plan’s total small-group enrollment likely to switch are the healthiest people, who are least that the plans did not realize any administrative savings, costly to insure. If an insurer in the exchange has to raise which meant they could not offer lower premiums to the premiums in any particular year, their healthy enrollees, exchange. Likewise, the exchange learned that it could not who use the system infrequently and thus are less attached itself provide administrative services related to enrollment, to particular providers or particular benefit structures, premium collection, and the associated services at a cost have fewer qualms about switching to another health plan significantly lower than that incurred by the health plans. to save a few dollars. Had the exchange dominated the small-group market, it might have produced some of the anticipated savings. But Insurers always prefer to insure whole groups directly the cost of serving small employers and individuals will rather than compete in the exchange. Not only do always be more expensive on a per capita basis than that they get the whole group exclusively, but they can be for large employers. reasonably assured of enrolling some healthy, lower-risk participants along with any higher-risk individuals that A lack of pricing power. After some brief initial success, might be part of the group. Each insurer worries that the California exchange also found it very difficult to if they participate in the exchange, their company may negotiate lower prices. With only a small share of the end up with a disproportionate share of the exchange’s total market, it had little bargaining power. Nor did it high-risk, high-use enrollees, a phenomenon known as have a captive supply of customers that insurers could “adverse selection.” reach only by participating in the exchange. Health plans could always compete for those same customers If the exchange has a sizeable market share that health outside the exchange. The key to bargaining is selective plans cannot afford to pass up, more will willingly contracting — offering a few insurers access to a sizeable participate. But without the inclusion of most large plans, population in exchange for a good price, as large the exchange will have trouble attracting enough enrollees employers do. That was not a viable strategy for the to command a large market share. As one former director exchange. In the end, the exchange needed the health of the California exchange noted, “An exchange is often plans much more than the health plans needed the just one health plan loss away from failure.” exchange. Building a National Insurance Exchange: Lessons from California  |  3 Not only was the exchange unable to negotiate lower Even if an exchange avoids such mistakes, it can fall prey prices; it was in constant danger of having to charge to adverse selection because health plans have strong higher prices than those available in the regular market. incentives to channel high-risk people to the exchange (as One former executive director of the California exchange well as to other insurers). For insurers, avoiding high-risk observed that health plans would never offer the exchange people is not just a matter of making profits; it is a matter a price lower than what they charged outside the of survival. An insurer that enrolls a disproportionate exchange, because they would enroll fewer people, losing share of unhealthy people with costly medical conditions some to other exchange insurers, and realize less money will be at a permanent competitive disadvantage and per enrollee. Rather than compete in the exchange, plans will lose market share. The danger is especially acute if will always prefer to insure people directly. insurance market rules significantly limit insurers’ ability to vary premiums based on risk — as most reformers agree Exposure to adverse selection. But the greatest threat is necessary. to the exchange is adverse selection. People involved in operations of the California exchange agreed that when It is thus not surprising that insurers operating outside the there is competition for the same customers within and exchange, as well as their agents, may encourage high-risk outside the exchange, the exchange is in “extreme peril” individuals and groups to go to the exchange rather of becoming a victim of adverse selection. If an exchange than buy from them. Even insurers participating in the attracts a disproportionate share of higher-risk individuals exchange may do this, because many of the costly people and groups, as the California exchange did at various will choose other exchange insurers (assuming that the times, it cannot succeed. The average medical claims exchange rules permit individual employee choice). cost of people enrolled in the exchange will be higher than in the outside market, which means that premiums Contrary to common thinking, even being big — as a must be higher, making it impossible for the exchange to national exchange would be — will not by itself ensure a attract customers. People will not buy health insurance representative, viable risk pool. An exchange can become through the exchange or stay within it if they can get the a big pool of high-risk people. same coverage less expensively elsewhere. Eventually, the exchange will fail. The Portability Mirage The last objective sought by proponents of To protect itself against adverse selection, an exchange exchanges — greater portability of coverage — cannot must not be more lenient than outside insurers in be achieved in a meaningful way if few people are accepting higher-risk enrollees. It must employ whatever insured through the exchange. Real portability for the medical underwriting and risk-rating practices are allowed employees of small firms is achieved only if many small in the regular market to avoid becoming a magnet firms offer coverage through the exchange, so that when for the unhealthy. California law permits insurers to employees change jobs they are likely to move to another adjust premiums up or down by 10 percent based on participating employer, which makes it possible for them health status. The California exchange made the initial to stay enrolled in the same health plan. mistake of not varying rates based on enrollees’ health status, while outside insurers did. The result was adverse selection against the exchange. 4  |  California HealthCare Foundation Implications agreed that an exchange should establish a risk-adjustment The key lesson of the California experience is that if mechanism to offset any financial advantages or the exchange is to operate as an active purchaser and disadvantages health plans experience as a result of not achieve desired objectives, it needs to be the exclusive enrolling a representative risk sample. A risk-adjustment source of coverage for certain defined population mechanism creates fair competition by requiring health groups. Structuring the exchange in this way changes the plans with a disproportionate share of low-risk people to equation in such a way that the pitfalls of the California transfer funds to plans with a disproportionate share of experiment can be avoided. high-risk people. Desirable Incentives for Insurers If all works well, the result would be to greatly reduce If the exchange is the sole source of coverage for some or eliminate the cost advantage or disadvantage of not market segments, it will be able to attract insurers, enrolling a population of representative risk, thereby selectively contract with health plans, and bargain reducing the incentive for plans to “cherry pick.” for better prices in the same way that large employers Such a mechanism will have the added benefit that a do, because it will be the only point of access to this health plan particularly skilled at serving people with business. Since the exchange is the whole market for expensive acute or chronic conditions will not be these defined populations, it cannot suffer from adverse financially disadvantaged by attracting a large number selection. (This assumes that everyone will be required of such individuals. Everyone benefits when people with to buy coverage in a reformed market. If there is no such difficult health problems enroll in health plans that are mandate, the individual market as a whole — and thus especially skilled at treating their maladies. Without risk the exchange — will almost surely experience adverse adjustment, no health plan can enroll a disproportionate selection.) share of such people and survive. The exchange is likely to achieve some price reductions, A Single Source of Coverage both through bargaining and because managed If the exchange is to become the only source of coverage competition is likely to work as envisioned. When for some population groups, who are likely candidates? individual enrollees can change health plans every year Analysts generally agree that the people least well served and the insurers cannot get access to them except through by the existing insurance market are those who buy as the exchange, the insurers will have strong incentives to individuals and small groups. They have virtually no offer attractive prices, good quality, and superior service bargaining power and no influence on insurer practices. to maintain or expand market share. Portability will also They pay substantially higher prices. They cannot become a reality for the populations buying through the easily and effectively negotiate the market because they exchange because they can readily keep their health plan lack time, resources, and inexpensive access to reliable when they switch employers. sources of information. Buying insurance through an exchange could alleviate some of these problems. It thus Effective Risk Adjustment seems logical to have the exchange be the place where Making the exchange the sole source of coverage for some individuals and very small employer groups, perhaps market segments does not solve all problems. Although all those with fewer than 10 or 15 employees, go to get the exchange will not suffer from adverse selection, coverage. individual insurers operating within the exchange may do so. The California experts interviewed for this analysis Building a National Insurance Exchange: Lessons from California  |  5 The California experts suggested that it would also be preferences rather than having the employer make that logical for the exchange to be the sole source of coverage choice — a feature that is necessary if the existence of for people who are being subsidized to buy private the exchange is to increase coverage portability and keep coverage, as the leading federal proposals envision. The prices in check through managed competition. But once exchange can efficiently administer the process and can individual choice is part of the exchange design, insurers effectively negotiate on their behalf. If tax dollars are to will prefer to generate business outside the exchange, be used to make coverage affordable, policymakers have as occurred in the California experience. Thus it will an obligation to ensure that the money is well spent, probably be necessary to require both that insurers to see that subsidized people are buying high-value, participate and that they charge a price no higher than cost-effective plans. The exchange provides an effective the one they offer outside the exchange. The insurers and efficient mechanism for determining who is eligible will still have an incentive to direct higher-risk people for subsidies and for ensuring that subsidized people are to the exchange rather than insuring them directly, in buying coverage appropriate to their needs. hopes that they might pass off some of the “bad” risks to other insurers. However, establishing an effective Choosing the Right Model risk-adjustment mechanism that operates both inside and Another implication of the California experience is outside the exchange would nullify the benefits gained that if the exchange is to compete with insurers selling from such tactics. coverage to the same customers in the regular market, it should be structured on either the “clearinghouse” model Summary or the “hybrid” model. That is, it should not attempt The history of the California exchange yields a number of to negotiate or bargain with health plans but instead important lessons that have implications for the design of should accept all willing insurers and let them establish a health exchange at the national level: prices based on their own assessment of the competitive conditions. The primary role of the exchange should be ◾◾ An exchange that seeks to be an active purchaser will to serve as a convenient place for people to choose among have a difficult time achieving its objectives if insurers competing health plans, giving them reliable, objective are able to compete for the same customers outside information that allows them to compare coverage based the exchange market. It will have trouble getting and on price and value. keeping health plan participation and bargaining for lower prices, and it will face a constant threat of If the exchange is to serve this purpose effectively, adverse selection. insurers should be required to offer a limited number of ◾◾ If the exchange is to operate as an active purchaser standardized benefit packages. Without standardization, and achieve desired objectives, it needs to be the it is very difficult for people to compare plans in a exclusive source of coverage for certain defined meaningful way. When the number of benefit structures population groups. Logical candidates include people is very large and each is offered at a different price, the who receive subsidies to buy private health insurance, number of variables is too large for people to deal with people seeking coverage as individuals, and small rationally. They cannot make wise choices. employers. The clearinghouse or hybrid models may still be ◾◾ If the exchange is to compete with insurers selling compatible with the goal of allowing individual employees coverage to the same customers in the regular market, to choose a health plan that best suits their needs and it should be structured on the “clearinghouse” model 6  |  California HealthCare Foundation or the “hybrid” model. To make even these models Author work, especially if there is individual employee Elliot K. Wicks, Ph.D., senior economist, Health Management choice, it may be necessary to require health plans to Associates, Washington, D.C. participate and to require them to charge the same A c k n ow l e d g m e n t s price both inside and outside the exchange. The author thanks the following people for generously giving ◾◾ Regardless of model, the exchange will be more likely of their time and expertise to help the author understand to achieve desired objectives if it requires insurers the California experience: John Ramey, Richard Figueroa, to offer a limited number of standardized benefit Sumi Sousa, Scott Bain, Sandra Shewry, John Grgurina, Rick Curtis, and Ed Neuschler. Thanks are also due to packages and includes a risk-adjustment mechanism. Peter Harbage for suggestions that helped to improve the manuscript. About the F o u n d at i o n The California HealthCare Foundation is an independent philanthropy committed to improving the way health care is delivered and financed in California. By promoting innovations in care and broader access to information, our goal is to ensure that all Californians can get the care they need, when they need it, at a price they can afford. For more information, visit www.chcf.org. Building a National Insurance Exchange: Lessons from California  |  7