Examining the community rating: South African style

The rating system introduced in South Africa by the Medical Schemes Act is so different from the American community rating system, it should not be called a community rating system.

When the new Medical Schemes Act was proposed in South Africa, it was widely argued that the American system of community rating should be adopted to determine the premiums for medical schemes. It is now widely believed that when the Medical Schemes Act was passed, the American system of community rating was, in fact, introduced in South Africa. Neither of these views is correct. The system argued for and introduced is not the American community rating system.

To understand what we have in South Africa, it is first necessary to look at what the Americans mean by “community rating”, before considering the peculiarities of the South African system.

Risk or experience rating

A distinction between risk rating – or experience rating, as it is sometimes called - and community rating can be made. Risk rating is the normal insurance rating system. Insurers collect premiums in advance, traditionally on a year-to-year basis, and notionally at least pay these into a risk pool. Claims are then paid from this pool.

South Africa, it is believed, was one of the first (if not the first) countries to change to shorter, monthly premiums. Conceptually it is better to think of a longer period, say a year. If at the end of the year, something is left over in the pool, the insurer knows the premium charged was correct. Claims, in the end, determine premiums.

Risk rating claims ratios

In addition to paying for claims, the insurer has other expenses, such as operating costs, acquisition of new business costs and paying a return to shareholders. Thus, an insurer can price insurance products by having a claims ratio of less than one and then tracking the claims ratio. Experience will tell the insurer what this ratio must be in order to survive.

So, for example, by tracking a ratio of say 75%, an insurer will know that 75% of the premium is needed to pay the costs of the claims and the remaining 25% will suffice to cover other costs and pay a return to shareholders. Because of investment income it is possible, with certain long tail liabilities, to have a ratio in excess of 100%.

Market forces affecting risk rating

Of course, in a competitive market an insurer cannot charge what it likes, because a competitor will charge a lower rate and the overcharging insurer will soon be out of business. This also means insurers have to ensure that insureds are all in the correct risk pool. For example, if age is a significant risk factor with higher costs associated with age, the younger insureds will migrate away from an insurer that tries to charge all insureds the same premium irrespective of age, to an insurer which has correctly priced the insurance and charges a lower rate to younger persons. The higher priced insurer will end up with the high claiming insureds. The risk rating system soon ensures that all insureds are being offered the correctly rated products.

Incidentally, it is not clear that age is the correct risk factor when it comes to medical risk rating. Some years ago we invited Professor Peter Zwifel, a leading health economist from Switzerland, to spend some time at Wits. He pointed out that age is more of a proxy than risk factor. The real risk factor is the period before death, when the bulk of medical expenses are incurred. It just happens to be that the older one gets, the closer one gets to dying and thus age becomes a good proxy for this risk factor.

Risk factors

A further point regarding the risk factors is that it is in the interest of insurers to select these to be cost effective to underwrite. This is the so-called “costless underwriting”. It becomes inefficient to incur excessive expenses at the underwriting stage, since not everyone will claim during the period of insurance.

So, for example, a medical insurer will not want to pay for all insureds to undergo a battery of expensive tests before accepting the risk. These inexpensive risk factors include things such as age, gender, employment (since employed persons are likely to be healthy), lifestyle, type of occupation and so on.

So, the market left to itself will work out a series of risk indicators from which the risk can be correctly rated and each person seeking cover will be able to purchase optimal cover from a cost perspective.

Community rating - American style

Community rating ignores the risk factors when determining premiums. Insurers, pricing according to a system of community rating, does not have a different rate for the young, old, male, female, employed, unemployed, healthy, sick and so on. It should be clear that this system cannot, as a simple matter of fact, survive in a free market.

Any insurer who tries to overcharge, say, the young, will end up insuring only the old and so on. Community rating insurers will become risk rating insurers by default. The community rating system can only exist if imposed by legislation that prohibits free market risk rating. The community rating system was introduced in New York and some other states with - as can be expected - very negative results.

Community rating - South African style

The so-called ‘community rating’ system was introduced in South Africa via s29(n) of the Medical Schemes Act 131 of 1998. The Act prohibits anyone carrying on the business of a medical scheme if it is not registered in terms of the Act. This prohibits the free market from correctly pricing medical schemes products. Risk or experience rating is outlawed. The system is thus economically sub-optimal.

S29(n) allows the premiums to be set with regard to two factors: income and number of dependants. The American system does not use income allow the rate to be set in terms of the income of the purchaser as a risk rating factor. Income is not a risk factor. Using income to determine contribution rates makes the levy a form of taxation. It is, not the American community rating system.

The inefficiencies of the community rating, which is economically inefficient, is are then amplified in the South African system. The system is actually a medical tax, and not a good one at that. It is not the American community rating system.