Related businesses and preservation of Medicare’s Medical Loss Ratio rules

Vertical integration in health care is increasing rapidly. National health insurers are in the midst of restructuring the organization of health care financing and delivery by acquiring upstream providers of health care services that include prescription drug distribution, pharmacies, home health agencies, and physician services. For example, the three largest pharmacy benefit managers (PBMs) are integrated with three large health insurers (UnitedHealthcare, CVS/Aetna, and Cigna).  UnitedHealthcare’s subsidiary Optum Care currently employs about 70,000 physicians, comprising nearly 10% of all active U.S. physicians, and owns about 2,200 different sites of care. CVS/Aetna has established walk-in clinical services through MinuteClinics in many of the nearly 10,000 pharmacies they operate around the country, accounting for 2.8 million patient visits annually. The company has also started acquiring physician practices, and recently offered $10.6 billion to purchase Oak Street Health, a company that employs roughly 600 primary care providers and has more than 150 medical centers nationwide. Several of the largest MA parent companies (excluding Blue Cross/Blue Shield plans) have recently purchased home health companies.

Medicare Advantage (MA) plans reflect those developments as most plans are parts of parent companies that own related businesses. The four largest MA parent companies (UnitedHealthcare, Humana, CVS/Aetna, and Kaiser Permanente) accounted for nearly 65% of MA enrollment in 2022. Our recent study found that each of these parent companies, except Humana, directed at least 10% of their medical spending to related businesses. In 2019, 17% of UnitedHealthcare’s spending was sent to related businesses, more than double the share of plan expenses accounted for by related businesses in 2016. Likewise, about 13% of CVS/Aetna payments in 2019 were made to related businesses, a fivefold increase over 2016.  Competitors with these insurers are responding by acquiring or developing PBMs, buying home health agencies, and integrating other suppliers of health services further increasing the presence of vertically integrated payers and service providers.

Vertical integration and Medicare’s Medical Loss Ratio regulation

One consequence of vertical integration is that it permits MA plans to circumvent regulations aimed at constraining the profits that can be earned from the MA program.

A plan’s Medical Loss Ratio (MLR) measures the share of premium revenues that a plan spends on health care claims. The Affordable Care Act required MA plans to maintain an MLR of at least 85% to improve alignment of “costs” and payments. If a plan uses less than 85% of its premium revenues for health expenses (as opposed to administrative costs or profits), then it must pay a rebate to the Centers for Medicare and Medicaid Services (CMS). If the plan repeatedly falls below the MLR threshold, then CMS can apply stiffer sanctions, including bans on enrolling new members and even contract termination.

Parent companies that own both health plans and related health care businesses can evade the MLR regime by altering transfer prices, the prices that MA plans pay to related health care businesses owned by the same parent company. Specifically, by charging higher transfer prices, a vertically integrated MA plan can move profits from the MA plan to the related business. This increases the MA plan’s MLR without reducing the parent company’s profits, weakening the MLR constraint.

Potential regulatory responses

Addressing issues of transfer prices in the MA program involves two key steps. The first is for CMS to gain greater visibility into current transfer pricing practices. This requires obtaining information on the use of transfer prices and the methods used to establish them. Specifically, CMS should require the parent companies of MA plans to report the identity of any departments or subsidiaries that provide medical services or products to their plans and the transfer prices used.

The second regulatory response would entail creating principles for evaluating whether the transfer prices in use by MA plans are consistent with regulatory provisions such as the MLR. CMS would develop guidance defining a reasonable method for establishing transfer prices within a vertically integrated insurance company. This guidance would be accompanied by the establishment of reasonable benchmarks for transfer prices. As a first empirical step towards setting a benchmark, the transfer prices used by parent companies of MA plans would be compared to the Medicare Fee Schedule if such a schedule exists. (Such a schedule will not exist for PBM services.)

Tax authorities have prior experience regulating transfer prices to combat tax avoidance by multi-national firms that operate in countries with very different tax structures. These include national tax authorities such as the Internal Revenue Service (IRS) and international economic organizations such as the Organization for Economic Cooperation and Development (OECD). This experience can help inform regulation of transfer prices in the context of the MA MLR rules.

The fundamental task for assessing transfer prices is developing a benchmark as the basis for defining a “reasonable” transfer price. The dominant line of thinking in the tax policy context is that transfer prices should be judged against an “arm’s length” benchmark. That is, the benchmark should be the price that would be charged between two similarly situated entities that are not vertically integrated. The typical challenge with this approach is that “arm’s length” prices are not always readily available.

In the case of MA, however, the fact that the prices MA plans pay to physicians and hospitals are typically very close to the prices paid by traditional Medicare may make identifying “arm’s length” prices easier. This suggests that CMS could adopt the prices specified in Medicare’s various fee schedules as the benchmark prices for health care services (including hospital services, physician services, and home health services). Of course, this approach would need to be modified if the prices paid by MA plans diverged from those paid by traditional Medicare in the future.

Developing a PBM benchmark would be considerably more difficult given the very complicated pricing dynamics of prescription drug markets. One strategy would be to employ so-called Advanced Pricing Agreements (APAs). APAs would be prospectively developed agreements between CMS and MA plans that would establish approved methods and pricing mechanisms for transfer prices. This would potentially work by having an application process to propose a transfer pricing approach. The application would include financial records from the firm and information on internal company transactions such as those discussed earlier. The application would propose a method for arriving at transfer prices. CMS would review the application and negotiate the terms of the transfer pricing agreement with the MA parent company. This would be expected to involve assessing which transactions were the most relevant to establishing a benchmark. APAs could reduce uncertainty for MA plans and transparently set out an agreed upon approach to establishing transfer prices.

Taken together, efforts to create visibility into industry practices and the establishment of benchmarks for transfer prices would serve to counter the current incentives to exploit vertical integration arrangements to circumvent the Medicare Advantage MLR.

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