Optimizing administrative expenses

Q: How much do health plans spend on administration and can they reduce that cost?

A: If a health plan gets a dollar in the door, it spends about 85 cents of it on benefits, about 12 cents on administration, and it gets to keep about 3 cents as profit or surplus. Those numbers come from a study I did looking at the annual statements of about 900 health plans. Of course there is some variability, but the numbers hold pretty true.

Health plans spend a lot of their time and attention trying to manage benefit costs. That's not an unreasonable area to focus on if 85% of the premium dollar goes to pay for benefits. However, reducing benefit costs can be a real challenge, as it requires changing member and provider behavior—a tall order.

On the other hand, while administrative expense represents a much smaller piece of the premium pie, health plans tend to be in control of their own administrative spending. Managing administrative cost, therefore, ought to be easier, as plans need only change their own behaviors rather than the behavior of third parties that don't appreciate being told what to do.

Too bad it's not that simple, because managing administrative expense can be very painful for organizations for a whole host of reasons. Ultimately, I have seen clients achieve significant improvement in their administrative expense positions. However, real bottom-line impact requires a comprehensive strategy, management buy-in and commitment, and major investments of time and energy.

Q: How do health plans spend their administrative dollars and why should they invest in reducing administrative spending?

A: Health plans spend administrative resources on many different activities related to delivering health plan products and managing their businesses. There are many people in the industry who believe that reducing administrative costs will have the overall effect of making more dollars available for benefits. I believe there is some truth to this argument, and that organizations do have a responsibility to try to optimize administrative spending.

It's important to keep in mind, however, that not all administrative costs are bad. In general, there are two types of administrative costs—those that are unique to the industry, like claims processing, medical management, or provider contracting; and those that are inherent in most every business, like marketing and sales, customer service, or accounting. A back-of-the-envelope estimate is that a little less than half of total health plan administrative costs are related to general activities inherent in most every business, such as marketing and sales, finance and accounting, information systems, customer services, and general overhead like human resources, legal, executive management, etc.

The costs that are unique to the industry can be further categorized as high-value activities and low-value activities. For example, medical case management is an administrative activity that is unique to health plans. Higher spending on case management can actually result in lower total costs or better patient outcomes. One might characterize case management as a "good" or high-value administrative expense. On the other hand, spending on premium accounting probably doesn't improve business performance, and hence this could be characterized as a low-value administrative activity.

Note that earlier I chose the word "optimize" rather than "reduce" administrative costs. If we accept that some administrative expenses are actually good for the system, then reducing all administrative expense isn't necessarily an improvement over the current situation. This reality must be considered in the administrative cost reduction conversation. Of course, the definition of "good" and "bad" administration is not always clear-cut. Although insurance companies get a sometimes justifiable bad rap for spending money on, say, claims administration, claims processing functions are important for combating fraud, waste, and abusive billing practices—market realities that can end up costing plans, and consumers, more in the long term. The challenge for organizations is in deciding which administrative activities actually represent that "good" administration and are therefore worthy of investment, and which activities are of low value and should be eliminated, automated, or streamlined.

Q: In what areas are administrative costs optimized today and where is there potential for additional future gains?

A: Organizations have invested heavily over the years on reducing administrative expenses in certain functional areas. Claims processing is an area where significant efficiency gains have been achieved over time. Today's claim processing operations are highly sophisticated and highly efficient. Aside from a wholesale change in the claims-processing paradigm, the most efficient organizations probably won’t see significant additional efficiency gains in this area.

However, there are other administrative areas where additional attention can likely result in further cost reductions. Automation of labor-intensive tasks remains fertile ground. For example, significant investments have been made in deploying self-service technologies whereby providers and members can access information and complete transactions without interface with a customer service agent. Instead of a $5 telephone call, the health plan incurs almost zero transaction cost. Self-service adoption, however, is not just about making the channel available; it also requires time, education, incentives, and perhaps a little member and provider cajoling. Self-service does a plan no good if members follow up a self-service transaction by calling to confirm the answer they received.

You would think after years of investment in automation technologies that most everything that can be automated is, but we continue to identify opportunities for organizations to use technology to eliminate manual activities. Hence, there remain opportunities beyond customer service to automate manual tasks and reduce low-value administrative activity in areas such as premium billing, member enrollment, rating, and underwriting, to name a few.

Q: What role do "economies of scale" play in reducing administrative costs?

A: Advocates of both managed care consolidation and single-payer systems often mention economies of scale as a potential benefit. The general idea is that larger organizations tend to have lower administrative costs on a per-member basis because fixed costs are spread over a larger population and because there are nonlinear variable costs associated with certain transaction-heavy functions, such as customer service and claims processing.

Our research on this topic, however, suggests that economies of scale aren't as significant as one might intuitively think when it comes to administrative costs. On the contrary, we find that the most significant administrative cost reductions due to scale economies occur as organizations grow from zero to approximately 500,000 members. Significant marginal savings are achieved across all functional areas as organizations grow from zero to 100,000 members. Between 100,000 and 500,000 members, the marginal savings are less and tend to be centralized among a few functional areas. Beyond a plan size of 500,000 members, the marginal savings are limited to specific functional areas and quickly diminish to a point where they become more difficult to quantify. This is not to say there aren't other advantages to having a high number of members, including the clout that comes with such scale.

Q: How is information technology positively and negatively affecting administration costs?

A: Information technology has had a huge effect on health plan administrative costs over the past decade. According to our administrative staffing and cost benchmarks, between 1998 and 2005 health plan staffing on a per-member basis actually decreased by about 10%. During that same time, however, managing a health plan didn't get simpler. To the contrary, the operating environment became significantly more competitive and complex. Although staffing decreased, administrative costs on a per-member basis increased about 50% during the same period. While some of that was due to wage increases and general inflation, spending on information technology and systems was a significant contributor to that increase. In fact, technology spending on a per-member basis actually increased more than 150% during that period. Technology has allowed health plans to do more with fewer bodies.

Today's health plan is highly dependent on information technology. Ten years ago, IT represented almost 10% of total health plan administrative cost. Today, that proportion has nearly doubled. The role of IT, however, is changing. For the past 20 years, IT has been leveraged as a tool for improving administrative efficiency through automation and self service. Although IT will continue to be used in that way, leading-edge organizations are exploring ways to actually use IT as a tool for improving care and reducing benefit cost. For example, organizations are investing in predictive modeling technologies to identify members at risk for specific conditions and get those members into focused care management programs. This new role for IT will not likely lead to administrative cost reductions, but rather to optimization of high-value administrative activities. In this sense, IT can help provide optimized administration in the same manner as medical management programs.

Andrew Naugle, MBA, is a healthcare management consultant in the Seattle office. He specializes in healthcare operations in general and health plan administration in particular.