Climbing out of the donut hole

As the calendar year progresses, many seniors with big drug expenses will start to fall into the Medicare Part D coverage gap, colloquially known as the "donut hole." Expressions of member dissatisfaction remain mild as this article goes to press because most seniors are still within the first layer of benefit coverage. But many will soon hit the outer wall of the gap—the approximately $3,000 spending band in which there is no coverage for the beneficiary under a typical Part D Prescription Drug Plan (PDP)—and the outcry for more coverage seems likely to grow. Presuming that Part D coverage will be able to recover from its shaky start and gain a firm footing in the marketplace, coverage levels will become an increasingly important competitive factor for PDPs.

The vast majority of PDP designs for 2006, the first year of the Part D benefit, are fairly conservative. Most carriers have been hesitant to take risks that might be associated with filling the gap or, in the parlance of the Dunkin’ Donuts® chain, making marketable munchies out of all that empty space. Only one carrier nationally is offering an enhanced product with brand name coverage in the gap.

There are good reasons for the plan design conservatism. First, Medicare Part D is a brand new program and no one has known exactly what to expect in terms of enrollment or member behavior. Part D is not mandatory coverage, so individuals can elect to use it or not. Second, the population of enrollees is still relatively unknown in terms of their health status and level of prescription drug use, so there is merit in proceeding cautiously. Consequently, the few plans that have offered options for filling the gap generally do so for generic drugs only.

That said, filling the donut hole may be a key area in which PDPs will compete in 2007 and 2008, as perceptions of market need and knowledge of the enrollee population increase. Additionally, PDPs will be competing with Medicare HMOs, or Medicare Advantage Prescription Drug (MAPD) plans in many geographic areas. Many of these older, traditional Medicare health plans have added prescription drug coverage in 2006 to align with the Part D introduction. This may eventually play to their competitive advantage because, unlike PDPs, they have a medical expense component. As a result, they may be able to manage overall plan pricing in such a way as to offer enhanced drug benefits, conceivably with little or no additional premium. They have an existing membership base, they know the health status of those members, and they have claims history. Consequently, they are probably in a better position than any of the PDPs to determine what their prospective drug costs will be over the next couple of years.

Still, there are other dangers to consider for more proactive or less risk-averse PDP sponsors. If you did have a PDP fill the coverage gap, that PDP would charge a higher premium for the richer benefit. This could lead to a detrimental enrollment trend that actuaries call "adverse selection," where prospective beneficiaries choose a richer plan benefit structure because they anticipate higher drug costs and hence perceive a greater need for that richer plan. This rationale, taken to its logical conclusion, will mean that a higher proportion of healthy people will enroll in the less expensive, lower benefit plan, while a large number of the less healthy people will enroll in the higher premium plan. This could possibly lead to one phenomenon of adverse selection that is called the"“selection spiral." Under this scenario, plan designers try to anticipate adverse selection by raising the premium rate to reflect the amount that would be needed to cover sicker beneficiaries. There remains, however, a significant problem: the spiral that develops exacerbates and feeds the adverse selection process—the higher the carrier raises the rates, the more severe the adverse selection becomes. Ultimately, the spiral proves financially disastrous to the carrier, because there is no way to adequately price the plan to cover so many unhealthy enrollees.

The Medicare Modernization Act includes two provisions for PDP sponsors to manage their risk. First, payments to the plans are risk-adjusted based on the historical claims experience of the enrollees. Second, for the first two years of the program, there are risk corridors that limit the total amount of loss a plan might experience. These two provisions provide some protection against adverse financial impact attributable to adverse selection. However, for enhanced plans, that protection is not complete. Both the risk adjustment mechanism and risk corridors apply only to the basic Part D benefits. For the enhanced portion of the benefits, the PDP is fully at risk with no federal protection from financial loss.

The risk of the adverse selection spiral may be mitigated by the penchant of seniors to be cautious and buy insurance when they can (and when they can afford to do so). Most people can’t perfectly predict their future drug needs. The older people get, the more susceptible they are to costly medical care and unexpected health problems. Just to be on the safe side, many seniors may err on the side of paying a little extra premium for the hope of a lot more protection, just in case. The resolution of this key issue of the Part D program will no doubt impact plan designs and competitive posturing for quite some time to come.

With time and more experience, plan carriers will have to make a conscious decision about balancing the market need with strong design features and attractive pricing. This is where it could really get interesting from a competitive standpoint. The PDP sponsor who can figure out how to provide meaningful coverage in the coverage gap—and do so in a way that enables it to effectively manage risks and remain financially sound—will definitely have a marketplace advantage. Achieving this will require a careful balance of three key elements: plan features that attract many of those impacted by the donut hole; other plan features that also attract healthy lives; and pricing that suits both of those targeted groups.

Tom Snook is a Principal and consulting actuary based in Milliman’s Phoenix office. He specializes in managed healthcare and health insurance issues for payers and providers, and his experience includes work for commercial, Medicaid, and Medicare clients. He is a frequent speaker at Society of Actuaries and other industry meetings and has published numerous papers and articles on health insurance topics.