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A group of California health insurers got state approval this week for insurance premium increases of more than 20 percent, renewing calls for federal limits on future rate hikes. Now, industry sources expect the Department of Health and Human Services to unveil its definition of "unreasonable" rate increases in September, the first major regulatory step toward enacting such federal premium limits.

The Obama health plan is part of the reason insurers are raising premiums. One Wall Street firm estimates that insurance mandates that go into effect this year will raise costs (and premium levels) by 8 to 10 percent in the individual market and 2 to 4 percent in the small group market on average. Because the mandates take effect for plan years beginning Sept. 23, and many states require 30 days notice for plan changes, insurers will need to file new products this week.

Companies deemed by HHS as seeking unjustified premium increases will be required to file lengthy disclosure forms to justify the rate hike and may be excluded from the "Exchanges" beginning in 2014 at the discretion of HHS.

Yet if health plans are barred from pricing their premiums to cover costs, it can quickly push them to insolvency owing to the unusual nature of health coverage.

Morgan Stanley's managed care analyst Doug Simpson laid out the potential effects of price controls on premiums in a recent research report. The ratio of revenue earned from premiums to the capital that plans set aside for paying out future claims is high in the health insurance business. This is especially true when compared with traditional property or casualty insurance.

That's because in contrast to traditional insurance, health coverage involves a high number of relatively small claims. This means only a small fraction of the premium revenue gets diverted to build a health plan's total capital reserve. This reflects the fairly predictable nature of medical claims. With health insurance, most of the current premium money gets spent paying for current medical bills.

This makes health insurers highly leveraged to their premiums. Any shortfall in those premiums, or inability to price them to match rising claims, can quickly erode a health plan's total capital reserve and, in turn, threaten its solvency. That's why caps on premiums are so corrosive--it denies health plans the ability to quickly adjust their revenue to meet their current medical claims.

Price controls on premiums will favor continued consolidation in the managed care sector, perhaps leaving Americans with far fewer health plans.

The bigger a plan, the more opportunities it will have to steal from surpluses across different states and product lines to make up for shortfalls in a given plan. So price controls on premiums will create strong incentives for plans to merge together.

Other plans will be forced out of business altogether. The combination of limits on a plan's medical loss ratio, and caps on the premiums it can charge, is an economic recipe that will leave us with far fewer insurance options today, and for 2014.

Scott Gottlieb, M.D., is a resident fellow at AEI.

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