Imagine hiring a contractor to oversee a home renovation and paying him 20% of total project costs. If the price of specialized labor or lumber doubles, the contractor’s fee doubles automatically — even if the scope of work, staffing, and effort remain unchanged. Under this arrangement, the contractor has little incentive to negotiate with subcontractors or suppliers; in fact, the contractor is financially rewarded for the cost increases he is expected to manage.
Under the Affordable Care Act (ACA), the medical loss ratio (MLR) limits how much insurers can spend on administration and profit. Insurers are required to spend a fixed percentage of premium dollars on medical care and quality improvement, with the remainder available for the administrative allowance — the portion covering corporate overhead, marketing, and profit. This requirement sets a minimum for medical spending and a maximum for administrative costs — two sides of the same rule.
Health insurance premiums are rising across both the ACA Marketplaces and the employer-sponsored market. In rate filings and actuarial trend projections, insurers largely attribute these increases to higher medical costs — driven by rising provider prices, increasing utilization, and growing specialty drug spending. These explanations have focused attention on the affordability consequences of premium growth. What has received far less attention is how the MLR allocates those increases. When medical costs push premiums up, the MLR automatically increases the dollars available for administration — even if rent, salaries, and IT costs haven’t changed.
The legislative design of the medical loss ratio
The MLR requires insurers in the individual and small-group markets to spend at least 80% of premiums on medical care and quality improvement, leaving a maximum of 20% for administration. In the large-group market, the threshold is 85%, with a 15% administrative maximum.
The thresholds were designed to ensure that a substantial portion of premium dollars is directed toward clinical care and quality improvement rather than overhead, especially when supported by federal subsidies.
Lawmakers sought to achieve these protections without destabilizing insurance markets or undermining insurer participation and competition. The different thresholds — 80% for individual and small-group markets, 85% MLR for large-group — reflect that larger markets achieve economies of scale and lower per-member administrative costs.
Why a static percentage creates problems
The application of a static percentage has produced unintended consequences as medical and nonmedical costs increasingly diverge.
Inflationary “passenger effect”: Because the administrative component is a fixed share of premium (15% or 20%), premium growth automatically increases allowable administrative dollars. That increase occurs even when administrative input costs are flat or growing more slowly. The result is a mechanical linkage between medical cost-driven premium growth and administrative allowance growth, rather than a linkage to actual administrative cost dynamics.
Asymmetric incentives: Because the administrative allowance scales with medical spending, rising medical costs increase the dollar amount available for operations — weakening the insurer’s incentive to constrain medical prices. Conversely, reductions in medical spending reduce administrative dollars, creating a disincentive to aggressive cost management.
Countercyclical squeeze: When general inflation outpaces medical inflation, the problem reverses. Nonmedical costs like wages, technology, and regulatory compliance rise, but the administrative allowance doesn’t increase to match. This can squeeze margins regardless of efficiency, threatening participation in the very markets the MLR was designed to protect.
The proposed fix: the Dynamic MLR
The Dynamic MLR solves these problems by indexing administrative spending to general inflation and medical spending to medical inflation. This decouples the two, eliminating the automatic administrative growth that occurs under current rules.
The Dynamic MLR replaces a fixed percentage with an efficiency standard that updates annually based on actual spending and inflation. The model begins with the insurer’s observed cost structure in the prior year, then adjusts each component forward using the inflation index most closely associated with that cost category.
The Dynamic MLR threshold for year t is:
\(\displaystyle MLR_t=\frac{S_{med,t-1}\times\left(1+i_{m,t}\right)}{\left[S_{med,t-1}\times\left(1+i_{m,t}\right)\right]+\left[S_{admin,t-1}\times\left(1+i_{g,t}\right)\right]}\)
where:
- \(S_{med,t-1}\) denotes medical spending in the prior year
- \(S_{admin,t-1}\) denotes administrative spending in the prior year
- \(i_{m,t}\) denotes the medical inflation rate applied in year t
- \(i_{g,t}\) denotes the general inflation rate applied in year t
The numerator is prior-year medical spending grown by medical inflation. The denominator is total spending: prior-year medical spending grown by medical inflation plus prior-year administrative spending grown by general inflation.
Application of the formula begins with baseline-year spending, which is split into medical and administrative components. In subsequent years, these components are inflated separately using their respective inflation indices, not reallocated based on any fixed-percentage threshold.
Because medical and administrative spending use different inflation measures, the threshold adjusts in both directions. When medical inflation outpaces general inflation, the threshold rises; when general inflation exceeds medical inflation, the threshold falls. In this way, the Dynamic MLR moves up or down based on the relationship between medical and general inflation rather than remaining fixed.
The Dynamic MLR operates as a recursive function in which each year’s threshold is calculated from the prior year’s cost structure, creating a path-dependent efficiency standard. This provides symmetric protection: when medical inflation outpaces general inflation, the threshold rises, preventing administrative margins from expanding; when general inflation exceeds medical inflation, the threshold relaxes, preventing insurers from being squeezed by rising operating costs.
Inflation indexing isn’t common in federal health regulation, but it’s been adopted where static thresholds would distort incentives or lose real economic value. The Inflation Reduction Act’s Medicare prescription-drug inflation rebate indexes allowable price growth to CPI-U, ensuring that manufacturers bear real price increases. The Stark Law’s physician self-referral thresholds and penalty amounts are explicitly indexed to CPI-U by CMS, preventing regulatory limits from losing real value over time. As an established regulatory tool in health policy, inflation indexing is used strategically where fixed nominal thresholds would distort incentives or erode real economic value over time.
Alternative approaches to MLR reform
Policymakers and analysts have proposed various ways to address MLR limitations, including raising thresholds (either once or incrementally), tightening what counts as medical or quality-improvement spending, and restricting how vertically integrated insurers account for payments to affiliated entities and pharmacy rebates. While these reforms target important issues around reporting integrity, consolidation, and administrative spending levels, they operate within the fixed-percentage structure established by the ACA.
None of these approaches change how administrative spending responds to divergent inflation. They retain the same fixed relationship between medical spending and the administrative allowance, leaving the framework insensitive to whether medical and nonmedical costs are rising at different rates.
How the dynamic MLR could have performed
Applying the Dynamic MLR framework retrospectively to observed premiums shows the indexed standard could have reduced coverage costs in most years. The difference between observed and counterfactual premiums represents an annual efficiency dividend.
Premium data come from KFF. Medical inflation and general inflation are measured using the CPI-U medical care component and CPI-U all items, respectively. Currant’s white paper describing the Dynamic MLR includes additional formulas, examples of calculations, tables, and data sources.
In employer markets, small-group savings consistently exceed large-group savings because the small-group administrative allowance (20%) is 33% larger than the large-group allowance (15%).
The Marketplace pattern illustrates the framework’s symmetric adjustment mechanism. From 2014 through 2022, the Dynamic MLR produced positive cumulative dividends per individual as medical inflation outpaced general inflation. From 2021 through 2023, general inflation outpaced medical inflation. As these differences worked through the formula’s recursive structure, the Dynamic MLR produced small negative dividends in 2023–2025. This symmetry has consumer-protection implications: By permitting larger administrative allowances when operating costs rise, the Dynamic MLR would have reduced pressure on insurer margins during a period when some insurers exited markets due to unfavorable economics.
The Dynamic MLR’s recursive structure creates built-in stability by smoothing year-to-year adjustments. Because each year’s threshold is calculated from the prior year’s observed cost structure, changes occur gradually rather than immediately in response to current-year shocks. A sudden spike in medical costs or administrative expenses affects the threshold in the following year, not instantly — dampening volatility and reducing the risk of sharp disruptive swings for insurers and purchasers.
The recursive design prioritizes predictable, incremental change over immediate responsiveness.
Implementation considerations
This analysis uses the ACA’s statutory thresholds as starting points, but the Dynamic MLR formula works with any baseline. If implemented, policymakers could set initial thresholds based on updated evidence about administrative costs, market conditions, affordability or insurer participation goals, or other policy considerations. Different starting thresholds would produce different savings estimates.
The Dynamic MLR formula uses medical inflation (price growth) for the medical side and CPI-U all items for administrative spending. This design choice treats medical and administrative cost growth as separate trends, each with its own index. Policymakers could refine these indices over time as evidence strengthens — for example, developing a composite administrative index that weights specific cost drivers. The core contribution is the indexing mechanism itself: decoupling administrative allowances from medical spending growth.
Implementing the Dynamic MLR in commercial markets would require amending federal law and issuing conforming regulations. The framework could also be applied to Medicare Advantage, Medicare Part D, and Medicaid managed care, though Medicare programs would require congressional action while Medicaid would require federal rulemaking and state implementation.
Why this matters
The Dynamic MLR eliminates these distortions — the administrative passenger effect, asymmetric incentives, and the countercyclical squeeze — by indexing each cost category to its appropriate inflation measure. Medical spending adjusts with medical inflation; administrative spending adjusts with general inflation. The threshold moves accordingly — rising when care costs lead, falling when operating costs lead. This ensures fairness across economic conditions rather than locking in advantages that depend on which inflation rate happens to run higher.
The framework is path-dependent and gradual, adjusting through small annual recalibrations rather than sudden shifts. It preserves the core MLR structure — a minimum share for medical spending, a maximum for administration — while making it responsive to cost realities. When static rules increasingly appear misaligned with divergent inflation trends, this approach offers a more balanced and durable alternative.
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