Editor's Note: This "Manatt on Medicaid" is the seventh in a series of updates focused on CMS's new Medicaid/CHIP managed care regulations. In the coming weeks, Manatt will be exploring key provisions of the regulations and highlighting their implications.


In its April 25, 2016 Medicaid managed care final rule, the Centers for Medicare and Medicaid Services (CMS) provides a revised framework for determining how managed care plans should be paid by state Medicaid programs. A previous "Manatt on Medicaid" addressed how the new medical loss ratio requirements affect plan payment. This part examines CMS's actuarial soundness requirements. Many of the actuarial soundness provisions go into effect for managed care contract rating periods beginning on or after July 1, 2017. However, certain requirements—such as the core requirements that rates be actuarially sound and be certified by an actuary and the prohibition on cross-subsidization of rates—are in effect as of July 5, 2016.

General Actuarial Soundness Standards

At its core, the actuarial soundness requirement is designed to ensure that states' payment rates to plans are sufficient to allow the plans to provide all necessary covered services to Medicaid beneficiaries under their care. Following this principle, the final rule defines actuarially sound capitation rates as "projected to provide for all reasonable, appropriate, and attainable costs that are required under the terms of the contract and for the operation of the managed care organization (MCO), prepaid inpatient health plan (PIHP), or prepaid ambulatory health plan (PAHP) for the time period and the population covered under the terms of the contract." CMS also elucidates two other principles for its actuarial soundness rules: (1) rates should be documented in sufficient detail to assess their reasonableness and (2) rates should be developed in a transparent and uniform way to ensure protection of public funds and beneficiary access to care.

In implementing these principles, CMS sets numerous standards for the capitation rates established by states. Among other requirements, the rates must:

  • Be developed in accordance with generally accepted actuarial principles and practices,
  • Be certified by an actuary, and
  • Be developed in such a way that plans can reasonably achieve a medical loss ratio (MLR) of at least 85 percent for the rate year (as noted above).

Typically, states develop different rates for different rate cells, that is, populations with particular characteristics such as age or gender. The actuarial soundness provisions require states to set a rate for every rate cell indicated in the plan contract. The final rule prohibits rates for any rate cell from cross-subsidizing rates of another rate cell; each cell's rate must be actuarially sound standing on its own. Similarly, rates for a particular rate cell cannot be based on the rate of federal financial participation (FFP) associated with the population covered under the rate cell. These rules are intended to prevent states from overpaying plans for populations with higher rates of FFP and underpaying plans for populations with lower rates of FFP as a means of maximizing federal and minimizing state expenditures.

Like the MLR rules, the actuarial soundness rules apply to the Medicaid portion of capitation rates paid under dual eligible Section 1115 demonstration programs.

Rate Development Process

The current Medicaid managed care regulation provides an overview of the process that states must follow in setting actuarially sound capitation rates. In contrast, the final rule sets out that process in much more detail. Under the final rule, states must:

  • Develop base utilization and price data;
  • Develop and apply trend factors, including cost and utilization trends, to the base data;
  • Develop the non-benefit component of the rate;
  • Make appropriate adjustments;
  • Take into account plans' past medical loss ratio in the development of the capitation rates; and
  • If using risk adjustment, use a generally accepted model and apply the risk adjustment in a budget-neutral manner across all plans.

States are not required to follow this precise order. Citing unique considerations for the development of capitation rates for the Medicaid program, CMS declined to align the rate development standards with those of the National Association of Insurance Commissioners (NAIC), which are applied to the commercial market.1

The base data must consist of encounter data and audited financial reports and may also include FFS data and unaudited financial reports. Generally, the base data should be derived from the Medicaid population and should be from the three most recent and complete years prior to the rating period. However, if base data on the Medicaid population are not available, they may be "derived from a similar population and adjusted to make the utilization and price data comparable to data from the Medicaid population." Likewise, the state can request an exception to the base data timeliness requirement. Like the base data, the trend factor must be developed from the Medicaid population or a similar population. However, the state actuary also may use national projections that are not specific to the Medicaid population as part of the analysis so long as those national projections are not the sole source used for setting the trend factor.

The regulation lists several categories that are appropriate to include in the non-benefit component of the rate: plan administrative costs, taxes, licensing and regulatory fees, contributions to reserves, risk margin, cost of capital, and "other operational costs associated with the provision of services." In the preamble, CMS clarified that costs associated with medical management, care coordination, quality improvement activities, corporate overhead, and the Health Insurance Providers Fee could be included in the non-benefit component of the rate.

Permissibility of Rate Ranges

Historically, some states have calculated a rate range, rather than a single rate, for each rate cell, and have submitted these rate ranges to CMS for approval. In the past, so long as the ultimate rate paid fell within the submitted ranges, CMS found that the rate was actuarially sound and did not require states to submit additional documentation. Due to this flexibility, states could use rate ranges as a tool to increase or decrease the rates paid to some or all plans without providing further notification to CMS and without justification for the rate change.

CMS is reducing this flexibility by prohibiting states from submitting rate ranges for actuarial soundness review. The change is based in part on CMS's concern that states have used rate ranges as a means of increasing capitation rates paid to plans without changing the plans' contractual obligations and without certifying that the increase was based on expenses materially differing from the actuarial assumptions used to develop the rates. Nevertheless, CMS recognizes in the final rule that there may be small programmatic changes that require minor adjustments to the capitation rates and that requiring states to obtain CMS approval for every de minimus change in rates would be administratively burdensome. As a result, CMS is allowing states to increase or decrease capitation rates by up to 1.5 percent without having to submit a revised rate certification to CMS. CMS selected 1.5 percent because plans generally have risk margins at or above that amount.

Adjustments to Rates to Reflect Health Status of the Population

The final rule leaves it up to the states as to whether to use a risk adjustment system, but requires that if states do implement risk adjustment, they must do so in a budget-neutral manner. This means that among all of the plans in the program, there is no aggregate gain or loss due to risk adjustment. Thus, if the population that enrolled in plans was sicker than expected, a retrospective increase in rates to all plans would not be a permissible risk adjustment.

However, there is no requirement in the regulation that other types of adjustments must be budget-neutral, and in the preamble CMS makes a distinction between risk adjustments and acuity adjustments. Risk adjustment is the "process of determining and adjusting for the differing risk between managed care plans," while acuity adjustment is "the process of determining the relative risk of the total enrolled population compared to a standard population." Moreover, CMS indicates that states could implement retrospective acuity adjustments so long as there was "significant uncertainty" about the health status of a population at the time the rates were developed. Such "significant uncertainty" may exist if new populations are moving into managed care or if the state allows for voluntary enrollment and there are concerns about adverse selection.

Rate Certification Submission to CMS

States must submit their proposed plan payment rates to CMS for approval in accordance with the same time frames that apply to CMS review of plan contracts, meaning that states seeking rate approval prior to an anticipated effective date must submit the rate certifications at least 90 days prior to the anticipated effective date. Under the final rule, states must submit certain documentation to CMS to enable CMS to verify that the rates being paid are actuarially sound. Among the required documentation, states must submit adequate descriptions of the base data and how the state actuary determined which base data to use, each trend factor applied, the development of the non-benefit component of the rate, adjustments, and risk adjustments. In the preamble, CMS said that it was not intending to use the documentation to check every calculation made by the state. Instead, CMS is seeking to understand the actions that actuaries took to develop the rates.

Some commentators suggested that states should be required to provide their rate-setting documentation to the plans or the general public. CMS declined to adopt this recommendation. CMS said it would be unreasonable to permit public comment on proposed payment rates. CMS also declined to adopt a suggestion that would allow plans to appeal CMS's determination that payment rates are actuarially sound. If a plan was dissatisfied with the payment rates, the plan could decline to contract with the state, CMS reasoned. Nevertheless, CMS said the agency is available to meet with plans informally during their review of capitation rates to hear and consider their concerns.