Very few insurance companies want to hold onto all of the risk that they agreed to take on. There are two ways around this problem.
The first is to commit fraud on a massive scale and laugh at the people who are filing two million dollar claims when their policies state there is neither a lifetime nor an event limit. That tends to lead to arrests of senior executives who were on the hookers and blow bonus level and the firing of the low level drones who were on the free pizza on fifth Fridays bonus level. From a self-interested perspective, this is a bad thing for the insurance company.
The other means of dealing with tail risk is to buy protection from another party. This is reinsurance. And it is quite common as a means of risk and cash flow control. Reinsurance is a contract between two parties.One party has a significant risk of all health care costs for 10,000 individual. It buys protection for the fourth or fifth standard deviation and greater level of risk to another company. Spreading the risk over the nation or often internationally allows for smaller variance costs. There are a few different ways risk can be sold and we’ll work through examples.
Cystic Fibrosis is an extremely expensive condition to treat and it is not randomly distributed as it is a genetic disorder. I’ve used this family before because I don’t have privacy concerns and it providers good numbers:
Affecting one in every 3,900 births in the U.S., CF is one of the most common genetic disorders known. Yet it afflicts too few people — just 30,000 in America…
Laura and Cate’s daily regimen of two pills of Kalydeco costs $841 per day; that’s $307,000 each year, making it one of the world’s most expensive drugs. In most cases, private insurance picks up the bill. Medicare or Medicaid may pay as well.
A reinsurance contract might be structured so that if a health plan has more than 3 CF members per 10,000 total members, the reinsurance company will pay half of the drug costs above $100,000. The health plan would have the baseline risk, but the reinsurance company would take a good chunk of the tail risk of having a family of seven CF patients sign up for insurance from a single provider. This same type of contract could apply to numerous other diagnosises and diseases.
Another common type of reinsurance is a contract where the original insurer pays the first half million dollars of claims in a year and then the reinsurer pays half of the next half million and everything above one million. Million dollar annual claim histories are very unusual events. A single insurer with a risk pool of ten thousand individuals can handle a normal load of million dollar or more claims becauase the total number of members with that claim history is miniscule. However, if a single insurer covered an electrician’s union that responded to a hypothetical Fukishima type disaester, that insurer would be wiped out even if the national level of million dollar claims barely moved.
Reinsurance most likely came into play for the Boston Marathon bombing victims as trauma care is extremely expensive and an isolated event concentrated costs into a very shallow pool.
The other type of reinsurance is between companies that self-insure (pay all the costs of employee medical care). In this scenario, the self-insured company uses the insurance company as a back-end administration and negoatiation unit. The health insurance company processes claims, handles member complaints and grievances and sells access to its network of providers (as well as the relevant discount) for a fixed cost per member per month. The self-insured company will often buy a form of insurance called “stop-loss” that is effectively reinsurance where the stop-loss seller will pick up the very high dollar claims.
Reinsurance is the black and tan of the insuranc industry.