The Basics

Virtually all sectors of primary insurance are backed not only by their own capital from such sources as retained premiums, earnings on investments, equity and debt, but also by the capital of reinsurance firms to which they regularly lay off risk through reinsurance “treaties” maintained between primary insurers and reinsurers. In most cases, the primary insurer is buying protection against the possibility that some rare set of circumstances might produce losses that it is unable to fund on its own. The practice is more common in areas like property and casualty insurance. Such companies could take heavy losses if multiple natural disasters struck within a short time frame, for example. The possibility of a "perfect storm" of large losses induces insurers to buy reinsurance on the commercial market. “Quota share” treaties provide for the automatic, or near-automatic, sharing of specified percentages of the risk of every new insurance policy originated by the primary insurer. “Facultative” agreements provide that whether the reinsurer will accept any part of the risk of an offered policy and, if any, the amount of risk of a given policy which it will accept will be determined through case by case negotiation. “First loss” reinsurance agreements are those in which a reinsurer is willing to accept the risk of paying the first claims up to maximum percentage when the policy is drawn, and the primary insurer is responsible for losses above that maximum – of course, it charges substantially more for accepting this first loss position that it would charge for sharing the risk of paying claims on a dollar-for-dollar basis. “Stop loss” reinsurance agreements are in effect the mirror image of “first loss” agreements: in a “stop-loss” agreement, the reinsurer agrees to start paying claims after they have reached a specified amount or percentage of the total. Because the stop-loss layer of risk is also usually capped with the primary insurer once again responsible for remainder after the stop-loss resinsurer’s cap has been reached, it could be thought of as called “second loss” reinsurance.

Selection Risk Transfer

The reinsurance sector makes some conventional reinsurance products available to conventional commercial health insurers, although it is not a field that lends itself as well to conventional reinsurance as such others as property and casualty insurance. However, the term “reinsurance” has also taken on a separate meaning among policy makers in the health finance field. In health insurance, "reinsurance" often means insurance against "selection risk": the risk that an insurer will acquire a larger-than-average share of costly customers.

In the current individual and small group markets, insurers' first line of defense against selection risk is the practice of underwriting. Through underwriting, insurers seek to determine the risk profile of individuals or groups before issuing coverage. After identifying the high-risk applicants, the companies then either deny coverage altogether, limit coverage for pre-existing medical conditions, or charge higher premiums.

In the group market, particularly in the small group market, insurers also use "minimum participation" to guard against selection risk. The insurer will not issue group coverage to an employer unless the employer ensures that a minimum share of its workers (usually 75 percent to 80 percent) participate in the coverage. That way, the insurer limits the possibility that only high-risk employees will enroll in the insurance plan.

While these practices help protect health insurers against selection risks, they also create problems for individuals and employer groups, particularly small employers, because:

• They can make health insurance unaffordable, or even unavailable, for individuals in poor health.

• They make it more difficult for insured individuals who develop medical conditions to retain coverage. A change in circumstances (such as in employment or residence) could result in a loss of coverage and a subsequent inability to get new coverage.

• They create obstacles to employers offering group coverage to their workers. In particular, smaller employers often find it difficult to induce enough of their employees to take up coverage and thus meet the insurer's minimum participation requirement for covering the whole group.

Policy analysts such as Edmund Haislmaier, Senior Research Fellow in the Center for Health Policy Studies at the Heritage Foundation have usefully distinguished between Exclusionary and Inclusionary risk transfer schemes. The "exclusionary" mechanisms segregate high-risk individuals from the low-risk population, subsidizing them in a separate pool. The "inclusionary" mechanisms keep high-risk individuals in the same pool as everyone else but seek to redistribute and/or subsidize their more expensive claims.

A common exclusionary mechanism is a state-run "high-risk pool" for the individual health insurance market. The pool offers coverage to people who have been refused coverage in the individual market due to poor health status. Although coverage carries high premiums, the premiums are not enough to cover the cost of claims by enrollees. To make up the difference, lawmakers use a mix of assessments on private insurers and public subsidies. In some states, the losses are funded entirely out of assessments on insurers and, thus, ultimately included in the premiums paid by everyone with health insurance coverage. In other states, the losses are funded primarily out of general revenue appropriations and, thus, are ultimately born by all the state's taxpayers. Still other states use a mix of both funding sources.

Inclusionary risk transfer mechanisms operate on essentially the same principle, except that high-cost individuals are not given separate coverage. Instead, some portion of their claims is pooled and then proportionately redistributed among the carriers in the market. As with high-risk pools, public subsidies may also be used to offset some of the cost of claims. This type of mechanism is often called, somewhat inaccurately, a "reinsurance pool." A more precise term is "risk-transfer pool.

Business Model: 

Classic reinsurance is sometimes useful to conventional health insurers. More often, the real conventional insurers need to find ways to transfer the risk that a given pool of health risks will contain statistically unusual number of high-cost health risks to a third party and/or the public sector.

Assumptions: 

1. Small groups in particular will generally be more concerned about this “selection risk” and this risk needs to be transfers to larger pools, e.g. all the conventionally insured residents of a state.
2. State regulators and legislators are willing to entertain ways to provide for coverage of this selection risk, particularly if little – or no – public funds are used to subsidize the higher cost patients.

Speaks to multiple leverage points.

• Risk sharing at the micro level balanced against risk management at macro level
• “Puddles” need larger “pools” for purposes such as selection risk sharing
  
• Potential  of new alliances to create risk pooling or collective purchasing/action
• “Puddles” such as groups with long health insurance policy tenors such as affinity groups, self-insured firms, and others may find it especially helpful to form alliances for selection risk sharing. Partners might include conventional reinsurers seeking to serve new markets, pension funds, and other sources of compassionate capital.