Health insurance: it’s all about the pool and capitalization
The law of large numbers uses probability theory to estimate the frequency of certain events with reasonable precision; the greater the number (or population), the greater the precision.
Collective spread of risk is a cryptic description for evaluating a large group with a low to high probability range of insurance claims coverage, e.g. younger people in better health versus older people tending towards poor health .
This is Part 2 – a Black Swan insurance event, if you will, illustrated in a partially hypothetical story of a self-funded health insurance pool situation. Part 1 – Royal Gazette “Insurers Need Knowledge Across All Industries” can be read here https://tinyurl.com/yzoaemn3
It is a story of Biblical proportions – except that it did not happen in Biblical times. Within 18 months, this self-funded health care pool (created by a major industry trade association) went bankrupt.
It is, however, true, and if the truth is known, these same types of situations occur more than we realize – or reveal.
Circumstances, times and locations have been changed for confidentiality reasons. This is the process of insuring the health of persons for minor and major disasters and the management of health insurance pools.
Part 2 – And that’s what they did.
A year later, the organization’s own self-funded insurance company was operational. It was great. All of the owner members have abandoned commercial health insurers and moved to their own association’s self-funded plan.
Health premiums were low.
Everyone was excited about this innovative strategy, believing it to be a great opportunity to control costs within and by the members of the group.
Employees in the commerce industry tend to be transient in nature, moving from job to job. In general, they are younger and healthier, and it was assumed that they would not make as many claims.
Their actuarial assumptions were that unless there was a major catastrophe to employee health (an outlier) early on, they might undervalue the commercial market health insurance premiums and still have d ‘large surpluses to be carried over.
The plan was working very well. Optimism reigned.
Health care premiums have been pouring in steadily for a year and a half. Claims costs appeared to be under control, remaining relatively low and stable. The outlook (and the profits) looked surprisingly good.
Within two to three years, their plan could likely accumulate a significant surplus of cash to invest. The director of the organization began to review the resumes of investment portfolio managers and talk about how the eventual profits could benefit the organization in other profitable insurances: workers’ compensation, insurance life and disability, etc. And, they might even be able to return certain bonuses to members as a future dividend.
Then two things happened.
The bottom fell out of the economy, quickly heading into yet another horrific recession.
A member of the association fell seriously ill, requiring indefinite years of extraordinarily expensive continuing care.
The costs started to go up; futures trading started to dry up.
Trying to stay solvent during another economic downturn, employers found they were unable to afford full health insurance benefits. They have started to cut back on benefit offerings while increasing premiums.
The economy has deteriorated, healthier young workers have been made redundant, bonuses have been increased again and again to compensate for the loss of healthier workers who have left.
Competition has accelerated.
Commercial insurers in the local market, sensing the challenges of the association fund, aggressively marketing, offered better rates – further exhausting workers who made few or no claims, leaving older and less healthy industry groups in the association’s health pool.
In the end, the large number of the association was skewed beyond belief. There would be no probability calculations, just the inevitability of an increase in claims across the board – due to the concentration of older workers and then the shutdown.
Large, well-rated long-term insurance companies – survive for a reason. They use actuarial assumptions (and many complex mathematical models) combined with documented historical real-life experiences to proactively calculate the odds of maintaining a sufficiently large, healthy, and diverse insurance pool.
They launch heavily capitalized; then maintain prudent investment reserves to carry them out through years of equilibrium or loss. They know what they are doing. Minimizing their success only benefits them.
Can Self-Funded Insurance Plans Work? Yes, they have and are doing it successfully – but even the very smallest minimal planning: law of large numbers, collective risk allocation, economic feasibility, competitive prices, adequate capital reserves – is far from sufficient to prevent a Black Swan event.
Extracts from Captive: The History of International Insurance in Bermuda by Catherine R Duffy, Country Manager of AIG Bermudes
“In 1919, long before Henry Tucker began to put in place the infrastructure for Bermuda to become Atlantic Switzerland, a young American named Cornelius van der Starr was looking to find his way in life after served his country in WWI.
“He wanted more than to survive, and at 27 he moved to the Far East, setting up a fire and marine insurance company in Shanghai, then spread across the world. In ten years, “CV” Starr had established itself as a major player in China and in the East elsewhere.
“In 1939, Starr moved its headquarters to New York, continuing to expand into Latin America as European competitors withdrew due to the war, and also opened a regional headquarters in Cuba.
“In 1947, all American business emanated from New York, when a central outside base was needed for all non-American operations. With Cuba’s economic instability a concern, with Panama’s language and legal system an obstacle, Mr Starr chose Bermuda – with its good standard of living, proximity to the United States and Bermuda law, on the basis of his knowledge of UK law.
“That same year he came to the shores of Bermuda to establish Bermuda’s first international insurance company and shortly thereafter, the legislation of the Parliament of Bermuda incorporated American International Company.
“Just about everything that Bermuda’s international insurance industry has since become can be traced back to Starr’s decision in 1947 to establish the headquarters of his non-US interests in Bermuda. Airco was the first large international public company to be fully managed from Bermuda and had a number of attributes that can still be found in the largest Bermuda-based insurance companies today.
Seventy years later, the author, Catherine R. Duffy, was promoted to AIG Country Leader. How visionary is that?
CV Starr, https://starrcompanies.com/About/History
• Martha Harris Myron, CPA JSM, originally from Bermuda, is a former skilled cross-border international financial planner and author of The Bermuda Islander Financial Planning Primers, International Financial Consultant for Olderhood Group Bermuda Ltd. and financial columnist for The Royal Gazette. All proceeds from these articles are donated by The Royal Gazette to The Salvation Army in Bermuda. Contact: [email protected]