July 26, 2007 | WebMemo on Health Care
In the debate over health care reform, some federal and state lawmakers are asking whether some type of reinsurance system might make health insurance more affordable. In exploring that rather arcane area of insurance practice, policymakers should have a strong understanding of the concepts involved and the potential benefits and limits of "reinsurance" mechanisms for health insurance markets.
When most people refer to "reinsurance" in health care, what they really mean is the related concept of risk transfer or risk-pooling arrangements. Such arrangements are designed to remove the obstacles faced by high-risk individuals and groups in getting health care coverage. Although risk transfer arrangements can help in this regard, they do not lower overall health care costs. Furthermore, policymakers must design arrangements to encourage universal participation from insurers and remove incentives for them to transfer costs to taxpayers.
Selection Risk and Its Discontents
In the classic definition, reinsurance can be thought of as an insurance company buying insurance for itself. 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.
However, those kinds of scenarios are not as plausible in other lines of insurance, such as life or health (except for very small carriers). While one can never say "never" in insurance, the risk that a large life insurance company will see half its customers die in the same year is virtually zero. The risk is equally low that a majority of customers of a large health insurance company will need major operations and hospitalization in the same year.
In the context of health insurance, what is usually meant by "reinsurance" is really insurance against a different kind of potential risk. The risk in question can best be described as "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:
"Inclusionary" and "Exclusionary" Risk Transfer
To address the above problems with selection risk, lawmakers have designed various risk transfer concepts. For the purposes of this paper, the concepts are divided into two basic types, "inclusionary" and "exclusionary."
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 termed is "risk-transfer pool."
Lawmakers should take into account the following considerations in designing and implementing health insurance risk transfer arrangements:
The biggest limitation of health insurance risk transfer mechanisms is that they do not directly reduce general health care costs. However, such mechanisms do give policymakers a tool that, in conjunction with other reforms, can create a smoother-functioning health insurance market.
The ability of individuals to choose and keep their preferred health insurance coverage is the key to creating a consumer-centered health care system. Choice and portability would create the right incentives for insurers and providers to compete in offering consumers better value in both health insurance and medical care-that is, more benefit at a lower cost.
But if consumers are to be induced, or even required, to obtain
health insurance coverage when they are in good health, then they
must also be assured that if their heath status changes in the
future they will be able to keep, and periodically switch (if they
desire), coverage at standard rates. An important component in
creating such a consumer-centered health insurance system is an
inclusionary risk transfer pool in which all insurers in a state
participate. Such a mechanism assures consumers that their ability
to choose coverage will not be restricted in the future due to
changes in their health status. At the same time, it assures
carriers that when consumers in poor health pick their plans, a
portion of their higher costs will be spread among all
policyholders in the market, and not just among those enrolled with
that particular carrier.
Finally, lawmakers must remember that while it is acceptable, for reasons of equity, to provide public subsidies to offset some of the costs associated with health insurance risk transfer arrangements, any such subsidies should be fixed and limited so as to avoid unintentionally creating incentives for carriers to transfer more of their risks onto taxpayers.
Edmund F. Haislmaier is Senior Research Fellow in the Center for Health Policy Studies at The Heritage Foundation.