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
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
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
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:
- 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.
"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
- Inclusionary designs offer more individual
choice. Under an inclusionary design, the risk transfer
mechanism is opaque to the insured-meaning that the individual is
not aware that a portion of his claims is being ceded to the pool.
In contrast, under an exclusionary design, the insured is given
separate primary coverage (through the pool). Thus, with an
exclusionary risk transfer mechanism such as a high-risk pool,
individuals lose choice of coverage in a health insurance market.
With an inclusionary risk transfer mechanism, high-risk individuals
retain choice of coverage.
- Exclusionary designs offer modest potential for
controlling claims' costs. Under an exclusionary design,
it is possible to contract with an entity to "case manage" the care
of pool enrollees. In theory, this could result in lowering the
aggregate cost of claims for high-risk individuals, compared with
what it might have been had they remained in the general market.
However, the extent of any such savings is heavily dependent on
whether the pool will really do a better job of case management
than the carriers issuing primary coverage in the market.
- Inclusionary designs must include incentives for
primary insurers to control costs. Under an inclusionary
design, the pool does not manage the costs of claims. Therefore,
policymakers must require the primary insurer to retain a portion
of claims it cedes to the pool. Typically, such rules specify that
the pool will only accept ceded claims above a certain threshold
(called the "attachment point"), and that the primary insurer must
pay a premium for ceding the risk to the pool. Above that
attachment point, the ceding carrier also remains responsible for
paying a portion of all claims (called a "risk corridor"). For
example, the rules might specify that a primary insurer can pay a
premium to cede claims in excess of $50,000 (the attachment point),
and must continue to pay 20 percent of the claims above $50,000
(the risk corridor).
- Risk transfer mechanisms do not lower general health
care costs. Regardless of design, risk transfer mechanisms
only shift or redistribute costs among funding sources.
Specifically, risk transfer mechanisms offer ways to more equitably
redistribute the costs of a small number of expensive cases or
individuals across a broader population. While these features
enable health insurance markets to function more smoothly, they are
not a solution for controlling health care costs in
- Government subsidies for risk transfer mechanisms do
not reduce health care costs. Whether for inclusive or
exclusive designs, subsidies simply shift costs onto taxpayers.
Nevertheless, a reasonable argument can be made for partial public
funding of health insurance risk transfer arrangements. When pool
losses are funded through assessments on commercial insurance
carriers, the costs are spread only among those covered by
commercial insurance. Partial taxpayer funding is a way to ensure
that pool costs are borne by a broader swathe of the public,
including: workers in self-insured firms, seniors with Medicare
coverage, and the uninsured. In sum, any proposal for public
funding of a risk transfer arrangement should be evaluated based on
the equity of its distributional effects-not on any expectations
for health system savings.
- The broader the redistribution of costs under a risk
transfer mechanism, the less burdensome it will be and the fewer
distortions it will create in the market. As with any kind
of insurance arrangement, the objective is to spread the high
claims of a few individuals among a large number of payers; the
more payers, the smaller the cost to each. Consequently, costs will
be spread more broadly if a state creates a single risk transfer
mechanism for health insurance than if a state creates, for
example, separate pools for its individual market and its small
- Support for risk transfer mechanisms will vary among
insurers based on differences in their business practices and
market size. In general, larger insurers, particularly
those that are dominant in a state's market, will be less
supportive of risk transfer mechanisms and less inclined to
participate if they are organized on a voluntary basis. Those
carriers may feel that they are large enough to handle potential
selection effects internally, giving them a competitive advantage
over smaller carriers. Conversely, a risk transfer mechanism
requiring all health insurers to participate will have the effect
of giving smaller insurers first entering the state's market a more
level playing field on which to compete against larger and more
Similarly, carriers that rely more on underwriting as a key part
of their business model are more likely to favor exclusionary
mechanisms, such as state high-risk pools, that enable them to
continue refusing coverage to applicants in poor health.
Complicating the equation is the fact that a particular risk
transfer design may present any given carrier with both advantages
and disadvantages. For example, an inclusionary risk transfer pool
might favor smaller carriers by giving them a more level playing
field in competing with larger carriers, but simultaneously force
them to end the practice of turning down applicants in poor health.
The same scenario would mean that a dominant carrier that offers
coverage to applicants in poor health (such as a Blue Cross plan
required by law to be the "insurer of last resort") could shift
more of the costs of high-risk policyholders onto the broader pool,
but might also face increased competition from smaller
- A risk transfer mechanism will be more successful if
all carriers in a state are required to participate in it.
The terms must give all carriers equal rights (to cede risks to the
pool) and equal responsibilities (to pay assessments to fund pool
losses proportionately based on each carrier's number of
policyholders). Furthermore, the fairest way to determine the rules
governing the pool is by agreement of all the carriers in the
state, under the regulatory supervision of the state's insurance
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.
Haislmaier is Senior Research Fellow in the Center for Health
Policy Studies at The Heritage Foundation.