Haris Ashley
Insurance is a financial arrangement that provides protection against risks. The basic function of insurance is the transfer or spreading of risk, which aims to reduce financial uncertainty and make accidental loss manageable. This is achieved by having the insured pay a small, known fee or insurance premium to an insurer, who assumes the risk of a large loss and promises to pay in the event of such a loss. The larger the number of insured individuals, the more accurately insurers can estimate probable losses and calculate premiums. To further spread risk, insurers may use reinsurance, where they purchase insurance policies from other insurers to limit their total loss in case of a disaster.
| Characteristics | Values |
|---|---|
| Basic function of insurance | Transfer of risk |
| Aim of insurance | Reduce financial uncertainty and make accidental loss manageable |
| What is transferred | Payment of a small, known fee (premium) |
| Who is the payment transferred to | Professional insurer |
| What happens in case of a large loss | The insurer pays for the loss |
| Risk pooling | The costs of the unhealthy enrollees are spread across all enrollees |
| Risk adjustment | Payments are transferred among insurers in the single risk pool based on the relative risk of their enrollees |
| Reinsurance | The risk is spread outside the country or to other insurance companies |
| Risk diversification | Insurance companies sell insurance policies covering the same risk over a specific period or offer a large number of policies with varying coverage across multiple areas |
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What You'll Learn
Risk pooling
The basic function of insurance is the transfer or "spreading" of risk. This involves substituting a small, known fee (an insurance premium) for the assumption of the risk of a large loss, and a promise to pay in the event of such a loss. The larger the number of premium payers, the more accurately insurers can estimate probable losses and calculate premiums.
The idea of risk-sharing is ancient. For example, Chinese merchants thousands of years ago would divide their cargo among several boats. If one boat was destroyed in treacherous river rapids, no merchant lost all his goods. Each lost only a small portion.
In the modern era, insurance companies use a strategy called "risk pooling" to manage potential financial losses. Risk pooling involves either selling insurance policies covering the same risk over a specific period or offering a large number of policies with varying coverage across multiple areas. By diversifying risks in this way, insurers can reduce the likelihood of facing large claims that could jeopardize their financial stability. For example, a company that sells flood insurance exclusively to homeowners in a small, localized region would be in trouble if that region experienced a flood. To mitigate this risk, insurers must distribute their flood insurance policies across various regions.
In the United States, the Affordable Care Act (ACA) requires that insurers use a single risk pool when developing premiums. Insurers must pool all of their individual-market enrollees together when setting prices. This means that the costs of the unhealthy enrollees are spread across all enrollees. The ACA includes a permanent risk adjustment program that transfers payments among insurers in the single risk pool based on the relative risk of their enrollees.
Insurers can also spread the risk by purchasing reinsurance from other insurers to limit their total loss in case of a disaster. Reinsurance is a form of "insurance for insurance companies" to ensure that no single company has too much exposure to a large event or disaster.
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Reinsurance
There are two main types of reinsurance: facultative and treaty. Facultative reinsurance covers specific individual risks, while treaty reinsurance covers broad categories of policies. Facultative reinsurance is normally purchased for individual risks that are not covered, or insufficiently covered, by reinsurance treaties, or for amounts that exceed the monetary limits of these treaties. As each risk is individually underwritten and administered, the reinsurer can price the contract more accurately to reflect the risks involved. On the other hand, treaty reinsurance is for a set period rather than on a per-risk basis, and the reinsurer covers all or part of the risks that the insurer may incur.
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Risk adjustment
The risk adjustment process involves gathering statistics, including patient demographics, diagnoses, and professional encounter data. This data is used to assign each member in the plan a risk score, which is based on members' active chronic medical conditions and the additional Medicare-approved services they require. Medical diagnoses are grouped into categories that share similar cost patterns, such as diabetes with or without complications, multiple sclerosis, and congenital abnormalities.
Accurate data and full documentation are crucial for successful risk adjustment. Healthcare providers are responsible for documenting each patient's active health conditions annually, using the appropriate codes from the International Classification of Diseases (ICD-10-CM). Specific information must be included in each health record to support the existence of the condition and the prescribed treatment plan. During the risk adjustment process, Healthcare Cost Conditions (HCCs) are assigned a Risk Adjustment Factor (RAF), which is used to predict ongoing care costs and adjust capitated payments.
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Adverse selection
A common example of adverse selection in health insurance occurs when a person waits until they know they are sick and require health care before applying for a health insurance policy. Since 2014, individual health insurance policies have been guaranteed issue, meaning pre-existing conditions are not a factor in determining eligibility and price. This has led to concerns about adverse selection, with healthy people opting out of purchasing health insurance until they need coverage.
Insurance companies have three options for protecting against adverse selection: accurately identifying risk factors, implementing a system for verifying information, and placing caps on coverage. To counter the effects of adverse selection, insurers may require premiums that reflect the customer's risk, distinguishing high-risk from low-risk individuals. For example, a racecar driver is charged substantially higher premiums for life or health insurance coverage than an accountant.
Empirical evidence of adverse selection is mixed. Several studies investigating the correlation between risk and insurance purchase have failed to show the predicted positive correlation for life insurance, auto insurance, and health insurance. On the other hand, positive test results for adverse selection have been reported in health insurance, long-term care insurance, and annuity markets.
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Risk transfer
The basic function of insurance is the transfer of risk. This transfer of risk is also referred to as "spreading the risk". The idea of risk-sharing is not new and has been around since antiquity. Chinese merchants would divide their cargo among several boats to protect themselves against the chance of financially ruinous upsets in the treacherous river rapids along their trade routes. Similarly, with insurance, the large losses of a few are distributed through an insurer to a large number of premium payers, each of whom pays a relatively small amount. The larger the number of premium payers, the more accurately insurers can estimate probable losses and calculate the amount of premium to be collected from each.
In the case of health insurance, the Affordable Care Act (ACA) requires that insurers use a single risk pool when developing premiums. This means that insurers must pool all of their individual market enrollees together when setting the prices for their products, spreading the costs of the unhealthy enrollees across all enrollees. The ACA also includes a permanent risk adjustment program that transfers payments among insurers in the single risk pool based on the relative risk of their enrollees. This helps to limit adverse selection and mitigate the effects of enrollee risk profile differences among insurers.
In some cases, insurers may want to insure a very large risk but are unable to do so on their own. In such cases, they can use reinsurance to spread the risk outside the country. Reinsurance is a form of "insurance for insurance companies" and involves sharing the risk by purchasing insurance policies from other insurers to limit their own total loss in case of a disaster. By spreading the risk across multiple companies, reinsurance helps to stabilize loss experience, protect against catastrophes, and increase capacity.
Overall, the transfer of risk through insurance is a way to reduce financial uncertainty and make accidental losses more manageable. By spreading the risk across a large number of individuals or companies, insurers can estimate and manage potential financial losses more effectively.
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Frequently asked questions
Insurance is a way for businesses and individuals to reduce the financial impact of a risk occurring. It is a transfer of risk, where the insurer takes on the financial risk on behalf of the insured in exchange for a fee.
Insurance companies use a strategy called risk spreading to manage potential financial losses. They do this by either selling insurance policies covering the same risk over a specific period or offering a large number of policies with varying coverage across multiple areas. By diversifying risks in this way, insurers can reduce the likelihood of facing large claims that could jeopardize their financial stability.
Reinsurance, also known as "insurance for insurance companies", is when multiple insurance companies share risk by purchasing insurance policies from other insurers to limit their own total loss in case of a disaster. It helps insurance companies spread the cost of risk among many other insurance companies, ensuring that no single company has too much exposure to a large event or disaster.
