Health insurance: a cautionary tale
The law of large numbers employs probability theory to estimate the frequency of certain events with reasonable accuracy; the larger the number (or population), the greater the accuracy.
Collective risk spread is an enigmatic description for assessing a large group with a range of low-to-high probability of insurance claims coverage, for example younger healthier individuals versus older people, tending towards ill health.
This is Part 2 – an insurance Black Swan 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 of all sectors” can be read here https://tinyurl.com/yzoaemn3
This is a story of biblical proportions – except it did not happen in biblical times. In 18 months, this self-funded healthcare pool (established by a large industry trade association) went bankrupt.
It is, however, true, and if truth be known these same types of situations happen more than is realised – or disclosed.
Circumstances, times, and locations have been altered for confidentiality. It has to do with the process of insuring people’s health for minor and major catastrophes and how health insurance pools were managed.
Part 2 – And so they did.
A year later, the organisation’s very own self-funded insurance company was up and running. It was great. All member owners dropped commercial health insurers and switched to their own association’s self-funded plan.
Health premiums were low.
Everyone was enthusiastic about this innovative strategy, feeling it was a great opportunity to control costs within and by the group membership.
Trade industry employees tend to be transient in nature, moving from job to job. Generally, they are younger and healthier, and it was assumed they would not make as many claims.
Their actuarial assumptions were that unless there was a major employee health catastrophe (an outlier) early on, they could underprice the commercial market health insurance premiums and still have large surpluses to carry forward.
The plan was working very well. Optimism reigned.
Healthcare premiums poured in steadily for a year and a half. Claims costs appeared under control, staying relatively small and stable. Prospects (and profits) looked amazingly good.
In two to three years, their plan could conceivably accumulate a large surplus of investable cash. The organisation’s executive began to review investment portfolio manager resumes, and to talk about how the eventual profits might benefit the organisation in other cost-efficient insurance: workers’ compensation, life and disability insurance, etc. And, they might even be able to return some premiums to the members as a future dividend.
Then, two things happened.
The bottom fell out of the economy, rapidly heading into another horrific recession.
One association member fell gravely ill, requiring indefinite years of extraordinarily expensive continuing care.
Costs started to mount; business future contracts started to dry up.
Trying to remain solvent during another business downturn, employers found they were unable to afford full-boat health insurance benefits. They started cutting back on benefits offerings, while raising premiums.
The economy worsened, younger healthier workers were made redundant, the premiums were raised again and again to compensate for the loss of the healthier workers who left.
Commercial insurers in the local marketplace, sensing the association fund’s challenges, aggressively marketing, offered better rates – further depleting the workers who made few or no claims, leaving the older less healthy industry groups left in the association’s health pool.
In the end, the association’s large number were skewed beyond belief. There would not be any probability calculations, just the inevitability of higher claims across the board – due to the concentration of older workers, then closing.
Large, long-term highly rated insurance companies – survive for a reason. They utilise actuarial assumptions (and numerous intricate mathematical models) combined with historical real life documented experiences to proactively calculate the odds of maintaining a large enough, healthy and diverse insurance pool.
They launch heavily capitalised; then maintain conservative investment reserves to carry them through break-even or loss years. They know what they are doing. To minimise their success is only to benefit them.
Can self-funded insurance plans work? Yes, they have and do, successfully – but even the tiny minimal planning: law of large numbers, collective risk spread, economic feasibility, competitive pricing, adequate capital reserves – is nowhere near enough to forestall a Black Swan event.
Excerpts from Held Captive: The History of International Insurance in Bermuda by Catherine R Duffy, country head of AIG Bermuda
“In 1919, well before Henry Tucker started to set up the infrastructure for Bermuda to become the Switzerland of the Atlantic, a young American named Cornelius van der Starr was seeking to find his calling in life after serving his country in the First World War.
“He wanted more than just to have survived, and at age 27, he set out to the Far East, forming a fire and marine insurance company in Shanghai and then expanded across the globe. Within ten years, “CV” Starr had established himself as a major player in China and the East elsewhere.
“In 1939, Starr moved his headquarters to New York, continuing to expand into Latin America as European competitors withdrew due to war and also opened a regional headquarters into Cuba.
“By 1947, all US business emanated from New York, while an outside central base was needed for all non-US operations. With Cuba’s economic instability a concern, Panama’s language and legal system a barrier, Mr Starr decided upon Bermuda – with its good standard of living, proximity to the United States, and Bermuda law, based upon his familiarity with British law.
“The same year, he arrived on Bermuda shores to establish Bermuda's first international insurance company and soon after, Bermuda Parliament legislation incorporated American International Company.
“Just about everything Bermuda’s international insurance industry has since become can be traced back to that decision by Starr in 1947 to headquarter his non-US interests in Bermuda. Airco was the first major international publicly owned company to be managed entirely from Bermuda and had a number of attributes that are still to be found today in the very largest Bermuda-based insurance companies.”
Seventy- odd years later, the author, Catherine R. Duffy was promoted to AIG Country Head. How visionary is that?
CV Starr, https://starrcompanies.com/About/History
• Martha Harris Myron, CPA JSM, a native Bermudian, is a former qualified international cross-border financial planner, and the author of The Bermuda Islander Financial Planning Primers, international financial consultant to the Olderhood Group Bermuda Ltd., and financial columnist to The Royal Gazette. All proceeds from these articles are donated by The Royal Gazette to the Salvation Army, Bermuda. Contact: email@example.com