How the Insurance Industry Deals with Problems of Risk Pooling and Risk Sharing - Article Example

Insurance is a part of financial system. It takes care of the financial consequences of certain specific contingencies both in case of individuals and corporate bodies. In Insurance terminology, such contingencies are called risky and they cause losses when they take place. The effect of these losses on financial system is not only negative but may be disastrous and catastrophic also. It results in substantial burden on the financial well being of those affected. It may be at micro- or macro-level. Individuals, corporate bodies and entire communities may be affected (ICFAI Centre for Management Research (ICMR), 2003). As stated above, risks are uncertain and there is a difference in their nature, uncontrollable or accidental. Generally, risks are regarded as occurrences that bring about only loss. Another feature of risk is the degree of controllability. Risks are not self-invited and their impact is difficult to control, once they occur. But there are certain types of risks which can be improved, i.e., their incidence can be reduced by pre-planning. In some cases, they can also be prevented by anticipating their behaviour based upon past experience. Basically, risk is fortuitous, something that is not planned, deliberate or will fulfil but something which may or may not happen. Risk pooling and Risk Sharing are related to health insurance which is also called as medical insurance. This insurance covers all types of disability, loss of income, medical expense and accidental death. It can be defined as “any form of insurance whose payment is contingent on the insured incurring additional expenses or losing income because of incapability or loss of good health (ICFAI Centre for Management Research (ICMR), 2003).” In medical insurance, benefits become payable on disability as a result of accident or sickness. Health insurance can address the problems related to rising medical expenses. A health insurance policy can be used as an accumulation plan. Risk Pools are especially related to health insurance where special programs are created by state legislatures with an aim to provide a kind of safety net for people who are “medically uninsurable (naschip.org).” “Medically uninsurable” here means people who do have a pre-existing health ailment and are denied insurance coverage or who are eligible to access only private insurance coverage that has got too many restrictions and at the same time is extremely expensive. The concept of risk pooling works because of the “law of Large numbers (Health insurance.info, 2006).” “According to risk pooling, a number of people get together and share their losses by averaging them together (Health insurance.info, 2006).” Risks which are pooled together as part of Risk pooling must be independent risks. The reason behind pooling independent risks together is because independent risks fluctuate at different times but not all at once. Risks that bring about losses, those which are beyond control, those whose financial consequences are measured and those that are predicted are managed by way of risk pooling. Risks need not be homogenous, but may be heterogeneous. As a matter of fact, the heterogeneous nature of risk will help the spread of risks better, because risks of similar nature are grouped together in the form of a risk pool. So, analysis of risk based upon its characteristics is an important part of risk management and insurance. Insurance companies are professional risk carriers and they do this by aggregating the risks. When it comes to risk sharing, it can be defined as the responsibility sharing of the risk impact with a different party by means of an insurance policy or an outsourcing contract (google). Risk sharing contracts in the insurance industry create a kind of burden over the companies. To be specific, they actually inflict huge amount of operational burdens (Abernathy, 2000). The basic problem that can be noticed with respect to the handling of risk pooling problems by the insurance industry is the lack of adequate systems. Most health plans often do lack systems of data management to perform risk sharing and risk pooling contracts. Most of the payer systems that were designed specifically aim at processing of claims. “In order to comply with risk sharing contract terms both the doctors and the health plans of the insurance companies need to operate outside the normal system design (Abernathy, 2000).” Let us consider an example for the above situation. Let us assume that a health plan has negotiated as contract of risk-sharing with a group that contains fifteen members in a particular market. The risk pool contains a wide variety of risk elements such as obstetrics, cardiology, radiology and urinology. All these risk elements when negotiated and documented will look absolutely fine and would pose no future problems. However, the actual problem arises when the health plan is not in a position to process the claim when they arise. “Actually the health plan must be able to process the claim, determine if it is associated with a risk arrangement, assign the claim to the proper risk pool, and provide periodic reporting to the provider groups (Abernathy, 2000).” The above discussed system, in order to be effective, must have timely accounting for incurred claims in order to match with the terms of the contract. There have been instances where risk sharing contract finally landed up in litigation which consequently leads to financial hardship. The actual problem in such kind of situations is the communication gap. To be specific, the negotiators of the risk sharing contract or not the ones who administer such contracts. The risk sharing in the insurance industry is also affected when correlated risk strikes. Loss management initiatives, if adopted by the insurance companies, will help in handling problems related to risk sharing mechanism (Sankaranarayanan). Loss management initiatives are an integral part of risk management programmes undertaken by various insurance companies. Risk management can be defined as “the identification, analysis and economic control of those risks that threaten the assets or earning capacity of an enterprise.” Risk management remains primarily focused on meeting regulatory requirements and only secondarily on protecting and enhancing the value of the franchise1. The following are the reasons for doing so: • A culture of risk awareness has yet to emerge • Compliance is not being turned into competitive advantage • the importance of governance is underestimated • Quantifiable risks are still the focus of too much attention. There are three steps involved in managing risk. They are: Risk identification Risk Analysis Risk control Risk identification – Risk identification involves discovering what threats exist or may at some time exist. There are many methods available to help identify risk2. Risk Analysis – By examining past data, the risk identifier assesses the risk and discovers the likely frequency and severity of the identified risk or risks, how often will they occur and if do occur, and then what is the likely financial consequence. Risk control – The final stage is the risk control. It may be that the risk is perceived to be so small that no action is taken. However, if a risk has any potential consequences some reaction should be apparent. There are two likely courses of actions to be taken concurrently, one, the physical control measure and the other, the financial controls. In order to avoid problems of risk sharing, whenever such a contract is entered into, and insurance companies needs to ensure that the particular health plan contains all the processes in place in order to administer the claims in the future. Past researches in the field of insurance have revealed that if an efficient cataclysmic events and the consequent exposure definitely has substantial effects on insurance companies. One important factor that is to be noticed in this context is that whenever there is limited capital available, most of the companies do not seem to work for designing proper systems for efficient risk sharing. In his recent survey done, Schlesinger (Schlesinger, 2000) points out that “the risk of non-performance is “always present for an insurable risk, but almost universally ignored in insurance theory” (Wright, 2003)”. Many researchers have carried out vast research on this issue and have found out that when a particular risk pool is falling short of financial resources in order to process the claims, an optimal participating insurance contract would be able to give full or marginal coverage (Wright, 2003). When it comes to risk sharing or risk pooling of an insurance, there exist a number of criterion that are to be satisfied in order the risk allocation to be effective. The first and foremost criterion that is to be met is that the amount of risk that is pooled or shared among a particular group should not be higher than the total stand-alone risk. In addition to this, the allocated risk of the pool should be consistent enough. To be more specific, the risk that is allocated to a particular group does not necessarily depend on the level of performing the allocation (Andersson). The government is also involving actively in increasing the potential of insurance industries in order to handle problems related to risk pooling and risk sharing. Bibliography Abernathy, M. (2000, April). Avoid Common Problems In Risk-Sharing Contracts. Retrieved November 18, 2008, from Care Magazine: http://www.managedcaremag.com/archives/0004/0004.risk.html Andersson, O. H. (n.d.). Risk Sharing and Capital Allocation. Retrieved November 20, 2008, from www.aktuarforeningen.dk: www.aktuarforeningen.dk/LinkClick.aspx?link=ARCH03V37N1_16.pdf&tabid=36&mid=367 google. (n.d.). Risk sharing. Retrieved November 18, 2008, from Google: http://www.google.co.uk/search?hl=en&rlz=1T4HPAB_enIN256IN256&defl=en&q=define:Risk+Sharing&sa=X&oi=glossary_definition&ct=title Health insurance.info. (2006). Dow does insurance reduce risk? Retrieved November 18, 2008, from Health insurance.info: http://www.healthinsurance.info/HIRISK.HTM ICFAI Centre for Management Research (ICMR). (2003). General Insuracne. Hyderabad: ICFAI Cneter for Management Research. naschip.org. (n.d.). Risk Pools. Retrieved November 18, 2008, from Naschip.org: http://www.naschip.org/what_is_a_risk_pool.htm Rudiger Dornbusch, S. F. (2008). Economics. McGraw-Hill International Edition. Sankaranarayanan, K. (n.d.). Climate change na dInsurance Industry. Retrieved November 20, 2008, from www.rmi.nccu.edu.tw/apria/docs/Concurrent%20I/Session%201/2707Climate%20Change%20andInsurance_APRIA07.rtf Schlesinger, H. (2000). Handbook of Insurance. Kluwer Academic Publishers. Wright, O. M. (2003). Efficient Risk Sharing within a Catastrophe Insurance Pool. Hamburg university. Read More