Funded Self-Insurance

In a large medical complex with a very high cash flow, it is possible to pay judgments out of operating receipts without risking insolvency. This is acknowledged by the Medicare/Medicaid reimbursement rules that allow a hospital to be reimbursed for legal losses (as a part of overhead) up to $100 thousand or 10 percent of the hospital's net worth. The hospital will have an unreimbursable loss for any amount over this threshold. The losses that are considered are not merely claims paid but the entire administrative cost of the claims processing, including the legal costs for defending claims. This limit forces all but the largest institutions to set up approved self-insurance schemes in order to avoid having a large part of their overhead declared unreimbursable. There are two minimal requirements for a self-insurance plan to be approved by Medicare/Medicaid. the plan must have a trust fund to pay future claims, and it must have a formal quality control program.

The amount of the trust is determine by standard actuarial techniques, based on the claims history of like facilities. The health care provider then pays money into the trust until it is paid up to the required level. The assets of the trust must be managed by a third party, usually a bank trust department. This trustee invests the trust funds in securities and other appropriate investment and pays the income into the trust. If the claims against the trust exceed the income, the provider must make periodic payments to the trust. If the income of the trust exceeds the claims, the excess may be held in the trust (not to exceed the required reserve by more than a given amount) and eventually returned to the provider as income. After the trust has been in force for a few years, the provider may elect to base the reserve calculations on the actual claims experience of the facility. A facility with a good claims record may then be able to reduce its reserve requirements. A reduced reserve will increase the facility's revenue, either by reducing the amount paid in or by increasing the amount of trust income returned to the facility. In either case, savings in the cost of administering the program will be returned to the provider. This provides an incentive to reduce claims that is lacking in traditional rated insurance.

Funded self-insurance may be set up on an individual provider basis or as a program in which a group of providers cooperates in risk spreading. If several providers with similar claims experience participate in a group plan, each provider will have a net savings over an individual plan. This savings will be realized from the shared administrative services and from reduced trust requirements. The trust fund will be less than the total of the individual determined trust funds. This reduction will be possible because the risk of an unusually large number of amount of claims will be shared by all the providers. The chance that all the providers will suffer an unusually bad run of claims at the same time is much less than the chance that a single provider will suffer more than its share of claims in a given time period.

There is also a psychological advantage to a multiprovider trust fund. A multiprovider trust will have enough reserves to settle any given claim without drastically depleting the trust. This will make it easier for the providers to authorize the settlement of a claims, especially a structured settlement, is the best protection against an unexpectedly large loss. While a single provider trust fund will be more seriously depleted by a settlement, it is still easier for a provider to authorize a settlement from a fund that can be replenished by periodic payments than to pay a cash payment of the operating revenues. If there is a liquidity problem with the trust investment, the trust portfolio can be pledged as collateral for a short term loan. As the portfolio is liquidated, the loan can be paid back with the proceeds. If the plan is unfunded, it is very difficult to borrow money to settle a claim.

The trust fund cannot be controlled by the insured party. The trustee should be independent of the provider, although the trustee is usually the providers banker. The trust fund must be invested in proper securities and cannot be pledged as collateral for lanes, except in conjunction with claims payments. However, though the trust cannot be used by the provider, it will increase the provider's effective deposits at the bank. This will give the provider added leverage in other transactions. A well-managed trust can be used to offset potential claims in a bond prospectus, assuring potential bondholders that their investments will be protected.

When a hospital or physician group has elected one of the variants of self-funded insurance, its expenditures for risk spreading become controllable. The costs can be lowered through aggressive quality control. Conversely, an unexpected increase in claims will be felt by the provider directly. Without the shelter of an outside insurance policy. The provider may be forced to pay out claims from operating revenues that exceed the trust fund. This is also true of providers who have less insurance than their risk exposure. To the extent that their liability exceeds their insurance coverage, these providers are in the same position as a provider who is "going bare." While providers with unfunded self-insurance are the least likely to have quality control programs, they are the group that stands to gain the most from an effective quality control program.

The Medicaid/Medicare requirements for a quality control program are fairly simple. The program must be a written one, and there should be some staff meetings devoted to presenting and discussing it; but there is little pressure to see that the program if effectively run. The government regulations are very vague about the content of approved quality control programs. They leave this to the health care provider. While this allows great flexibility in tailoring an effective program, it also allows the facility to ignore the risk management program in favor of seemingly more pressing matters. Our thesis is that quality control is extremely cost-effective and should be a primary function of the various health care providers.

The captive insurance company is a variant on the funded self-insurance plan. A captive insurance company is owned or controlled by one or more providers. It may sell coverage only to the owner institutions, or it may sell insurance to outside providers. The legal requirements for a captive insurance company are a trust fund to cover claims and administrative procedures to process claims. The amount in the trust will be the same as that in a trust for a comparable self-insurance plan. Depending on state law, a captive company may give the institutions increased freedom in investing the fund and certain tax advantages. The captive company may also have better access to the reinsurance market. Since decreased claims will increase the "profits" (or decrease the expenses) of the captive company, a captive company provides the same financial incentive for effective quality control as a self-insurance plan.

While there are many advantages to spreading the risks of a self-insurance program among several providers, there are advantages to a single-facility plan. The more providers that pool their risks, the closer their chance of loss will approach the industry average. If a specific provider can reduce its chance of loss below the average of the other providers in the pool, it will save money by leaving the pool. It is important for a provider to investigate carefully the claims experience of other providers before entering into pooling arrangements. Once in a self-insurance pool (or multiple-provider captive company), the provider should require a periodic audit of the claims processed by the pool. If any of the providers experience a disproportionate record of loss, the other members of the pool should consider reevaluating the relative contributions to the pool. A provider with a very low incidence of claims should evaluate the benefits of an individual self-insurance program. The resulting savings may be significant.

The main risk of an individual self-insurance plan is that a single claim may exceed the reserves of the trust. The best protection from this risk is to buy an excess coverage policy from a commercial insurance company. This type of policy will have a very high deductible. This high deductible, at least $500 thousand, will prevent the commercial carrier will not incur any administrative costs or defense costs unless there is a chance that the claim will exceed the deductible. Excess coverage is much cheaper than primary coverage because of the reduced overhead and the relative infrequency of judgments or settlements exceeding the deductible. The problem with excess coverage is that the commercial carrier will pressure the provider to settle as many cases as possible for amounts below the deductible. The provider may prefer to fight a claim that can be settled only for an amount close to the deductible. The provider will have little to lose (a judgment over the deductible being insured) but much to gain, since the chance of a plaintiff winning a malpractice suit is much less than 50 percent. It is important that the contract with the excess coverage carrier explicitly establish all conditions and restrictions on settlement. The provider must beware of excess coverage agreements that give the commercial carrier the sole right to determine when a case will be settled.