Insurance is one of the most popular methods of funding employee benefit plans, but, as explained in later chapters of the Handbook, many other options exist. The advantages and disadvantages of using insurance in the design of a benefit plan are discussed:
A number of reasons account for why insurance can be used effectively in an employee benefit plan. One advantage is the known premium (cost); it is set in advance by the insurance company. The employer may have better control over its budget with a known premium, because any high shock losses would be the problem of the insurance company and not the insured. Having an outside administrator also can be an advantage to the employer. The employer does not have to get involved in disputes involving employees over coverage of the plan, because these would be handled by the insurance company. Employees may prefer insurance to some other form of funding in order to obtain the financial backing of an outside financial institution. This, of course, depends upon the financial strength of the insurance company selected, and care should go into this choice. Insurance companies often are leaders in the area of loss control and may help in the design and implementation of systems designed to control costs for the employer. A final advantage is that it may be more economical for an employer to use insurance rather than other alternatives. The insurance company may be more efficient and able to do the job at a lower total cost.
Insurance is not always the preferred method of funding employee benefit plans. A number of costs are involved that must be considered. Insurance companies charge administrative expenses that are added to the premium (or loaded) to compensate for their overhead expenses. Home office costs, licensing costs, commissions, taxes, loss-adjustment expenses, and the like all must go into the loading. One must realize that the premium covers not only direct losses but also the insurance company's overhead as well. The amount may vary from a small percent of the premium (e.g., 2 percent to 5 percent) to potentially a very high amount (25 percent or more) depending on the type of contract involved. Another potential disadvantage is that employer satisfaction is directly affected by the insurer's ability to handle claims and solve problems. Slow payment or restrictive claim practices can have an adverse effect on employees.
Whether something is an advantage or disadvantage often depends upon the specific insurance company involved. It is important to use care in the selection of an insurer. Checking out the insurer with other clients and carefully analyzing the carrier's financial stability are critical elements in the selection process.
It often is said that anything can be insured if one is willing to pay the premium required. Insurance companies, however, normally will insure a risk only if it meets certain minimum standards. These standards or prerequisites are needed for an insurer to manage the company in a sound financial manner. Without suitable risks, an insurance company can find itself in serious financial trouble. An insurance company is subject to the same problems as any other business—inadequate capitalization, a weak investment portfolio, or poor management. Insurance companies have the additional problem of insuring risks that could result in catastrophic losses.
The following is a list of the characteristics of a risk that are desired in order for it to be considered an "insurable risk":
1. There should be a large number of homogeneous risks (exposure units).
2. The loss should be verifiable and measurable.
3. The loss should not be catastrophic in nature.
4. The chance of loss should be subject to calculation.
6. The loss should be accidental from the standpoint of the insured.
It should be noted that this list is what is considered ideal from the standpoint of the insurance company. Most risks are not perfect in all aspects, and insurance companies have to weigh all aspects of a risk to determine if, overall, it meets the criteria of an insurable risk.
The insurance company must be able to calculate the number of losses it will incur from the total number of risks it insures. Assume that a life insurance company has just been formed and it is to insure its first two people. Each wants $100,000 of life insurance. The company needs to know what the chance of dying for each of the two people is in order to calculate a premium. Without this information, the company will have no idea of whether these people will live or die during the policy period. Should both die during this period, $200,000 would be needed for the claims. If neither dies, the company would need nothing for the claims. The conclusion one reaches is that the premium should be somewhere between $0 and $200,000. This information is not very helpful, and the insurance company could not insure the risk. What is needed is a large number of similar risks so statistics can be developed to determine an accurate probability of loss for each risk being evaluated. Insurance is based on the law of large numbers, which means that, the greater the number of exposures, the more closely the actual results will approach the probable results that are expected from an infinite number of exposures. For example, life insurance companies have accumulated information over the years that enables them to develop mortality tables that reflect the expected mortality for a given type of risk. They are able to do this because of the large number of lives that have been insured over the years. Medical, dental, disability, and life risks all require large numbers of cases to determine proper premium rates.
Employee benefit plans may or may not have the numbers needed to determine loss expectations accurately. This would depend upon the specific plan. Those plans with large numbers of homogeneous risks can be experience rated. This means the premiums will be calculated with the data from the plan experience itself. Smaller plans would not have an adequate number of risks, and other alternatives would be needed. For example, small plans can be combined with other small plans to get creditable statistics, or insurance companies might ignore small-plan statistics and rely on loss statistics developed independently of the plan.
It is important that an insurance company be able to verify a loss and to determine the financial loss involved. Certain risks pose no problem in determining if a loss has taken place. Examples would be fire and windstorm losses with a home or a collision loss with one's auto. Furthermore, the financial value of these losses can be determined accurately by the use of appraisals and other forms of valuation. Other risks are harder to evaluate. An example is a claim for theft of money from a home. Did the theft take place? Did the person have any money at home to be stolen? With risks that are difficult to evaluate, the insurance company has to take other precautions to protect itself from false and inflated claims.
Employee benefits are subject to the same types of problems. Death claims and retirement benefit claims probably would be the easiest in which to determine whether a loss has taken place or not. Once a death claim is verified, the amount of loss is normally the face value of the insurance contract. Few problems result from death claims. The same is true of retirement benefits. Assuming the age of the retiree can be verified, then the benefit promised by the plan will be paid. The other extreme might be disability income claims. In some situations, an insurer might be uncertain whether a valid claim exists or not. Some disability losses, such as back injuries, are very difficult to determine. Is the insured actually disabled or not? Still other employee benefit losses may fall between these two extremes. Medical and dental losses might fall into this category. When an employee benefit loss is difficult to verify or measure, the insurer may attempt to overcome the problem through several methods. Policy provisions are helpful in such situations. Benefit maximums, waiting periods, preexisting conditions clauses, alternate medical verification, required second opinion on certain surgical procedures, and hospital-stay monitoring are a few of the provisions that help in these situations.
A serious problem occurs when a large percentage of the risks insured can be lost from the same event. Assume a fire insurance company insured all of its risks in one geographical location. A serious fire could result in catastrophic losses to the company. This did happen in the early history of fire insurance. Fires in London, Chicago, Baltimore, and San Francisco resulted in insurance company bankruptcies and loss of confidence in the industry. It became obvious that a geographic spread of the risks insured was essential, because a concentration of losses from one event could seriously impair or even bankrupt a company. Cases exist in which it is almost impossible to obtain a spread of the risks. In such cases, insurance becomes difficult or impossible to obtain. Flood and unemployment losses would be examples. Unemployment can cover wide geographic areas, and a geographic spread would not help prevent a catastrophic loss. The same could be true for flood losses. The federal or state government might insure this type of risk, but it would be necessary for it to subsidize the premium rates to make them affordable.
Employee benefits are seldom subject to problems relating to inability to get a geographic spread of the risk. Benefit plans often insure life risks, hospital and dental risks, and disability income losses. For the most part, these types of risks are not subject to catastrophic loss due to geographic location, but examples can be imagined in which catastrophic losses might exist. The possibility of a plant explosion or a poison gas leak causing a large number of deaths or medical losses, or a concentration of certain diseases because of the exposure to certain elements that are indigenous to a specific employee group theoretically exist. Usually, however, this is not an important consideration in underwriting typical benefit plans. Policy limitations, reinsurance, and restrictions on groups insured all can be used to minimize the problem to the extent it exists.
For an insurance company to be able to calculate a premium that is reasonable to the insured and that represents the losses of a particular risk, certain information is essential. Data on both the frequency of losses and the severity of the losses must be available to determine the loss portion of the premium. This often is referred to as the pure premium portion of the premium. Essential to the pure premium calculation would be a large number of homogeneous exposure units as previously discussed. If an employer is large enough, the plan losses alone could be used to determine the pure premium portion. The meaning of "large" depends upon the type of risk involved. At least several hundred employees probably would be needed for full reliance upon the data.
For an employee benefit plan to be acceptable to an employer and to employees, the plan must have a premium that is considered reasonable relative to the risk being insured; that is, the insured must be able to pay the premium. An insurance company's expenses not related to the losses covered by the pure premium must be added to that premium to obtain the total premium. The expense portion may be referred to as the loading associated with the risk. The "pure premium" plus the "loading" would make up the total premium to be paid by the plan. Employees who pay a part or all of the premium (participating plan) will not participate if they can obtain a lower premium in an individual insurance plan or if they can be insured through a spouse's plan at a lower cost, and the employer will be unable or unwilling to pay the premium if the rate is not reasonable.
Why would a premium be noncompetitive? This could happen for any number of reasons. For example, a plan could be populated by a high number of older employees. The resulting rate may mean that the younger employees can find lower-cost insurance outside of the plan. The younger employees are unwilling to subsidize the rates for the older employees. Also, the employer may not want to pay the needed premiums. Other reasons for noncompetitive plans could be poor loss experience from a high number of sick and disabled in a plan, or a plan having specific benefits that have resulted in high loss payout. For example, a plan may provide unlimited benefits for drug- or alcohol-related sickness, and the plan member makeup may have resulted in heavy payout for these problems. The bottom line is that the resulting loss experience has made the plan noncompetitive. It is not unusual for an employee group initially to pay a rate that is considered reasonable only to have the plan premiums become unreasonable over time. Failure to keep the average age of the members in the plan low or a higher incidence of illness could be the reason.
The employer must keep track of the factors contributing to premium increases. Inflation related to medical benefits has in recent years resulted in plan costs increasing beyond the regular cost-of-living index. This is particularly true with plans covering prescription drugs. The cost of this coverage has dramatically increased over the past 15–20 years. Constant review of benefits, benefit levels, employees covered by the plan, and competitive rates for alternative plans must take place. It has become common for plans to move away from "first dollar" medical benefits and to incorporate deductibles, waiting periods, and other cost-saving features. An obvious factor to review is the cost of alternative plans. Would it be financially sound to use an alternative insurance plan or an alternative method of delivering the benefits, such as a health maintenance organization (HMO) or a preferred provider organization (PPO)?
This problem can be serious in some forms of insurance, such as property and liability coverage, but is of less importance in the life and health areas of employee benefits. The insurance company does not want to pay for a loss if it is intentionally caused by the insured. It is obvious that payment should not be made if one intentionally destroys his or her home by arson or purposely wrecks an automobile.
An employee could intentionally cause a personal loss, but it would mean causing harm to himself or herself. For example, suicide or attempted suicide could result in death or medical claims. This type of problem can be reduced or eliminated by policy provisions restricting benefits in some manner if it is necessary. Determining whether a loss is accidental normally is not a problem in life, medical, and disability claims.
Insurance companies consider providing insurance to employee benefit plans if they meet the minimum standards of an insurable risk. Benefit plans in general fit the minimum standards as set forth above. Such plans would include life insurance, medical and dental insurance, disability income, and retirement programs. Policy provisions, benefit restrictions, and reinsurance can be used to help alleviate problems to the extent they exist. Life insurance probably is the best example of a plan that meets all the desirable standards of an insurable risk. Disability income, although normally insurable, creates more of a problem from an insurability standpoint. Although not a common employee benefit, excess unemployment insurance would be a benefit that borders on being uninsurable.
Adverse selection is the phenomenon in the insurance mechanism whereby individuals who have higher-than-average potentially insurable risks "select against" the insurer. That is, those with the greater probabilities of loss, and who therefore need insurance more than the average insured, attempt to obtain the coverage. For example, people who need hospitalization or surgical coverage seek to purchase medical insurance, those who own property subject to possible loss by fire or flood obtain insurance, and individuals who own valuable jewelry or objects of art purchase appropriate coverage. This tendency can result in a disproportionate number of insureds who experience losses that are greater than those anticipated. Thus, the actual losses can be greater than the expected losses. Because adverse selection is of concern to insurers for both individual and group contracts, certain safeguards are used in each case to prevent it from happening.
Under a block of individual insurance contracts, the desirable situation for an insurance company is to have a spread of risks throughout a range of acceptable insureds. The so-called spread ideally will include some risks that are higher and some that are lower than the average risk within the range. Insurers attempt to control adverse selection by the use of sophisticated underwriting methods used to select and classify applicants for insurance and by supportive policy provisions, such as preexisting-conditions clauses in medical expense policies, suicide clauses in life insurance policies, and the exclusion of certain types of losses under homeowners policies.
The management of adverse selection under group insurance contracts necessarily is different from the approach used in individual insurance. Group insurance is based on the group as a unit and, typically, individual insurance eligibility requirements are not used for the group insurance underwriting used in employee benefit plans. As an alternative, the group technique itself is used to control the problem of adverse selection.
Self-funding, or self-insurance, is a common method of providing financing for employee benefit plans. Essentially this means that the organization is retaining the risk. It is important to realize, however, that many of the activities performed by the insurance company under an insured plan still have to be done. The identical problems associated with insurable risks for an insurance company exist for the firm that is self-funding or self-insuring. Therefore, the characteristics of an ideally insurable risk would be just as important for those firms that use self-funding as they are for an insurance company. The mechanism used for funding is not directly related to the question of whether a risk is a good one to include in the benefit plan. One should realize that only large firms with many employees would be able to meet all the characteristics of the ideally insurable risk. It is not uncommon to find that firms that say they self-fund or self-insure have, in fact, some arrangement with an insurance company or companies to insure part or all of a particular benefit. Many firms use insurance to provide backup coverage for catastrophic losses or coverage for losses the firm feels cannot be self-funded. The self-funded or self-insured plan has most of the characteristics found in the definition of insurance and has many of the same problems.
1 comments:
Thanks for explaining all these important concepts that are related to insurance. I find this article highly beneficial to me as I wanted to learn about them in detail.
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