AHM Health Plan Finance and Risk Management: Types of Risk

Types of Risk
Course Goals and Objectives
After completing Types of Risk, you should be able to

Distinguish between pure risk and speculative risk

Define risk management
Define the risks included in risk-based capital (RBC) requirements for health plans
Explain how C-risks and RBC risks relate to health plan solvency
Discuss the three broad strategies health plans use to deal with risk

To understand many aspects of healthcare financing, you must first understand the risks the
various participants in health plans face. Generally speaking, risk has a direct association with
costthat is, in the long run the greater the exposure to risk, the greater the costs that follow
from that risk. In the following sections, we explain the concept of risk and explore the methods
that health plans use to manage the risks associated with the financing and delivery of
healthcare.
The Concept of Risk1
Risk exists when there is uncertainty about the future. Individuals and businesses both
experience two kinds of riskspeculative risk and pure risk.
Speculative Risk
Speculative risk involves three possible outcomes: loss, gain, or no change. For example, after
an investor purchases stock in a publicly traded health plan, the stock price will either rise, fall,
or stay the same. The investors financial returns on that stock will follow the stock price plus
whatever dividends the health plan issues. Thus, the owner of the stock faces speculative risk to
the extent that the future returns on the stock are uncertain.
Likewise, when a health plan purchases a new information system, the health plans owners
hope that the initial investment in the system will result in an increase in operational efficiency
and in the level of customer servicefactors that will help the health plan earn a profit (if the
health plan is for-profit) or a higher level of retained earnings (if the health plan is not-for-profit).
Furthermore, the health plans owners hope that the total benefits that derive from the health
plans investment in the information systembenefits such as increased income and market
shareexceed the benefits the health plan or its owners could have received by investing the
same amount of money in a different information system.
Again, uncertainty and risk are present in this investment decision because there is a possibility
that this particular information system will not work as hoped, and that the health plan will incur
greater expenses and fewer benefits than anticipated from the system, thereby losing money on
its investment. There is also a possibility that the investment will neither lose nor gain a

significant amount of moneythat is, the benefits of the system as measured by increased
revenue are essentially equivalent to the increases in costs associated with that system.
In this regard, many expenditures made by a health plan are much the same as an investment
the health plan is investing in itself. The health plans owners or stakeholders are in a position
similar to owners of other investments such as stocks or bonds: owners invest their money and
accept some financial risk in the hopes of seeing some benefit that translates into financial gain.
The Concept of Risk
Pure Risk
Pure risk involves no possibility of gain; there is either a loss or no loss. An example of pure
risk is the possibility that you may contract a serious illness. Such unforeseen illnesses will
result in economic loss in the form of lost wages and increased medical expenses. If, on the
other hand, you do not become seriously ill, then you will incur no losses from that risk. For a
health plan, examples of pure risk include the possibility that its home office building will be
damaged by fire, or that the health plan will be a victim of fraud, or that an employee will act in a
negligent manner and in so doing expose the health plan to financial liability. Notice that like
speculative risk, pure risk contains an element of uncertainty, but unlike speculative risk, pure
risk contains no possibility of gain.
The possibility of economic loss without the possibility of gainpure riskis the only kind of risk
that healthcare coverage is designed to help plan members avoid. The purpose of healthcare
coverage is to compensate, in part or in full, a plan member, either directly or indirectly, for
financial losses resulting from unintentional illness or injury.
The coverage is not designed to provide an opportunity for the plan member to obtain a financial
gain from his or her healthcare needs. In other words, healthcare coverage is not designed to
be a means of engaging in speculative risk for plan members. Instead, plan members transfer to
the health plan the pure risk of medical costs arising from plan members unforeseen illnesses
or injuries.
Notice that healthcare coverage does not necessarily prevent events that are associated with
pure risk: many plans include wellness programs to reduce the frequency of illnesses, but
neither participation in the wellness program nor the coverage itself necessarily prevents any
one illness. Instead, the plan member transfers the pure risk of facing large and unexpected
medical bills to another partyfor example, the health plan. The health plan itself, by charging
actuarially derived premiums for accepting this risk, engages in speculative risk, because it may
either experience a gain or a loss from its business, depending on the rate at which plan
members utilize services and the health plans administrative and other business costs.
The following examples describe situations that expose an individual or a health plan to either
pure risk or speculative risk:
Example 1 A health plan invested in 1,000 shares of stock issued by a technology
company.
Example 2 An individual could contract a terminal illness.
Example 3 A health plan purchased a new information system.
Example 4 A health plan could be held liable for the negligent acts of an employee.

The examples that describe pure risk are

examples 1 and 2
examples 1 and 4
examples 2 and 3
examples 2 and 4
Risk Management
Individuals and businesses are surrounded by risks. Accepting risk is a key business function of
health plans, and a vital part of a health plans business activity involves managing those risks.
Risk management is the process of identifying risk, assessing risk, and dealing with risk. 2
Broadly speaking, the goals of risk management for a health plan involve assuring that the
organization survives, operates efficiently, sustains growth and effectiveness, and, in the case of
publicly owned for-profit health plans, increases shareholder value. Health plan finance is
concerned not only with pure risk, but with a specific type of speculative risk called financial risk.
Financial risk is the possibility of economic or monetary lossor gainin undertaking or
neglecting to undertake a certain action. Figure 2A-1 asks you to consider the risks in a typical
health plan situation.
In situations such as the one discussed in Figure 2A-1, the health plan, employer, provider, and
plan member can benefit from using risk management to deal with the risk each faces. Because
health plans are presented with a large number of financial risks in the course of conducting
business, health plans use a variety of risk management techniques to minimize the possibility
of undesirable financial outcomes.

However, in order to achieve a return on financial resources, a health plan must accept the
financial risk of engaging in business activities. Similarly, an investor typically accepts some risk
in order to achieve a return in, for example, the stock market. For businesses and investors, risk
and return are therefore closely related.
Another way to look at the risk-return relationship is that the greater the risk associated with an
investment or business activity, the greater the potential return must be in order to offset the risk
the investor is taking. This direct relationship between the amount of risk and the amount of the
potential return required to make the risk financially acceptable is known as the risk-return
trade-off. The risk-return trade-off is a basic consideration in decisions concerning many core
business activities health plans undertake. For example, where regulations allow, an HMO will
charge higher premiums to a high-risk group of enrollees than to a low-risk group of enrollees,
because as the risk-return trade-off suggests, the HMO will only accept greater risk in exchange
for greater potential returns.3
In this lesson and many that follow, we will discuss ways in which health plans manage the risks
that they face. First, however, we continue with an overview of the specific types of risk
generated by a health plans business, and the relationship between those risks and the health
plans solvency.

Risk Categories Faced by Health Plans

In the most general sense, any activity undertaken by a business entails some risk, and
ultimately every risk has the potential to impact the business financially. Health plans, for
example, face risks when entering a new market, exiting a market, or deciding to continue to
operate in a given market. The health plan faces other risks in plan design activities, benefit
coverage decisions, pricing products, choosing an information system, hiring employees,
reacting to the regulatory environment, or developing provider reimbursement contracts.
To manage and understand risk, managers have divided risk into different categories. The first
categories of risk we will discuss are called contingency risks, or C-risks.
Risk Categories Faced by Health Plans
C-Risks and Solvency
Contingency risks, usually called C-risks, are general categories of risk that have direct bearing
on both cash flow and solvency. Solvency is generally defined as a business organizations
ability to meet its financial obligations on time. To continue operations, for example, a health
plan must be able to pay those medical costs it is contractually obligated to pay as those costs
come due. Thus, financial risks have a direct bearing on an health plans ability to stay solvent,
and the ability of a health plan to stay solvent is a minimum requirement for the health plans
continued operation.
In accounting terms, solvency in a health plan is closely related to the amount of capital and
surplus (also called owners equity) that the health plan has on hand. Capital and surplus is, at
the most basic level, the difference between a health plans assets and its liabilities:
Assets Liabilities = Capital and surplus
Risk Categories Faced by Health Plans
C-Risks and Solvency
For a business to be solvent, it must have sufficient liquid assets to meet liabilities that are due.
Liquid assets are those assets that are either held in cash or can be easily and quickly
converted into cash. Money market funds and checking accounts are examples of liquid assets,
but an office building is not a liquid asset.
For health plans, solvency also refers to the legal minimum standard of capital and surplus that
every health insurance company must maintain. The issue of health plan solvency is extremely
important from a regulatory point of view, because the ability of health plans to pay the covered
medical benefits of enrollees is a public policy priority. We will discuss regulatory standards for
solvency in the next lesson.

There are four C-risks. Each measures aspects of a health plans financial and management
operations that can influence its solvency. Although C-risks were developed to apply to the life
and health insurance industry, they have also influenced the development of methods that
managers and regulators use in assessing the level of risk faced by health plans. Following is a
brief discussion of each type of C-risk:

C-1, or asset risk, is the risk that a health plan will lose money on its assets, including
investments in stocks, bonds, mortgages, and real estate.
C-2, or pricing risk, is the risk that the health plans experience with morbidity or
expenses will differ from the assumptions that were used in pricing the health plans
products. For health plans, this risk is typically the most important factor in determining
whether or not a plan is solvent.
C-3, or interest-rate risk, is the risk that interest rates will shift, causing the health plans
invested assets to lose value.
C-4, or general management risk, is the risk that financial losses will result from
business management decisions.

Businesses that have significant assets face these C-risks to varying degrees, but the relative
importance of each C-risk varies from business to business. For example, a typical health plan
faces much different levels of exposure to asset and interest-rate risks than do life insurers or
banks. Life insurers usually collect premiums on a life insurance policy for many years before
paying a claim on that policy. Thus, life insurers typically maintain a significant portion of their
assets in long-term investments, which causes both asset and interest-rate risks to be very
important factors in their profitability.
In contrast, a health plan will begin paying for medical costs relatively soon after first receiving
premiums from, for example, a group health policy. Because the health plans medical payments
come much sooner and more frequently than a life insurers payment of a claim on a life
insurance policy, a larger portion of a health plans assets will flow into and out of short-term,
liquid investments. Because these assets are liquid, they can be sold for cash more easily than
many long-term investments, which, generally speaking, makes liquid assets less subject to
asset risk than long-term investments. Thus, the health plan faces relatively smaller asset risk
than businesses such as banks, because banks tend to hold long-term investments such as
mortgages.
In certain business activities, however, health plans can face significant asset risk. For example,
health plans typically use sophisticated computer technology to track utilization data, provider
reimbursement, enrollee information, customer service, and medical costs. Tracking data is a
crucial part of an health plans ability to manage costs and risk exposure. Additionally, many
types of data must be tracked accurately for a health plan to meet regulatory requirements.
Consequently, any threat to the value of the computers used for tracking and analysis is an
asset risk.
Although health plans face relatively less exposure to interest-rate risk and asset risk than do
banks or life insurance companies, health plans face considerable pricing risk under almost all
health plan contracts. For most health plans, pricing risk is the most important risk the
organization faces. Pricing risk is so important because a sizable portion of the total expenses
and liabilities faced by a health plan come from contractual obligations to pay for future medical

costs, and the exact amounts of those costs are not known when the healthcare coverage is
priced.
For example, suppose a health plan enters into a group contract that is renewable on a yearly
basis. The health plan will set a price (premium) in advance for the expenses it expects to incur
in delivering healthcare services to the groups plan members. Although medical costs will be
paid throughout the year, the premium cannot be renegotiated until the end of the contract year.
The plan faces considerable pricing risk during the contract because the possibility exists that
assumptions made in pricing the plan benefits at the beginning of the contract will not
necessarily match the actual medical costs.

In any market where health plans face constraints in pricing their services, these health plans
also face pricing risk. In competitive markets such as those in which health plans typically
operate, competition itself is usually the most important constraint on pricing, because in such
markets health plans will compete with each other for market share partly by attempting to keep
their prices (premium rates) low.
Additionally, government activities also place constraints on pricing in some markets. For
example, as we discuss later in another lesson, the federal government develops payment
schedules for federal healthcare programs, most notably for the Medicare and Medicaid
markets. Health plans operating in these markets may find it impossible to adjust the payments
they receive for the healthcare coverage they provide. At the same time, health plans in many
markets are subject to mandated benefit laws. These laws add to the expenses health plans
incur while operating in the market because such laws require health plans to cover healthcare
expenses for certain treatments or benefits. Thus, health plans may be constrained in both
setting the payments they receive and in the methods they have for reducing expenses. Both
conditions can serve to increase the pricing risk health plans face.

Finally, general management risk is also an important issue for health plans, because
management decisions are critical to a health plans financial outcomes. Decisions related to
controlling costs, improving customer service, designing plan benefits, and structuring provider
reimbursement contracts are all critical management decisions.
Management risk also includes the risk that actual expenses will exceed the amounts budgeted
for those expenses. Accurate estimates of future expenses and liabilities allow health plans to
retain sufficient liquid assets to meet obligations. Beyond solvency concerns, accurate budgets
also allow management to use resources efficiently so that the assets generate the greatest
possible return. If the management of a health plan underestimates expenses for an upcoming
financial period, the health plan may either fail to retain sufficient assets to cover current
obligations, or be forced to sell long-term assets at a loss to meet those obligations, or take
other financially costly steps to stay solvent.

Management risk is always present in a business, because management constantly faces

choices concerning how to allocate financial resources to achieve the best financial outcomes.

For example, after satisfying regulatory requirements for solvency, an HMOs management must
decide the specific level of capital and surplus the HMO will maintain. If management fails to
retain a sufficiently high level of surplus, then the HMO may not be able to absorb losses
incurred from other financial risks.
On the other hand, holding excessive amounts of surplus is not risk-free, because this excess is
not being earmarked for core business functions such as developing a greater market share.
Furthermore, the optimum level of surplus for any HMO will change over time as internal and
external conditions change. Consequently, management risk is present at any level of surplus.

Some of the variables that management must take into consideration when making financial
decisions are wholly or partly within the health plans control. For example, an health plans
management has considerable control over whether or not to contract with a given provider, and
whether or not to include that provider on the health plans list of primary care providers.
However, the health plan has only partial control over the reimbursement rate it pays the
providers in its network, because the health plan must negotiate that rate with providers.
Many other variables, such as government laws and regulations, the general rate of inflation in
the economy, and the general rate of increase in medical costs, are often beyond the health
plans control. Thus, the risk that a management decision will result in unfavorable financial
outcomes increases whenever changes in general business conditions increase in frequency or
severity.
Risk Categories Faced by Health Plans
Regulatory and Antiselection Risks
In our discussion of general management risk, we pointed out that health plans have varying
degrees of control over internal business decisions and external business conditions. For the
health plan industry, a very important source of external risk is regulatory risk. Regulatory risk
is the risk that changes in regulations or laws may adversely affect the financial condition of an
health plan. We will discuss some of the laws that carry regulatory risk in Risk Management in
Health Plans and Provider Reimbursement and Plan Risk, but for now you should know that
there are a number of regulatory risks faced by health plans.
Chief among these risks is the possibility that healthcare reform may result in rate caps or
mandated benefit laws. Rate caps, which are most common in markets such as Medicare where
the government itself is the payor, limit a health plans ability to increase revenue in response to
rising medical costs, and therefore increase the risk that a health plan will become insolvent.
Laws mandating certain health plan benefits or contractual obligations have the effect of
increasing expenses for a health plan operating in that jurisdiction. Although regulatory risks
such as premium caps and mandated benefits are particularly important to health plans risk
management function, health plans also face regulatory risks that are not unique to the
healthcare industry. Tax laws, regulations and laws governing employment, building and safety
codes, and other laws have a tendency to change over time, and the possibility of regulatory
change carries with it regulatory risk.

Risk Categories Faced by Health Plans

Regulatory and Antiselection Risks
In a health plan environment, antiselection is the tendency of people who have a greater-thanaverage likelihood of loss to seek healthcare coverage to a greater extent than individuals who
have an average or less-than-average likelihood of loss. Antiselection risk for health plans is
the possibility that a higher-than-anticipated percentage of people who need greater-than
average healthcare benefits will sign up with a healthcare plan.
Antiselection can occur because individuals often know much more about their health than a
health plan can know. People who know they are ill or believe that they are likely to become ill
tend to more actively seek health coverageparticularly coverage with enhanced benefits
than do healthy people who believe they will not become ill. If an health plan has designed its
health plan and premium rates assuming a utilization rate based on an average population, but
attracts enrollees who are less healthy than average, the health plan faces higher-thanexpected utilization rates because of antiselection.
Contingency risks, or C-risks, are general categories of risk that have a direct bearing on both
the cash flow and solvency of a health plan. One of these C-risks, pricing risk (C-2 risk), is
typically the most important risk a health plan faces. Pricing risk is crucial to a health plans
solvency because:
a sizable portion of any health plans assets are held in long-term investments and any
shift in interest rates can significantly impact a health plans ability to pay medical benefits
a health plan relies heavily on the sound judgment of its management, and poor
management decisions can result in financial losses for the health plan
a situation in which actual expenses exceed the amounts budgeted for those expenses
may result in the health plan failing to retain assets sufficient to cover current obligations
a sizable portion of the total expenses and liabilities faced by a health plan come from
contractual obligations to pay future medical costs, and the exact amounts of those costs
are not known at the time a products premium is established
Risk Categories Faced by Health Plans
Regulatory and Antiselection Risks
Antiselection also occurs when people choose between competing plans. For example, suppose
a large employer offers two health plans to its employees. Both plans cover the same range of
medical treatments, but Plan A has relatively high deductibles and relatively low monthly
enrollee contributions. Plan B has relatively low deductibles and relatively high contributions.
Enrollees who anticipate that they will make frequent and expensive trips to their doctors may
be willing to make high monthly contributions if their deductibles are low, but enrollees who
anticipate little need for medical treatment will be more likely to sign up for a plan with low
monthly contributions. Thus, Plan B may, on average, attract less healthy enrollees than Plan A.
Actuaries play an important role in recognizing the risk of antiselection and judging the financial
impact of that risk in such situations.

Risk Categories Faced by Health Plans

Regulatory Solvency and Risk-Based Capital Requirements
As we mentioned earlier, all businesses, including health plans, are concerned about their own
solvency. In addition, health plans are interested in the general financial condition of the
healthcare industry for at least two reasons. First, all health plans are better off if the public has
faith and confidence that health plans are financially stable and reliable. Second, health plans
recognize that regulators and elected officials see financial stability and reliability in the
healthcare industry as a public policy goal. In pursuit of this goal, lawmakers and regulators
have established legal solvency standards that directly impact how health plans manage risks.
However, solvency standards themselves vary widely depending on the type of health plan
being regulated. HMOs, for example, are typically regulated as insurers, and as such must
comply with state insurance laws. On the other hand, federal law exempts self-funded
employer-sponsored health plans from state insurance laws and regulations. Recall from
Healthcare Management: An Introduction that under self-funded plans an employer or other
group sponsor, rather than a health plan or insurer, is responsible for paying plan expenses.

Because employees typically contribute to the financing of employer-sponsored health plans,

much of the federal regulation governing the financial aspects of these self-funded plans is more
concerned with defining the fiduciary duties of those who exercise control over the plan, rather
than concern with setting solvency standards for the plan sponsor. We will discuss self-funding
in more detail in Fully Funded and Self-Funded Health Plans.
In the next sections of this lesson, we examine two solvency standards regulators use to set
financial requirements with respect to risk for health plans. The first standard is from the HMO
Model Act as developed by the National Association of Insurance Commissioners (NAIC). The
second standard is known as risk-based capital (RBC).
Regulatory Solvency and Risk-Based Capital Requirements
HMO Model Act and Solvency5
The HMO Model Act is a model law, developed by the National Association of Insurance
Commissioners (NAIC), that is designed to aid state governments in regulating the licensure
and operations of HMOs. More than half of the states have adopted the HMO Model Act or
substantial portions of this model law.6
Under the HMO Model Act and most state laws, an entity that wishes to operate as an HMO
must obtain a certificate of authority, often called a license. A certificate of authority (COA) is a
certificate issued by the state authority that regulates HMOs; the COA certifies that all
requirements have been met for the establishment of an HMO in accordance with the states
HMO laws. Generally, the purpose of licensing is to ensure that an HMO is a solid, dependable
organization, fiscally sound, and able to meet specified quality standards for healthcare delivery.

Among other requirements, the HMO Model Act sets financial requirements for HMOs seeking
to obtain COAs. An HMO must have an initial net worth of $1.5 million and thereafter maintain
the minimum net worth described in Figure 2A-2. In this context, net worth is an organizations
total admitted assets minus its total liabilities (its debts and obligations, including obligations to
pay for in-network and out-of-network care for its providers). An admitted asset is an asset that
state HMO or insurance laws permit on the Assets page of a companys Annual Statement.
We discuss financial statements in more detail in Accounting and Financial Reporting, but you
should recall from Healthcare Management: An Introduction that the Annual Statement is a
financial report that most health plans have to file to comply with state insurance regulations.
From a business and financial management standpoint, the ongoing net worth requirements
listed in Figure 2A-2 contain some important elements. First, the net worth requirements set a
minimum fixed level of capital and surplus for all HMOs.

Second, after an HMO has reached a certain size, as measured by premium income and
medical expense payments, the capital and surplus requirements will vary according to the size
of the HMO. HMOs that receive more premiums or have experienced higher healthcare
expenditures than other HMOs must have a higher net worth, and each HMOs net worth
requirement increases as the HMO grows larger.
Third, an HMO must be able to accurately track and report the financial results of a number of
its operations. These results include, but are not limited to, premium revenues, uncovered

healthcare expenditures, total healthcare expenditures less those paid on a capitated (typically
a per member, per month) basis.
The HMO Act net worth requirements for HMOs attempt to reflect an important principle of risk
exposure for health plans: The larger the number of enrollees in the plan, the greater the health
plans net worth requirement should be, assuming coverage levels remain the same. The higher
net worth requirement makes sense intuitively, because in the long run a large group of
enrollees will generate more healthcare costs than a small group will generate. Therefore, an
HMO providing coverage for the large group must have greater surplus to pay those expenses
as they come due.
A second principle reflected in the HMO Model Act is that the larger the number of enrollees
covered by an HMO, the more predictable the morbidity experience of the covered group should
be. For HMOs with a large number of enrollees, predictable morbidity experience tends to result
in more predictable claim expenses. This increase in predictability decreases the chance that
expenses will be so unexpectedly high in any one period that the HMO will experience
insolvency, assuming that the premiums are set on an actuarially sound basis. The HMO Model
Act therefore requires that plans meeting the net worth requirement through the percent-ofpremium method must maintain 2% of premium revenues for the first $150 million in premium
revenues, but only 1% of the premium revenues greater than $150 million.
The HMO Model Act sets certain requirements that an entity that wishes to operate as an HMO
must meet. These requirements include:
having an initial net worth of at least $5 million
maintaining a net worth equal to at least 5% of premium revenues for the first $150 million
in premium revenue
using a prospective method to estimate future risk
obtaining a certificate of authority (COA) before beginning operations
Regulatory Solvency and Risk-Based Capital Requirements
Disadvantages of the HMO Model Act Solvency Standards
The HMO Model Act represents one approach to developing solvency standards. This kind of
approach mandates a minimum level of capital and surplus for any health plan that falls under a
law based on this model act. One drawback to this type of solvency regulation is that other than
adjusting for the size of the HMOs premiums and expenditures, this approach mandates the
same solvency requirement for all organizations that must comply with the regulation. In other
words, the size of an HMOs premiums and expenditures is assumed to reflect accurately the
level of risk the HMO faces. Our discussion of C-risks, however, suggests that two health plans
that receive the same premium income may be exposed to very different levels of financial risk
depending on their approaches to pricing their products, investing their assets, and managing
their utilization costs.
Furthermore, the HMO Model Act is retrospective in its assessment of risk. That is, it uses past
expenditures and premium income to estimate future risk. For plans that are growing or

shrinking, past data may be a less accurate predictor of risk than the same data would be for
plans that have stable enrollment figures.

Another problem exists in terms of the assumption that the amount of premiums an HMO
charges always directly corresponds to the level of the risk an HMO faces. In some cases
involving plans that are experiencing difficulty remaining solvent, this is a false assumption.
For example, suppose an HMO had experienced low claims in the recent past and was meeting
its net worth requirements through the 2-percent-of-premium method. Under the HMO Model
Act, this HMOs net worth requirement would fall slightly as a result of the HMOs lowering its
premium revenue (that is, as a result of the HMOs decreasing its rates to policyholders).
However, lowering rates without decreasing the benefit coverage actually increases the HMOs
exposure to risk.
Thus, under these circumstances, the model acts method of determining net worth would not
necessarily require an HMO that increased its risk of future insolvency to increase its net worth
requirement. Typically, HMOs are prudently managed, and will not lower premium rates so much
that insolvency occurs. However, in cases where insolvency has occurred, extremely
competitive pricing in the HMOs market is often a key contributing factor in the insolvency.
Retrospective net worth methods, such as the HMO Model Act method, can under some
circumstances fail to anticipate this increased risk.
Regulatory Solvency and Risk-Based Capital Requirements
The Development of Risk-Based Capital Requirements
To tie the capital and surplus requirements more closely to the actual level of risk faced by
different health plans, the NAIC began, in the early 1990s, to develop risk-based capital (RBC)
formulas for all life and health insurance companies. However, NAIC members recognized that
this formula did not adequately reflect the range of risks present in the health insurance
business. Further, the financial standards contained in the HMO Model Act and various states
HMO and insurance statutes may not apply to some provider organizations or certain other riskbearing entities. Recognizing the limitations of relying upon a single minimum fixed level of
capital and surplus requirements, the NAIC then began a process to create a separate RBC
formula for all health insurers and health plans that accept risk.
The RBC formula for health plans (health plan-RBC) is a set of calculations, based on
information in the health plans annual financial report, that yields a target capital requirement
for the organization. The RBC formula applies to health plans in states that have adopted
legislation to implement RBC requirements. The Centers for Medicare and Medicaid Services
(CMS), the federal agency that oversees the Medicare program, requires PSOs to be state
licensed, and has therefore become interested in RBC requirements as a secondary regulator.

The RBC formula assesses the specific level of risk faced by each health plan. Under RBC
requirements, a health plans target surplus is not simply a function of the premiums it receives
or the costs it has incurred in the recent past, but also reflects the underlying risks the health

plan faces and how the health plan manages those risks. For example, as we will see in
Provider Reimbursement Arrangements and Capitation and Plan Risk, health plans can use
provider payment methods to transfer some utilization risk from themselves to the providers who
make treatment decisions. In a healthcare context, utilization risk is the possibility that the rate
of use of medical services by a given enrolled population will exceed the predicted rate. Higherthan-expected rates of utilization tend to result in higher-than-expected costs for the entity at
risk for utilization. For health plans, utilization risk is a critical factor in the financial outcome of
the health plans business, because a large portion of an health plans total expenditures involve
medical expenses. Higher-than-expected rates of utilization can occur simply because a given
populations legitimate need for medical services is greater than the actuarially predicted need.
However, utilization risk is increased in situations where overutilization occurs. Overutilization
is the use of medical services or procedures that are not medically necessary. Because
providers make many treatment decisions, one of the central financial strategies in health plans
is the use of provider reimbursement systems that motivate providers to avoid treatment
decisions that result in overutilization. Consequently, the RBC requirement is adjusted for any
provider payment methods the health plan has in place that reduce the health plans risk.

The health plan-RBC formula takes into account five different kinds of risk:

Affiliate riskthe risk that the financial condition of an affiliated entity causes an
adverse change in capital
Asset riskthe risk of adverse fluctuations in the value of assets
Underwriting riskthe risk that premiums will not be sufficient to pay for services or
claims
Credit riskthe risk that providers and plan intermediaries paid through reimbursement
methods that require them to accept utilization risk will not be able to provide the
services contracted for, and the risk associated with recoverability of the amounts due
from reinsurers
Business riskthe general risk of conducting business, including the risk that actual
expenses will exceed amounts budgeted

You should notice that many of these RBC risk categories parallel the C-risks we discussed
earlier. The system of C-risks was developed before RBC, and formed the basis for the
development of RBC risk categories and the RBC formula. For this reason, the C-4 (general
management risk) is related to the RBCs business risk category. Both systems also include a
category for asset risk. Finally, the C-2, or pricing risk, is paralleled by the RBCs underwriting
risk.
However, RBC also contains differences that reflect the nature of the health plan industry. For
example, as we have mentioned, interest-rate risk for health plans is relatively small, so the
RBC does not have a separate interest-risk category. Also, the RBC categories reflect the fact
that the level of risk faced by health plans is significantly impacted by provider reimbursement
methods that shift utilization risk to providers. We will discuss provider reimbursement methods
in later lessons, but for now you should know that such reimbursement methods, in which
providers assume at least some utilization risk, have two effects on RBC risks.

Regulatory Solvency and Risk-Based Capital Requirements

The Development of Risk-Based Capital Requirements
First, these reimbursement methods decrease the risk that the health plans will be exposed to
higher-than-expected levels of utilization. By decreasing this utilization risk, the health plan is
decreasing its underwriting risk. Consequently, a health plans underwriting risk can be
significantly reduced when the health plans use these reimbursement methods.
Underwriting risk is the greatest risk component of a typical health plans RBC formula, and
often largely determines the health plans net worth requirement. The structure of provider
reimbursement methods used by health plans therefore becomes a key strategy for risk
management in health plans. The RBC formula explicitly recognizes this. The strategy of using
provider contracts to manage risk is also valid for health plans that are not subject to RBC
requirements, because the underlying utilization risk is important to all health plans, no matter
what method is used to determine their minimum net worth requirements.
The second influence of provider reimbursement contracts on a health plans RBC formula is
reflected in the credit-risk category. The credit-risk category recognizes that transferring
utilization risk to providers does not eliminate the health plans responsibility to arrange for
medical services covered by its health plan. If these providers accept too much risk and become
insolvent, the health plan will incur a number of expenses, including those associated with
having to develop new provider contracts, or even new provider networks.

The risk-based capital formula for health plans defines a number of risks that can impact a
health plans solvency. These categories reflect the fact that the level of risk faced by health
plans is significantly impacted by provider reimbursement methods that shift utilization risk to
providers. The following statements are about the effect of a health plan transferring utilization
risk to providers. Select the answer choice containing the correct statement:
The net effect of using provider reimbursement contracts to transfer risk is that the health
plans net worth requirement increases.
Once the health plan has transferred utilization risk to its providers, it is relieved of the
legal obligation to provide medical services to plan members in the event of the providers
insolvency.
The greater the amount of risk the health plan transfers to providers, the larger the creditrisk factor becomes in the health plans RBC formula.
By decreasing its utilization risk, the health plan increases its underwriting risk.
Regulatory Solvency and Risk-Based Capital Requirements
The Development of Risk-Based Capital Requirements
Even if providers do not become insolvent, but simply refuse to renew contracts at old
reimbursement rates, then the health plans cost of paying these providers would increase if the
health plan wished to continue contracting with the providers. The greater the amount of risk the
health plan transfers to providers, the larger the credit-risk factor becomes in the health plans
RBC formula. Thus, transferring risk to providers through reimbursement contracts decreases

the health plans underwriting risk, but increases the health plans credit risk. However, because
the underwriting risk is by far the largest risk in the RBC formula for health plans, the net effect
of using provider reimbursement contracts to transfer risk is that the health plans net worth
requirement will decrease.
Health plans also use several other strategies to transfer certain risks. Transferring risk using
these strategies can also increase an health plans credit risk. For example, health plans can
purchase various types of insurance to protect themselves against losses that would result if an
unexpectedly large number of plan members incur catastrophic medical expenses. Credit risk
captures the risk that the entities selling insurance to the health plan will be unable to make the
agreed-upon payments should the insured-against event occur. We discuss these forms of
insurance in more detail in a future lessons.
Regulatory Solvency and Risk-Based Capital Requirements
The Structure of the RBC Formula
The RBC risks for a given health plan are assigned numerical values. These values are
arranged in a formula that generates the total amount of risk faced by the health plan. The
mathematical modeling used to develop this formula is beyond the scope of this text, but there
are two characteristics of this formula that you should understand.
First, numerical values for all the risks are eventually added together, because RBC attempts to
capture the total risk of financial failure faced by the health plan. Second, the formula performs
mathematical operations on the separate risks before adding the risks together. The result of
these operations is that if one of the risks is greater than the others, the influence of that large
risk on the health plans financial strength is emphasized. Because underwriting risk is typically
the most important risk faced by health plans, the underwriting risks influence on the health
plans financial strength is often much greater than any of the other risks, and the RBC formula
reflects this relative importance.
Strategies for Controlling Risk
The categories of risk that we have discussed so far can be used by managers and regulators
to analyze the ways in which an health plans operations influence the health plans financial
strength. In this portion of the lesson, we will examine three general strategies for controlling
various types of risk. These three strategies are to avoid risk, transfer risk, and accept risk.
Health plans must identify and assess both their exposure to risks and the possible responses
to those risks. A basic, but important, economic principleopportunity costapplies to any
financial decision that a health plan makes in choosing among the three risk control strategies,
as well as in choosing among specific courses of action once a strategy is selected.
Opportunity cost is the benefit that is given up when limited resources are used to achieve one
goal rather than another.8 health plans, like all businesses, have limited resources, and in
choosing risk management strategies, also have to make decisions to allocate those resources.

Avoiding the Risk

Avoiding the risk involves either taking action or discontinuing an action in order to avoid or limit
exposure to the risk. Many businesses avoid financial risks by choosing either not to enter
certain markets or to exit markets in which risk is increasing.
Suppose, for example, that a health plan believes that changes in federal regulation increase
the risk that payment rates in a certain Medicare market will cause that market to become
unprofitable. A health plan may choose to avoid the risk of operating in that market by either
withdrawing from or not entering that Medicare market.
An important point here is that health plans do not simply avoid all risks, because their core
business involves accepting financial or business risks of one type or another in exchange for
premiums or other payments. In other words, avoiding risk is a useful management technique in
reducing expenses and risk exposure, but in cases of speculative risks, avoiding risk also
results in decreased chance of potential financial gains.

In our example, a decision to avoid the risk of entering a new market would allow an health plan
to avoid the start-up costs of developing that market and the operational costs of doing business
in that market, but would also mean that the health plan would give up the potential income it
would receive from operations in that market. In situations involving speculative risk, opportunity
costs are always associated with any decision involving the strategic allocation of funds.
From a financial management point of view, a decision to avoid a risk often involves two
analyses: first, an analysis of the savings that can be had by avoiding the risk, and second, an
analysis of the amount of revenue or other financial gain that that could be had by accepting
and managing the risk. Generally speaking, the smaller the likely benefits of accepting a risk,
and the lower the costs of avoiding that risk, the greater the likelihood that a health plan will
elect to avoid the risk.

If a risk is a pure risk from the point of view of the health plan, then there will be no possibility of
gain in retaining the risk, and the health plan will likely attempt to avoid the risk. For example,
healthcare fraud is potentially a substantial risk for health plans, and all health plans expend
some resources in attempting to avoid being subject to fraud.
The decision to avoid or accept any given risk, however, often varies not only according to the
activity that generates the risk, but also the qualities of the specific health plan that is
contemplating the risk. For example, beginning operations in a new market always involves risk
for a health plan, but the same market may be more risky for one health plan than for another.
The degree of risk the individual health plan faces will depend on a great many factors, such as
whether or not the health plan already operates in the markets geographical location, whether
or not the health plan has experience operating profitably in similar markets, and whether or not
the health plan has sufficient capital available for the purpose of entering the market.

Transferring the Risk

Transferring the risk involves shifting some or all of the financial responsibility connected to a
risk from one party to another. As the concept of risk-return trade-off suggests, the party that
agrees to accept the financial risk usually does so in exchange for some type of financial
incentive.
A common form of risk transfer for both individuals and businesses is insurance. Under an
insurance contract, the insurer agrees to pay a specified amount of money if certain events
occur in exchange for receiving a payment (usually called a premium) from the party seeking
the insurance. For example, most physicians purchase malpractice insurance. A physician
purchasing malpractice insurance pays a premium to an insurer that agrees to pay a specified
amount of money (or to cover certain costs incurred) if the physician is sued for malpractice.

Health plans themselves may purchase insurance for a variety of risks, ranging from property
insurance to insurance that provides financial protection against catastrophic and unexpected
claims rates. In general, health plans can use this last type of insurance to reduce the health
plans exposure to the risk of having to pay larger-than-expected medical expenses, and in
doing so, the health plan reduces its underwriting risk. We discuss the forms of insurance
important to health plans in more detail later.
As important as insurance is as a means of transferring risk, health plans almost always use
other types of contractual, non-insurance risk transfer as well. For example, suppose a large
employer is willing to self-fund the healthcare coverage it offers to its employees. Recall from
Healthcare Management: An Introduction that under a self-funded plan, an employer, rather
than a health plan or insurance company, remains financially responsible for paying plan
expenses, including claims made by enrollees. In this case, the employer also decides to
contract with a health plan to provide the administrative services necessary for operating the
health plan.

If the employer agrees to pay the health plan for these services based on the number of
employees that sign up for the healthcare coverage, then the employer is transferring to the
health plan some of the business risk of operating complex administrative functions. In
exchange for payment, the health plan accepts the risk that administering the plan will be more
expensive than anticipated. In this case, although there has been a transfer of risk, the health
plan is not functioning as an insurer because the employer is retaining the responsibility to pay
for the medical costs of the plan under its employee benefit program, and no insurance contract
has been made.
Another important area in which health plans use contracting rather than insurance to transfer
risk is the area of provider reimbursement. As we will see in the next few lessons, hospitals and
individual physicians can be compensated in ways that transfer some of the risk of unexpectedly
high rates of utilization from the health plans to the providers. For example, a health plan retains
utilization risk if it pays physicians on a per-treatment basis, because the more treatments a
physician provides to plan members, the greater the medical expense liabilities the health plan
faces. However, if the health plan pays the physician a rate that is based on the number of plan
enrollees that choose the physician as their primary care doctor (rather than the number of

treatments the physician supplies to those patients), then the physician assumes some or all of
the utilization risk.

The greatest risks faced by health plans involve utilization rates. The premium payments an
health plan receives are based in part on projected utilization rates. A central financial risk that
health plans face, then, is that the utilization rates will be higher than expected, and the cost of
providing healthcare coverage to plan members will exceed the revenue the health plans
receive from premiums or other payments. health plans almost always transfer some of this risk
to other parties through a number of plan design elements and provider reimbursement
methods.
For example, deductibles and copayments are common elements in health plans. By including
these elements, the plan transfers a small portion of the utilization risk from the health plan to
the plan member. This transfer of financial risk is important to health plans primarily because it
motivates plan members to avoid seeking unnecessary medical treatments, and thus makes the
plan member a partner with the health plan in controlling utilization rates. Similarly, some types
of provider reimbursement contracts contain elements elements that financially motivate
providers to avoid supplying medically unnecessary treatments. We discuss these
reimbursement contracts in the next few lessons.
Accepting the Risk
The final general strategy for controlling risk that businesses as well as individuals use is to
accept the risk. To accept the risk means to assume financial responsibility for the risk. In a
health plan environment, health plans typically accept the risks we have discussed in this
lesson, particularly underwriting risk, utilization risk, and various types of business risk. A health
plan that provides a healthcare plan to a group often accepts some or all of the utilization risk
within the terms of that group contract. In this case, the group seeking coverage is transferring
risk, but the health plan is accepting risk.
By definition, accepting risk exposes an health plan to the possibility of losses. The financial
outcome of accepting risk in exchange for premiums or other payments largely depends on how
well the health plan is able to predict the costs associated with the risk, and how well the health
plan is able to manage those costs. In the next few lessons, we discuss the means by which
health plans adjust the total amount of risk they are exposed to and some of the methods health
plans use to manage the costs of those risks. We also discuss how health plans predict the
costs of the risks they agree to accept, and set premiums at an appropriate level.

Early in this lesson we noted that the general goals of risk management for an health plan
involve assuring that the organization survives, operates efficiently, sustains growth and
effectiveness, and, in the case of publicly owned for-profit health plans, increases shareholder
value. While risk managers seek to achieve each of these goals, they must also balance the
actions of the organization so that the achievement of one goal does not prevent the
achievement of the others. A health plan that seeks to maximize growth and profit will spend
considerable effort in controlling costs at all operating levels, but will not cut expenses that are
vital to the health plans continued survival. For example, a health plan will bear the expense of

verifying that the healthcare providers with which it contracts have proper credentials, because
for regulatory and liability-exposure reasons a health plan would not survive if it negligently
contracted with unqualified providers. Similarly, a for-profit health plan will retain sufficient liquid
assets to remain solvent rather than distribute all earnings to shareholders, because remaining
solvent is a necessary condition of the health plans survival.
In general, the acceptance of risk by an health plan implies that the health plan is prepared to
manage that risk. Risk management is a process in the sense that, for many risks, the health
plans management must expend resources on the control of that risk for as long as the risk is
present. The next lesson will explore this process in more detail.