Risk and Insurable Losses in Health Insurance

Understanding Risk, Loss Exposures, Perils, and Hazards

In insurance, risk is defined as the uncertainty concerning the occurrence of a financial loss. Anytime you face a situation or circumstance where a financial loss is possible, you are facing a loss exposure. A loss itself is a reduction in economic value or an expense resulting from an event. For example, if an individual incurs medical bills resulting from an emergency appendectomy, those bills represent a direct financial loss to that person.

Risk is divided into two distinct categories: pure risk and speculative risk. Pure risk involves only the possibility of loss or no loss, with no possibility of financial gain. Activities like gambling and investing in the stock market are examples of speculative risk. Traditional insurance generally does not cover speculative risks because they offer a possibility of gain as well as loss. Therefore, only pure risks are commercially insurable.

To understand how losses happen, you must distinguish between perils and hazards. A peril is the direct cause of a loss. In accident and health insurance, sickness and accidental bodily injury are the two primary perils covered by policies. A hazard, on the other hand, is a condition or situation that creates or increases the probability or severity of a loss from a peril.

Hazards come in multiple forms. A physical hazard is a tangible physical condition that increases the likelihood of a loss, such as high blood pressure in an applicant or a damaged floor that could cause a fall. A moral hazard involves an intentional or dishonest tendency of an individual that increases the chance of a loss, such as submitting a fraudulent insurance claim. A morale hazard involves an attitude of carelessness, indifference, or apathy regarding risk because insurance exists; an example is failing to take prescribed blood pressure medication because insurance will pay for hospital care. Finally, legal hazards arise from statutory requirements or court actions that increase the frequency or severity of claims.

Methods of Handling Risk

Risk management is the systematic process of identifying, analyzing, and treating loss exposures. Individuals and organizations do not simply react to losses; they use organized techniques to address them. The five primary methods of handling risk include avoidance, retention, sharing, reduction, and transfer.

Risk avoidance means eliminating a loss exposure entirely by choosing not to participate in an activity. Refusing to participate in high-risk sports to prevent injury is an example of risk avoidance. While avoidance completely removes a specific risk, it is not always practical or possible for essential life and business activities. Risk reduction involves taking proactive steps to decrease the frequency or severity of a loss. Receiving recommended preventive care and installing smoke alarms are clear examples of risk reduction.

Risk retention means keeping and absorbing the financial consequences of a loss exposure. Deductibles, copayments, and coinsurance in health insurance policies are mechanisms of risk retention because you pay those out-of-pocket amounts yourself. On a larger scale, self-insurance by an employer is a structured method of risk retention. Risk sharing involves distributing the financial burden of potential losses among a group of individuals or businesses. In risk sharing, each member of the group agrees to contribute toward paying the losses incurred by any member.

Risk transfer involves shifting the financial burden of a loss exposure from an individual to another party. Purchasing an insurance policy is the most common method of transferring risk. When you buy insurance, you transfer the financial risk of covered losses to the insurer in exchange for a premium, subject to the policy's limits, exclusions, and cost-sharing provisions. Premiums collected from many policyholders create a common fund from which individual claims are paid.

Elements of an Insurable Risk

Insurers cannot offer coverage for every type of pure risk. For a risk to be commercially insurable, it generally must satisfy specific underwriting characteristics. First, the loss generally must be fortuitous rather than deliberately caused by the insured. Second, an insurable loss should be identifiable and measurable, including when it occurred and the amount of financial loss. Third, an insurable loss must be statistically predictable across a large population of insureds so the company can calculate adequate premiums.

Fourth, an insurable loss must not be catastrophic to the insurer as a whole. A single event that damages millions of policyholders simultaneously could bankrupt an insurance company. For this reason, many insurance policies exclude or limit losses from war or nuclear hazards, although exclusions depend on the type of insurance and the policy. Fifth, insurable risks generally require many substantially similar exposure units so insurers can estimate aggregate losses effectively.

Finally, the premium charged for an insurable risk must be economically feasible and affordable for the prospective policyowner. If the premium approaches the potential benefit, coverage may be economically impractical for a buyer. Additionally, while many insurance policies aim to compensate an insured for a covered financial loss, fixed-benefit health policies pay stated amounts regardless of actual expenses.

The Law of Large Numbers and Adverse Selection

The foundation of insurance pricing is the law of large numbers. The law of large numbers states that as the number of similar exposure units increases, actual loss results will more closely approximate expected loss results. Insurers use the law of large numbers to estimate aggregate claim frequency and help set premium rates, although actual claims may differ from estimates. It is critical to understand that the law of large numbers enables insurers to predict losses for an entire group, but it cannot predict which specific individual will suffer a loss.

Underwriting is the process of evaluating insurance applications and classifying risks within applicable legal limits. Insurers use underwriting to group similar risks and charge appropriate premiums. However, this process interacts directly with the legal environment. For example, ACA-compliant major medical coverage cannot be medically underwritten, which means insurers cannot deny coverage or adjust an individual's premium based on health status.

Adverse selection is the tendency of individuals with a higher-than-average probability of loss to seek or maintain insurance coverage to a greater degree than standard risks. A person who expects high medical costs and is therefore more likely to enroll in available coverage illustrates potential adverse selection. Insurers may use lawful underwriting and policy terms to manage adverse selection, but an ACA-compliant major medical plan cannot deny coverage or charge that person more because of a preexisting condition.