Determining optimal risk retention in the healthcare industry

Healthcare Financial Management, April, 1994 by Gregory L. Daniels, Patrick M. Lynch

INSURANCE/RISK MANAGEMENT

Several methodologies may be used for determining the level of risk that a healthcare organization should retain as part of its overall insurance and risk management program. Approaches used in the past, however, may not be appropriate to use in the 1990s. This article proposes a more comprehensive methodology of risk determination.

The 1980s brought unprecedented challenges to long-term financial planning efforts in the healthcare industry. Healthcare financial managers faced downturns in profitability, growing labor costs, increasing competition for capital, a greater need for debt financing, and, at the same time, a greater demand for quality health care at more affordable prices. Today's healthcare reform proposals, if enacted, may complicate financial planning efforts even further. With the prospect of global budgeting and/or managed competition, financial managers will be searching for more ways to streamline the performance of their organizations.

Total cost of risk

One expense that is growing in relative importance, and that often has been overlooked in the past, is a hospital's total cost of risk. Total cost of risk refers to costs associated with property and casualty insurance exposures. These costs include insurance premiums, losses retained and paid directly by the hospital, and claims handling and loss control expenses. Limiting total cost of risk is becoming a more significant part of a hospital's overall financial planning process and is demanding greater attention from healthcare financial managers.

Losses that are retained are usually the greatest portion of the total cost of risk. Hospitals may use a variety of mechanisms to fund these losses, including deductibles, self-insurance trust funds, retrospective rating plans, and captive insurance companies. As healthcare financial managers and risk managers plan their renewal strategies each year, however, they must decide what portion of each property or casualty loss should be assumed by the hospital rather than be transferred to an insurance company.

In general, levels of risk retention have risen steadily over the years. It is not unusual today for a hospital to select retention levels that are expressed in million-dollar multiples, and the potential exposure can have far-reaching implications. Related cost considerations can affect many of the indicators used to evaluate a hospital's financial performance.

A variety of approaches have been used to set risk retention levels, but the different approaches usually adhere to two guidelines: "Avoid swapping dollars with an insurance company," and "Do not risk a lot for a little."

Stated another way, all reasonably predictable losses should be retained. If not retained, they will be included as an identifiable part of the insurance premium (complete with built-in profit margins). In addition, when substantial limits of protection are available at competitive rates, transferring the risk (i.e., buying true insurance) may be the best alternative, regardless of past retention levels or expected short-term premium savings.

The two guidelines notwithstanding, risk managers often have used various other financial rules of thumb in their analyses. Some of the more common financial rules suggest that risk retention levels should approximate:

* 1 percent to 5 percent of annual revenues and/or cash flow,

* 150 percent of budgeted costs,

* 1 percent to 5 percent of earnings per share,

* 1 percent to 5 percent of working capital, and

* 1 percent of the organization's net worth.

While these percentages recognize that risk-retention decisions affect the balance sheet, income statement, and cash flow statement, they fail to recognize targeted goals, financial ratios, or measures of performance that are specific to the healthcare industry. Although they represent a financial perspective, they do not give complete consideration to marketing issues, the different types of exposures involved, or the propensity of an individual corporation to take or avoid risk. A more comprehensive approach using financial, actuarial, and insurance marketing techniques can facilitate a more informed and more disciplined decision-making process.

Financial ratio analyses

A hospital's financial performance can be measured in many ways. When evaluating alternative levels of risk retention, it is important to recognize the varying impact on key financial indicators, not only on those used internally, but on those used by sources of third-party reimbursement, investors, creditors, and competitors. The objective is to calculate the maximum cost of risk that can be absorbed without violating targeted levels of performance of each of these indicators.

The first step is to establish pro forma financial statements that allow projections to at least a five-year horizon. This step is important for two reasons. First, even though maximum retained losses can be set at one level for all years involved, actual losses incurred within that limit will vary from year to year, causing the total cost of risk to fluctuate. Second, even if losses within the chosen retention level remained fairly constant, the relative impact on key financial indicators is likely to vary. What may be a comfortable level of risk today easily could violate next year's financial ratio limitations.