Managing financial risk with options on futures

Healthcare Financial Management, May, 1995 by Michael T. Bond, Brenda Stevenson Marshall

RISK MANAGEMENT

With the rise of managed care and capitation, more providers will be sharing in the financial risk of providing care. To help protect their organizations from the risk of unexpectedly high utilization under such a fixed-payment system, healthcare financial managers soon will be able to use options on futures contracts.

These contracts provide wide profit potential but limited loss potential. Before investing in options on futures, however, healthcare financial managers should consider issues such as basis risk and trading costs.

As healthcare providers establish risk-sharing integrated delivery systems, they assume the characteristics of traditional health maintenance organizations (HMOs). That is, they accept the responsibility for providing, or assuring the delivery of, healthcare services to a voluntarily enrolled population, and in return they receive a predetermined, fixed prepayment for each enrollee. Integrated delivery systems and HMOs also share the need to remain competitive while managing financial risk.

For a risk-sharing healthcare organization to be profitable - and, in some instances, to survive - it must be able to adjust to the variations in costs that arise from unexpected variations in utilization. For example, newly insured people or people in tax-supported programs initially may use health-care services extensively and, thus, incur high healthcare costs for the organization. Because a healthcare organization does not have a utilization history for these people, cost increases cannot be predicted accurately. As another example, people with chronic illnesses, such as the elderly, may incur high costs over an extended period; however, the magnitude and duration of the rise in expenditures for these patients are unpredictable.

Currently, the healthcare industry lacks widely accepted and applied risk-adjustment mechanisms. Therefore, healthcare organizations that accept financial risk are left with insufficient knowledge of the specific risks they may encounter.

One strategy that other industries employ to offset potential losses when the magnitude of those losses is unknown is options on futures contracts. As with futures contracts, options on futures contracts allow organizations wishing to manage risk to lock in a fixed price for a financial instrument or a commodity at a future date regardless of the commodity's market price at that time.

When the Chicago Board of Trade (CBOT) introduces group health insurance futures contracts and options in the future, financial managers in risk-bearing healthcare organizations will be able to trade options on futures contracts to reduce the effect of unpredictable increases in healthcare costs.

How options work

A futures contract is a legally binding agreement to buy or sell a financial instrument or commodity at a certain time in the future. The price of the contract is established in the auction market of the CBOT. Futures contracts for financial instruments are settled in cash, and the amount is based on the value of an index at the end of trading on the final day of the contract period.(a)

Options on futures contracts involve the right, but not the legal commitment, to buy or sell a futures contract at a predetermined price during a designated time period. There are two types of options: call options, which involve purchase of a futures contract, and put options, which involve sale of a contract.

Participants in the options market may assume a position in an underlying futures contract at a certain price (called the strike or exercise price) within a specific time period. The premium or price Of the option is determined through auction market trading on the floor of the CBOT.

Health insurance options

When the Chicago Board of Trade introduces options on health insurance futures, those options will be based on the changes in healthcare costs anticipated by the market as reflected by the underwriting results for a pool of health insurance policies. The price of an options on futures contract will be determined by the expected change in the cost of claims and premiums for a pool of health insurance policies.

The price upon settlement of a futures contract at the end of the contract period will be based on an incurred loss ratio for the pool of insurance policies. This loss ratio will be determined by dividing the total amount of claims by the total amount of premiums paid during the period of the health insurance futures contract. The settlement price will be determined by multiplying the incurred loss ratio (claims divided by premiums) by an arbitrary figure - $100,000.

The amount of claims paid will not be known until a futures contract expires, so a proxy for claims paid is used to calculate the price of a futures contract. This proxy is known as the completion rate, and it is valued at 90 percent.

The settlement price of a futures contract is calculated by multiplying $100,000 by the incurred loss ratio, which then is multiplied by the completion rate of 90 percent. (For more information, see "Offsetting Unexpected Healthcare Costs with Futures Contracts" in the December 1994 HEALTHCARE FINANCIAL MANAGEMENT, pp. 54-57.) The settlement price of an options contract is derived from the settlement price of the futures contract.