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Reinsurance: How States Can Make Health Coverage More Affordable for Employers and Workers

Executive Summary

Policymakers are increasingly drawn to the concept of government-sponsored reinsurance as a strategy for significantly reducing premiums for health insurance, particularly for small groups and individuals. This report aims to inform readers about the mechanics of reinsurance, the experience of two states that have approached reinsurance in different ways, and the issues that states should consider prior to implementing a reinsurance program for their small-group and individual markets.

Basics of Reinsurance
Reinsurance essentially is insurance for insurance companies (and, sometimes, for other organizations that face risk, such as employers that self-insure their employees' health care costs). As with so many other types of insurance policies, reinsurance is not activated until a deductible is met; and there is a "ceiling," or upper limit, on reinsurable expenses. Reinsurance policies also have coinsurance rates (amounts that the policyholder must pay for particular services) that apply to expenses between the deductible and ceiling.

Government-based reinsurance rests on the principle that insurers need relief from the risk of "adverse selection," which occurs when a disproportionate share of the people applying for insurance policies expect to have extraordinarily high medical costs in the coming year. When this happens, insurers could be forced into bankruptcy. But if the state or federal government creates a program that assumes responsibility for the bulk of these extreme expenses, insurers have less reason to fear adverse selection. With such programs in place, moreover, they can significantly lower premiums.

Insurers typically worry about two types of very large losses—aggregate losses for a group being above some overall level, and loss per insured person exceeding some threshold. Aggregate losses could exceed expectations if more group members had expenses above the average than was expected for the group. In this case, the insurer would not have set premiums high enough to cover those aggregate losses. To place a limit on their exposure to such expenses, insurers often purchase reinsurance. In such cases it is known as aggregate stop-loss reinsurance, since it puts a stop to overall losses above some level.

Annual losses per insured person also could become excessive—perhaps passing the threshold above which people are in the top, say, 5 or 1 percent of the country's health care expenditure distribution. Many companies with self-insured health plans, as well as insurers, purchase excess-of-loss reinsurance in order to avoid bearing full risk for any individual's expenses that exceed some level.

Reinsurance in Practice
While many states have begun to consider providing reinsurance, thus far only two have actually done so. "Healthy New York" (HNY) and Arizona's "Healthcare Group" (HCG)—the former being an excess-of-loss plan and the latter an aggregate stop-loss program—provide two successful demonstrations of the strategy's feasibility.

By providing protection to insurers for the risk of extraordinarily high costs incurred by any individual, HNY is in effect establishing a back-up reservoir of funds to help pay for catastrophic cases. In this way, insurers do not have to build such reserves into their premiums, which can thus be lower. In contrast, HCG provides protection to insurers for the risk that a large number of enrollees may have above-average but not necessarily extraordinary expenses—a situation that typically occurs when they are more likely to have chronic health problems. In this case, Arizona is lowering premiums by subsidizing the higher-than-average expenses of all the enrollees.

Another key difference between the programs is their incentive structure for insurers. The excess-of-loss reinsurance in HNY requires the insurer to retain a good deal of the risk of an enrollee's costs exceeding a threshold ($5,000 currently)—the insurer is responsible for 10 percent of the costs between $5,000 and $75,000 and all of the costs above $75,000. So the insurers have a strong incentive to manage the care of individuals whose medical expenses begin to go above $5,000. The aggregate-loss reinsurance structure of HCG does not contain an incentive for the insurers to manage the medical care of high-cost individuals. Instead, the plan encourages insurers to reduce total costs. The state will audit all of HCG's expenses if it applies for subsidies—not just the expenses of the high-cost enrollees.

The premiums initially offered under HNY (in January 2001) were about half those for individuals in the regular direct-pay, individual market in New York, and were between 15 and 30 percent lower than premiums of comparable policies for small firms. HNY's premiums declined another 6 percent in the second year of program operations; and shortly thereafter, when the threshold was lowered, premiums declined another 17 percent. In New York City in 2004, Healthy New York premiums were 40 percent lower than the average small group HMO premium and two-thirds lower than the self-pay individual market premium. The state's efforts to publicize and market HNY were hampered early on by the 9/11 terrorist attacks on New York City and the Department of Insurance's efforts to help the people and companies affected. But expanded marketing efforts since 2003, combined with lower premiums, have since increased the program's enrollment—between December 2003 and December 2004, it almost doubled. As of May 2005, the program had 92,368 individuals enrolled.

Arizona's program has similarly benefited the state and its people. When HCG began providing reinsurance in fiscal year (FY) 2001, the total state subsidy was $8 million per year. By FY2004, because expenses had been significantly reduced, this subsidy could be cut to $4 million.

Key Issues for States
When other states consider reinsurance programs, they need to consider the lessons learned from these two initiatives as well as some of the issues—related to operations, cost estimation, and financing—presented in this paper.

Four operational issues are critical:
  • Choice of type of reinsurance to provide (aggregate stop-loss or excess-of-loss) and the pros and cons of each
  • The need for transparency as to why someone has high expenses
  • The threshold level of expenses for activation of the reinsurance
  • Setting up an auditing or verification of claims submitted for reinsurance.

    Five issues connected to estimating the costs of a reinsurance program are also important:

    • Obtaining and adjusting expenditure data
    • Estimating the number of uninsured people who would purchase health insurance if reinsurance were in place
    • Estimating total expenses of people with costs above different thresholds
    • Estimating program costs with different ceilings on reinsurable expenses and different cost-sharing splits between insurers and the reinsurance program
    • Estimating the net costs of the program by factoring in state expenditures for the currently uninsured.

    Finally, this paper offers some discussion of how a reinsurance program might be funded. If a state finances a reinsurance program with state revenues—as opposed to raising revenues from the insurers themselves—the program is more likely to have the desired effect of encouraging insurers to reduce their premiums and enroll more people.

    Publication Details



    Reinsurance: How States Can Make Health Coverage More Affordable for Employers and Workers, Katherine Swartz, Ph.D., The Commonwealth Fund, July 2005