Risk Theory and Capitation

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Risk Theory and Capitation

• Thomas Cox, RN, BA, BSN, MS, MSW
• Doctoral student
• Virginia Commonwealth University
• School of Nursing
• October 16, 2000

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The pump don't work 'Cause the vandals took the
handles

• SUBTERRANEAN HOMESICK BLUES
• Words and Music by Bob Dylan 1965
• Warner Brothers Inc.
• Renewed 1993 Special Rider Music

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Introduction

• Understanding capitation is critical for a health
  care providers financial health
• Small providers MDs, NPs, group practices,
  community hospitals, and nursing homes face a
  variety of risks when they enter into capitation
  agreements
• As a providers patient profile shifts from fee
  for service to more capitated patients, the
  greater the diversity of special considerations,
  paperwork, and risk and the more unpredictable
  their financial outcomes

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Topics of Discussion

• Historical issues
• How insurance works
• How reinsurance and capitation compare
• Different types of risk
• When to seek such contracts
• When to refuse such contracts
• Conclusions

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In the beginning there was growth, refinement and
the dawning of a new era...
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EVOLUTIONARY STEPS IN THE DEVELOPMENT OF THE
MODERN HEALTH CARE ENVIRONMENT 1

• Social Darwinism--the application of the theory
  of biological evolution to social relationships
  attributed to Herbert Spencer. Social Darwinism
  sees life as an unrelenting struggle for The
  survival of the fittest.
• That is, evolution was seen as scientific
  justification for the doctrine of "every man for
  himself."
• The view is consonant with Thomas Jeffersons
  view of limited roles for government. It also
  implies that government not only should not, but
  must not attempt to ameliorate hardship or
  protect people against economic hazards for fear
  of frustrating the "natural" evolution of society.

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EVOLUTIONARY STEPS IN THE DEVELOPMENT OF THE
MODERN HEALTH CARE ENVIRONMENT 2

• 1860s First private health insurance plans in the
  US
• 1883 German national compulsory health insurance
  program1902 First U.S. workmen's compensation
  law enacted 1906 American Association for Labor
  Legislation (AALL)
• 1908 Workmen's compensation for Federal
  employees1911 British National Health Insurance
  program1912 Social insurance, including health
  insurance, endorsed in platform of Progressive
  Party (candidate Theodore Roosevelt)
• 1916 AMA Social Insurance Committee, recommends
  compulsory, State-run health insurance.

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EVOLUTIONARY STEPS IN THE DEVELOPMENT OF THE
MODERN HEALTH CARE ENVIRONMENT 3

• 1929 a group of schoolteachers contracted with
  Baylor Hospital in Dallas, Texas, to provide
  room, board and specified medical services at a
  predetermined monthly rate.
• 1930s Kaiser Industries creates first managed
  care organization providing healthcare to
  employees by using salaried staff physicians at
  company-owned medical facilities.
• 1950. Social Security Act amendments include
  grants to States for "vendor payments" for
  welfare recipients.
• 1956 Military Medicare" program enacted,
  providing Government health insurance protection
  for Armed Forces dependents.
• 1960 Kerr-Mills bill signed into law.
• 1965 Medicare (as part of the Social Security
  Amendments of 1965) signed into law by President
  Johnson.

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EVOLUTIONARY STEPS IN THE DEVELOPMENT OF THE
MODERN HEALTH CARE ENVIRONMENT 4

• By the 1960s most commercial health insurance
  policies included hospital care, surgical fees
  and related physicians' services (major medical)
  coverage.
• During the next three decades, public and
  private health insurance plans for the elderly
  (Medicare) and the poor (Medicaid) extended
  coverage to ever increasing numbers of citizens.

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EVOLUTIONARY STEPS IN THE DEVELOPMENT OF THE
MODERN HEALTH CARE ENVIRONMENT 5

• Managed care plans (MCP), grew steadily from the
  1930s.
• MCPs increased dramatically in the 1970s.
• The 1973 Health Maintenance Organization Act set
  federal standards for HMOs and removed many
  restrictive state laws. The act provided grants
  for HMOs in diverse geographic areas and required
  employers to offer federally qualified HMOs.

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EVOLUTIONARY STEPS IN THE DEVELOPMENT OF THE
MODERN HEALTH CARE ENVIRONMENT 6

• By the end of the 1980s, healthcare inflation
  had hit consumers and employers alike, and an
  increasing number of Americans were joining the
  ranks of the uninsured.
• At the same time, the tightening of the
  healthcare services belt had begun in earnest.

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RECAP

• From the 1860s until the last few years, the
  healthcare insurance/financing landscape was an
  ever increasing, ever expanding, increasingly
  extending collection of entitlements to service
  and well-being.
• More recently, due to increased costs and
  increasingly micro-managed health care, the
  picture has become ever more chaotic, increasing
  numbers of people have less coverage and are more
  vulnerable to the financial vicissitudes of
  illness.
• Patients are increasingly concerned about the
  conflicts of interest of their providers,
  providers are increasingly focused on the
  financial advantages of not rendering care and
  the general health and well being of the populace
  seems to be in danger.
• Why has this happened?

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It would be easy to imagine that what went wrong
was mere financial chaos coupled with poor
business practices. But the truth emerges as
patterns within patterns...
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MANAGED CARE DEFINITION

• Managed Care Organization (MCO) -- Business
  entities (both for profit and not for profit)
  providing systems which integrate the financing
  and delivery of appropriate healthcare services
  by contractual arrangements with medical
  providers to furnish a comprehensive set of
  healthcare services to members explicit
  selection of healthcare providers formal
  programs for ongoing quality assurance and
  utilization review and financial incentives for
  members to use providers and procedures approved
  by the plan.

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CAPITATION DEFINITION

• Capitation
• A method of paying medical providers through a
  pre-paid, flat monthly fee for each covered
  person. This payment is independent of the number
  of services delivered or the costs incurred by
  the health professional in providing those
  services.

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RISK DEFINITION

• Risk
• Uncertainty about future loss. The inability to
  predict the occurrence or size of a loss.

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How to Appreciate Capitation

• What is the essence of a capitation agreement?
• What are the correlates of capitation?
• How do capitation agreements influence the health
  care system?
• Are there unseen risks and rewards?
• Can we understand capitation agreements in new
  and different ways?

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CONVENTIONAL VIEWS OF CAPITATION

• Capitation contracts are
• Value neutral
• Unbiased
• Agreements between equals
• Environment Independent
• Fair
• Risk Free
• Health promoting

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The De-Mystification of Capitation

• Capitation contracts are
• Risk laden
• Between unequal participants
• Inherently unfair
• Against the public interest
• Win/Lose not Win/Win situations
• Destructive of professional-consumer
  relationships
• Health risks for consumers
• Business risks for professional contractors

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An actuary is a person, who passes as an expert
on the basis of a prolific ability to produce an
infinite variety of incomprehensible figures,
calculated with micrometric precision, from the
vaguest of assumptions, based on debatable
evidence, from inconclusive data, derived by
persons of questionable reliability, for the sole
purpose of confusing an already hopelessly
befuddled group of persons who never read the
statistics anyway! Kathleen Miller
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Risk, Profit and Insurance

• The essence of an insurance contract is that a
  small entity (often a person) enters into a
  contract with a larger entity (the insurer) and
  for a fee, transfers their exposure to liability
  for a large loss to the insurer who by combining
  the premiums of many insureds can meet the losses
  that do occur and even make a profit.

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Legitimating Assumptions

• Some, if not many, procedures performed are
  unnecessary and can be better controlled by a
  provider then by the insurer
• Providers can enter such contracts knowing what
  they are agreeing to
• Capitation fees are adequate to meet the needs of
  providers
• No moral hazards or self-selection risks will
  occur
• Timing of payments is not a problem
• Contracting parties are equals
• No unexplained actuarial issues exist

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How does insurance work?

• A large, financially stable, company sells many
  relatively small policies
• Losses are relatively rare events
• Average costs are very predictable due to the law
  of large numbers
• Insurers accurately predict and limit their loss
  and expense costs
• Insurer can provide policies at relatively low
  cost
• Insured is willing to pay for policy to reduce
  risk and because the cost is far lower then the
  potential loss
• By writing many policies across geographic
  regions the insurer reduces the likelihood of
  conflagration loss (many losses close in time or
  space)

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How does insurance work?

• An insurer charges the average loss to the
  policyholder expenses profits risk
  incentive
• The risk of loss is relatively low and the
  average cost is small compared to the potential
  uninsured loss assumed
• Insurers that do not cover both their expected
  costs and a risk premium go bankrupt eventually
• Income precedes payment of losses often by many
  years
• Since money today is worth more than money
  tomorrow insurer can make money just by the
  passage of time

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How does re-insurance work?

• A re-insurer charges an amount it believes will
  cover its losses, expenses and generate a profit
• Re-insurer covers geographically isolated risks
• Re-insurer will generally have continuing
  financial relationships and can recoup losses
  over time
• Re-insurer has the expertise to evaluate the
  losses it assumes
• Re-insurer will generally limit its liability or
  charge extra premium for unpredictable loss
  potential
• Re-insurer generally has three times the assets
  required to meet unpredictable extreme costs

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Re-insurance Capitation Contracts

• In both cases, the insurer is reducing the risks
  of loss by negotiating a contract for another
  entity to assume the liability for those risks.
• Re-insurers however, know exactly what they are
  doing, most health providers do not.
• Re-insurers limit their liability. Few providers
  do.
• Re-insurers have abundant assets to withstand
  losses, most providers do not.

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When a provider takes on a fraction 1/k of an
insurers clients it spreads its variability in
experience out by a factor of the square root of
k. While it still has a mean centered on the mean
of the insurer the probability of very high
losses increases.
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Why do capitated providers fail?

• Do not know their operating costs (ongoing
  expense analyses as well as unusual loss
  potential)
• Have insufficient assets to buffet early or
  extreme expenses
• View new patients as income rather than expenses
• Need more staff, equipment, and supplies before
  they get income from contract
• Income streams are delayed until they perform
  under the contract
• Serving a small catchment area subjects providers
  to conflagration losses even flu season may
  qualify

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Why do capitated providers fail?

• Moral hazards exist if having insurance increases
  the probability that the patient will use
  services
• Self-selection (customers choose high service
  providers because they know they need services)
  works against higher quality capitated providers
• Small providers of service do not benefit from
  economies of scale in the provision of services
• Basic health service costs are not well met by
  insurance but are borne by capitated providers

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Risks Faced by Capitated Providers

• Uncertainty regarding expenses
• Uncertainty regarding costs to service patients
• Unlimited potential for losses
• Uncertainty about timing of income, losses, and
  expenses
• Uncertainty about operating costs
• Additional costs incurred to borrow money to meet
  expenses while waiting for income
• Short contract periods mean extreme costs may not
  be covered by future profitable contracts

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In truth, providers that enter into capitation
agreements without doing the preparatory work end
up in a vise caught between the needs of their
patients and their need to maintain solvency with
resources too limited to accomplish both...
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When is a capitation agreement sound?

• Excess human and equipment resources already
  exist
• Provider can very accurately predict the costs it
  will incur with new patients
• Assets readily exist to mediate loss risk and
  financial risks associated mis-timed payments
• Providers can manage multiple contract benefit
  scenarios efficiently
• Marginal costs for serving extra clients are less
  than marginal income to be earned

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When is a capitation agreement unsound?

• Provider will need to hire new staff, and
  purchase new equipment before contract begins
• Providers marginal costs will rise with new
  clients
• Provider needs additional revenue to meet
  expenses
• Provider will have to borrow money to gear up and
  perform under contract
• Providers are unable to distinguish covered from
  uncovered services efficiently
• Provider has no plan for dealing with income
  delays

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Why are capitation agreements generally unsound?

• Market forces drive insurer pricing to a minimum
  to cover losses (90 for some insurers),
  expenses, and ever smaller profit margins
• The loss part of the insurers premium is
  adequate to cover past service costs, but may not
  cover future costs
• The insurer cannot pay out more than its loss
  costs in capitation payments to providers
• Benefits of the Law of Large Numbers are lost
  when a relatively small cohort is transferred to
  provider group
• If the insurer maintains expense costs and
  profitability there is no extra risk premium for
  the provider group

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Conclusions

• From the standpoint of insurance regulation
  risk transfers to smaller, less solvent, and less
  stable re-insurers from larger, more solvent and
  more stable insurers are deemed to be against the
  public interest.
• Capitation agreements transfer risk in exactly
  the wrong direction, inevitably leading to
  financial strains, reduced profitability, delayed
  and denied services, defaults and lower levels of
  service quality and quantity.
• All of this was predictable before the first
  capitation agreement was signed.

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Capitation contracts, like spider webs capture
the unwary