Question

Suppose a large employer contracts with an insurer to provide health insurance coverage or workers’ compensation coverage for its employees. The employer (the insured) really self-insures, and the insurer is a third party administrator. Any benefits paid by the insurer to the employees is reimbursed by the employer. The employer may buy excess coverage, such as coverage for annual health benefits exceeding $10 million. The insurer and the employer can negotiate the premium for the policy at very low transaction costs. We examine the implications of the Coase theorem for claims settlement costs. We provide the scenario in this homework assignment. You explain who should be liable for claim settlement expenses to minimize total cost. The premium is the present value of losses, benefits, and expenses, so minimizing total cost minimizes the premium. Claim settlement costs are of two types: Claims department overhead: setting up claim files, estimating medical costs and disability, making out checks to injured parties or medical practitioners, and so forth. Investigation and defense costs for fraudulent claims or cases where the employer is not liable. For health insurance, these are claims where the physician or hospital overbills (or bills for services not provided) or the employee is not sick (but malingers to obtain time off from work). For workers’ compensation, these are cases where the disability does not stem from a work-related accident. The insurance policy states who pays these costs. Either the insurer pays them and is reimbursed by the employer, just as for benefits and loss costs, or the insurer pays them and charges for them in the policy premium. Ultimately, the employer pays all costs, not the insurer. Pricing actuaries don’t care whether the cost is covered by a charge in the premium or a reimbursement from the insured. The legal incidence of these costs depends on the policy. The policy may say that the insurer pays the cost and charges for them in the premium or the insurer pays the cost and receives a reimbursement from the insured. Transaction costs are zero. Both the insurer’s management and the employer want to minimize overall costs. Suppose the insurer bills its claims department overhead costs to the employer after incurring them. Do the claims adjustors have an incentive to handle claims efficiently? Would the claims department prefer to adjust claims leisurely and bill the insured for the time spent or adjust claims efficiently to hold down costs? If the insurer’s management wishes to minimize total claims handling costs so that it can attract more business, would it wish to have the claims department overhead included as a charge in the premium or collected as a reimbursement from the employer? Which would the employer prefer to minimize its total costs of coverage? Suppose the insurer pays investigation and defense costs from its own pocket (does not collect a reimbursement from the insured) and includes a charge of $100,000 in the policy premium. A claim is reported with an estimated cost of $50,000 which seems suspect. The insurer can (i) spend $10,000 investigating the claim, with a 50% chance that the claim will be found fraudulent, or (ii) pay the claim for $50,000 and collect the full reimbursement from the insured. Which would the insurer’s claim department prefer in the short run? To minimize total costs and attract business, which would the insurer’s management prefer? To minimize its long-run cost of coverage, which would the insured prefer?

Answer 1

 

Crudely states that in presence of externalities, if the transaction costs were low, the transaction would be efficient, irrespective of how the costs are allocated. However, this is rarely the case in the real world.
Hence, it is best to compare the costs in each possible scenario and then allocate the costs.

In this case, since the claims adjustors’ overhead costs are in the end reimbursed by the employer, the claims adjusters do not have an incentive to handle claims efficiently. Rather, in absence of inefficient information flow or transparency, the claims adjustor has an incentive to overstate the overheads.
In case the insurer’s management wants to minimize the total claims handling cost, it will definitely focus on lowering the claims adjustors’ overheads and handling the claims more efficiently. However, from the costing point of view, the insurer’s management will prefer having the overhead costs to be collected as reimbursement rather than be included in the premium.

This is for two reasons

The First is the cost quoted to the employer will be that of the premium and not the overheads. Hence, the insurer will collect the hidden cost of overheads in the later stage but the pricing of the insurance in terms of premium will appear to be more attractive and competitive.

The second reason is, that the cost of insurance also called a premium, can be calculated more accurately based on actuarial studies. The overheads cannot calculated as accurately for an individual employer (insured party). Hence, the insurer has a chance of over or under quoting the premium.
This will decrease the competitive pricing advantage or overall profit of the insurer, respectively. The insured or the employer will also like the overheads to be billed separately and not included in the premium. This way, it will have a more equitable basis for comparing the premium quotes and also have a supposedly close monitoring on the overheads costs

The insurer does not bear the cost of insurance payment ultimately. It is reimbursed from the employer for the claims. On the other hand, the cost of investigation has to be borne by the insurer. Hence, there is no incentive for the insurer to conduct the investigation, at least in short run. In the long run, weather to conduct investigations will depend on the expected number of suspicious claims and the cost of investigating each claim.
Based on the given data, the insurer will prefer adding an extra $100k in the premium and investigate some of the claims, not more than 10 in a year. However, from the competitiveness perspective, the insurer’s management does not have an incentive to investigate any claim, as they do not bear the cost of claim.
Adding an additional charge of $100k for investigations will only decrease their competitive advantage.
On the other hand, the insured or the employer will prefer the investigations to happen in the long run, even if the premium increases. In the long run, the number of claims will go down as a possibility of investigation will deter employees from claiming a dubious claim. This is an -indirect benefit, even in absence of thorough investigations from the insurer.