A significant challenge healthcare provider self-insureds face is how much money they need to set aside in order to fund the costs of resolving claims. That amount – kept as cash reserves – is hugely important to the financial wellbeing of the company.
Many organizations face real difficulties with this:
- Too little held in reserve from underestimating risk can result in an embarrassing situation for the Risk Manager, General Counsel, and CFO explaining to their board why a certain case was reserved at a fraction of the ultimate claim value. Under-reserving threatens all of the good financial planning and operational excellence pursued by the entire organization 365 days a year. In today’s increasingly difficult healthcare financial ecosystem, an unexpected loss can turn a net gain for the year into a net loss.
- Too much money held from overly conservative reserving practices can mean a loss of profits from high funding premiums, and potentially millions of dollars unnecessarily locked up when that money could be better spent pursuing the mission of the organization. Over-stated reserves put pressure on capital, increase loss funding estimates for subsequent years and require reinsurers to charge more premium.
So, it’s important to get it right.
Most often, the responsibility for determining the ultimate value of claim or lawsuit lies with the insurance claims adjusters, who look at the facts of the case in light of past experience, the opinion of their experts, and potentially what other similar cases have resolved for, and give their best educated guess of what the eventual value of the case will be.
While similar fact scenarios may turn up from time to time, the truth is that no two cases are alike. With the multiple factors driving exposure, the complex information that needs to be weighed, and the added uncertainty of what a jury may decide to award, intuiting the true “value” of a claim is enormously difficult.
The truth is, as Daniel Kahneman points out in Thinking Fast and Slow, making subjective judgments about future events based on the past experience of the decision maker is very risky behavior due to inherent cognitive biases and logical reasoning fallacies.
It is no wonder why self-insureds often find their reserves to be either habitually too high or too low depending on the person making the reserve decisions, and sometimes, radically too low when an “unexpected” loss arrives.
At The Risk Authority, we recognized that the standard guess-method could too easily result in an inaccurate estimate of true financial exposures, and so we went hunting for a more robust, transparent methodology that would enable stakeholders to understand the information, risks and the values that went into the reserve decision-making process.
We developed a novel approach known as Decision Analysis Reserve Targeting, or “DART” for short, which brings to bear the tools of Decision Analysis and the Enterprise Risk Management framework to the Reserve decision-making process.
For those unfamiliar with the field, Decision Analysis is an academic discipline pioneered at Stanford and Harvard Universities in the 1960s and 70s that is concerned with addressing the challenges of making high-quality decisions under uncertainty in situations like this. The Enterprise Risk Management process provides a scaffold for ensuring robustness and an iterative process for continual improvement.
Rather than take the process out of the hands of the expert claims adjusters, DART leverages their expertise and addresses potential errors by guiding them through a scientific and structured decision-making process, of:
- Developing a model of all of the decisions, risks and uncertainties in each claim or law suit,
- Applying high quality Bayesian subjective probability assessments to all the possible outcomes, and finally,
- Calculating the mean liability, known as the “expected value,” which then becomes the case Reserve.
By breaking the decision making process up into simple pieces, the DART process provides:
- Clear guidance to the organization for setting the loss reserve on each case, leveraging the expertise of the decision-makers, while removing the guesswork of the standard process;
- Accurate, early assessment of the liability and exposure in each case
- Optimization of the amount held in reserves versus payouts, addressing the issues of over and under-reserving;
- High confidence in the aggregate held in Reserve, and therefore the robustness of the insurance program;
- A transparent, thorough, and defensible understanding of the issues and exposures in a case;
- Unique depth of insight that provides clarity for communicating and driving case strategy.
Stay tuned for an upcoming webcast and paper on the DART methodology, and in the meantime, if it piques your interest, don’t hesitate to contact us for more information and a demonstration.
By: Simon Mawer
Simon serves as Program Manager of Risk Management for The Risk Authority, where he provides claims, risk and decision analysis consulting services for the Stanford University Medical Network and client organizations beyond. He is a lawyer of the Supreme Court of New South Wales, Australia, holds a Bachelor of Laws and Graduate Certificate of Legal Practice from the University of Technology, Sydney, and will graduate from the Stanford University Center of Continuing Education with a Certificate in Strategic Decision and Risk Management in 2014.