Insurance Overview, Part I: Theory of Risk Transfer for Physicians
Risk is an involuntary reality of life. No matter what you do (or don’t do) there are risks, great and small, that you are handling whether you realize it or not. There are five possible ways to handle risk:
- Risk Avoidance
- Risk Retention
- Risk Reduction
- Risk Sharing
- Risk Transfer
Certain types of risk can be avoided by simply not engaging in the activity that presents risk. I recall a conversation I had while driving with a friend and her roommate. While on the freeway, a motorcyclist flew right by us and I joked that I would never get a motorcycle because I’d be the guy who gets hit by a truck as I’m pulling out of the motorcycle dealership, waaaaka waka! The roommate, who was an ER nurse, shook her head and began to tell me how she sees motorcycle injuries regularly and that my joke is actually a lot more accurate than I may have realized. My joke is an example of risk avoidance where handling the risk of road rash, broken bones, or worse injuries and death related to motorcycle accidents is to not ride a motorcycle in the first place.
What about you, the physician? When this injured motorcyclist comes to you for medical attention, you’re faced with the risk of being sued for malpractice. Even if you do everything right! Doctors are targets. My father, an anesthesiologist, has been sued multiple times, but never been found liable. Utilizing risk avoidance, however, would have you deny this poor soul necessary medical attention. So risk avoidance isn’t always a good option. Let’s look at your other options.
When you decide that engaging in an activity outweighs the risk, your default option is to retain that risk. Continuing from my motorcycle example, many people choose to ride despite the risk of physical injury and financial hardship. Physical injury can only be retained, however, financial risks associated with injury have the option of retention or another form of handling risk that we’ll talk about shortly. If the financial risk is retained, the rider is choosing to rely on their own resources to pay for medical treatment and/or to cover their other financial obligations should they become disabled or die.
The same goes for a physician who chooses not to purchase professional liability insurance. Should you be sued, not only do you run the risk of being found liable, but just the expenses of hiring an attorney and lost wages can be extremely expensive and potentially derail you from your financial goals.
If you’re going to retain the risk of an activity, but paying to transfer it away is too costly, or even impossible as noted above regarding physical injury, then risk reduction is a good strategy. A motorcyclist can wear a helmet and heavy clothing, use a flickering headlamp to be more noticeable, and practice defensive driving techniques to reduce the likelihood of an accident or at least reduce the damage caused by one.
Physicians can reduce risk of malpractice lawsuits by following established procedures and having great relationships with their patients. One of the strongest protections against malpractice lawsuits is when patients like their doctor¹.
A middle ground strategy is risk sharing where you only retain a manageable amount of risk and transfer the remaining risk to a third party. Risk sharing is most common in health and property and casualty insurance policies when deductibles, copays, and coinsurance are counterbalanced with cost of the premium. A good example of this is a high deductible insurance plan where the insured accepts a certain amount they may have to pay in a given year, but is capped once the deductible is reached.
The risk transfer strategy is a complete transfer of risk to a third party, usually an insurance company. This is most common with life insurance, particularly term policies. Let’s put a little twist on our previous two examples of motorcyclists and physicians and say that a physician goes for a ride on his motorcycle and is killed in an accident. This physician had a family, a mortgage, and some private debt. The physician recognized the risk of riding around on a motorcycle and transferred the financial risk to an insurance company by purchasing a term life policy that covered all his financial obligations.
WHEN TO USE WHICH STRATEGY
Now that we’ve gone over the different risk strategies to employ, let’s put it all together and go over when it makes sense to use which strategy. Depending on the activity, there are two considerations. First, the frequency of loss, and second, the severity of loss as summarized in the following table:
When both the frequency and severity are high, you should avoid that activity. For example, Russian roulette has a frequency of a 1 in 6 chance of realizing the risk and the severity of the risk is nearly certain death. No other strategy than avoidance should be used! Okay, okay, this is an extreme example, a more realistic example would be investing in penny stocks. These companies being traded for less than $5² are considered extremely speculative. While there is an added element of the possibility for a reward, there is a high frequency of loss and therefore should be avoided, at least in my opinion.
When there is low frequency of loss, but high severity, you can either transfer the risk completely or share it to the degree in which you feel comfortable. Insurance companies are willing to take on the risk because, using the law of large numbers, they can figure the statistical likelihood of incurring loss and use that as a basis to pool your premiums with millions of others. This type of scenario that takes the most thought because there is clearly a need to transfer the risk to some degree, but to what nth, and which type of insurance?
When the frequency of loss is high, but the severity is low, it’s best to take measures to reduce the loss. Because of the likelihood of incurring loss, insurance companies won’t take on the risk, and if they did, premiums would be prohibitive. So your only option is to reduce the loss as much as possible. For example, when you examine a patient with a common cold, you would take steps to prevent catching the illness yourself like putting on gloves, wearing a mask, and washing your hands. But if you were to catch the cold despite that, it’s only a minor loss.
Finally, when both frequency and severity are low, you can retain the risk because loss isn’t likely, and when it does happen, it’s not a big deal.
So what do you think? Does examining the theory behind risk management help you to make a more conscientious decision towards handling risk?
Next week in part II, I’ll go over the different types of insurance available and how they fit into the risk sharing and risk transferring strategies along with how some forms of insurance have a savings component to them.