The futures look bright.

If your company is considering taking the self-insurance route to control healthcare costs, maybe you should investigate health insurance futures contracts. Some say the new hedging tool defies Murphy's law, because you just can't lose.

Health insurance futures contracts, a powerful new hedging tool soon to be released by the Chicago Board of Trade, may help companies freeze previously uncontrollable health-care costs. This innovative technique can benefit any organization, regardless of how fast and unexpectedly its costs and claims are rising. It may be especially useful for companies interested in self-insuring but afraid of health-care cost volatility.

Here's how it works: The Chicago Board of Trade has created an index that tracks how fast national health-care costs are rising and at what rate medical services are used. A representative sample of 10 major health insurers supplies information to the CBOT on the number of insureds, premiums collected, claims paid and so on. The policies reflect similar group sizes, covered benefits and deductible and coinsurance levels.

The CBOT's insurance pool manager analyzes the submitted information and assembles an index reflecting the pool's aggregate policy characteristics. The CBOT updates the index every January and July, and futures contracts are then bought and sold accordingly. Futures contracts based on January information will expire in the following June, September, December and March, while contracts based on July information will expire in the following December, March, June and September.

The index reflects claims paid per $100,000 of premiums collected. Specifically, the index's value at the end of each quarter will reflect claims incurred during the previous quarter that are paid by the end of the current quarter. For example, the value of the June index at the end of June (called the June "settlement" price or closing price) will be, for each $100,000 in premiums, the claims filed between January 1 and March 31 and paid between January 1 and June 30. Thus, if $65 million in claims were paid out for $100 million of premiums in force from the pool, the "settlement" or ending value of the June index would equal $65,000: ($65 million / $100 million) x ($100,000) = $65,000.

The settlement price of the June index, which is 65 here, is the loss ratio for January through March, with a runout through June. Health-care hedgers use the staggered indices (June, September, December and March) to freeze their future health-care costs.

Suppose that in January a major health insurer writes $10 million in one-year group-health-insurance policies. From the $10 million in annual premium income, the company expects to pay $7 million in claims, which is a 70-percent loss ratio for the year. Because of increasing regulation and other factors, the company has a rather thin profit margin. Therefore, if health-care costs rise faster than anticipated during the upcoming year, an underwriting loss is very likely. The company could freeze its health-care costs for the upcoming year by hedging its position in the futures market.

The company's actuary has forecast quarterly and annual loss ratios. Quarterly loss ratios rise throughout the year in both pools because premiums remain constant, while health-care costs and claims multiply.

In January, this company, along with all other health-care insurers using futures, will collectively forecast the quarterly indices' upcoming settlement prices so they can use them to hedge their exposures. Assume that these insurers share the same expectations as the CBOT actuary on loss ratios for the pool of typical policies. In January, the forecast settlement price for the June index will be the forecast first quarter's loss ratio (66 percent) times the completion rate by June (90 percent), expressed as a percent of $100,000 in premium income: .66 x .90 x $100,000 = $59,400.

Thus, in January, the market expects that for each $100,000 in premiums collected in the first quarter from the CBOT pool, $59,400 will be paid out to claimants by June 30. Since contract prices are set up to be the loss per $100,000 in premium income, $59,400 becomes the June contract price expected in January. Similarly, the September contract price predicted in January becomes: .70 x .90 x $100,000 = $63,000.

December and March contract prices are calculated in the same manner. As the year progresses, these prices will constantly change to reflect the market's shifting expectations about health-care costs.

The company can protect its annual premium income by buying an equivalent amount of premium income in the futures market. It can determine the number of contracts it should purchase by dividing the amount of premium income to be protected ($10 million) by the premium each futures contract represents ($100,000), and dividing this quotient by the forecast completion rate for the pool: $10 million/$100,000/(.9) |is similar to~ 111.

Since the company earns one-fourth of its annual premium each quarter, it should buy one-fourth of its annual contracts each quarter, or 28 contracts per quarter (27 in the last quarter, so that the total is 111). The company will use 28 June contracts to hedge its first quarter, 28 September contracts to hedge its second quarter and so on.

BUT WHAT IF PRICES HICCUP?

Suppose health-care prices jump unexpectedly early in the year and, as a result, the loss ratios for both the company and the CBOT pool consistently rise throughout the year, creating a loss ratio of 77 percent, or 3 percent higher than forecast.

Given these loss experiences, the CBOT pool manager can calculate each quarter's settlement price. For June, the settlement price is the first quarter's actual loss (67 percent) on $100,000 of premium income times the percent actually paid out (.90), or $60,300. Assume the completion rate remains constant at 90 percent, although it would actually vary slightly. In September, the settlement price is the second quarter's actual loss (72 percent) on $100,000 of premium income times the percent actually paid out (.90), or $64,800.

In order to cancel its futures position at the end of each quarter, the company sells the same number of contracts that it bought in January for that particular quarter, thus canceling its position in a Peter-pay-Paul manner. For example, in June, the company sells 28 contracts, canceling the 28 June contracts it had previously bought in January. In September, the company cancels September's contracts by entering 28 September contracts to sell, canceling the 28 September contracts it bought in January.

The company is actually contracting to buy or sell cash in the amount of the contract. Theoretically, a buyer would take delivery of the cash, while a seller would make delivery of the cash, but actually, all buyers and sellers must cancel their contracts before delivery time, taking their gains or losses in the process.

If the company sells at a settlement price higher than its purchase price, then it has a gain. Conversely, if the settlement price is lower, the company incurs a loss. For example, in June the company sells 28 June contracts for $60,300 each. Since it bought these contracts last January for $59,400, it has a June gain of $25,200 (|$60,300 - $59,400~ x 28). In September, the company sells for $64,800 the contracts it bought in January for $63,000, a total gain of $50,400 for the 28 September contracts.

Due to the extra 3-percent increase in health-care costs for the year, the company incurred a loss of $300,000 (.03 x $10 million). However, by using health-care futures, the company was able to almost completely offset this loss with a corresponding gain of $297,900 in the futures market. Thus, the real loss is only $2,100 ($300,000 - $297,900), only a small fraction of what it would have been without hedging. This example assumes that the company's loss ratios changed in lockstep fashion with the CBOT loss ratios. In reality, they will not track each other exactly, so the close-out gains or losses will be slightly higher or lower.

If the increase in health-care costs is ever less than expected, the company incurs a loss in the futures market from buying contracts at the beginning of the hedging period and selling them later at lower prices. However, this futures loss would be almost exactly offset by the unanticipated gain in the company's ordinary income. Thus, hedging with futures is immune to Murphy's law -- no matter what happens, the company effectively freezes its health-care costs in advance.

Any major brokerage firm can help a firm design and implement an effective hedging program. Brokerage commission costs are low (as low as $15 to $20 per "round trip" contract for large-volume hedgers) and well worth the small investment, given their impressive benefits. Futures contracts -- one of the oldest financial techniques in the world -- have finally arrived in the health-care arena. Now you can hedge your bets accordingly.

Dr. Ray is an associate professor of finance at the University of Louisville in Louisville, Kentcky.