AHM Health Plan Finance and Risk Management: Health Plan Financial Information

Objectives

After completing Health Plan Financial Information, you should be able to

Define financial information and list examples of a health plan’s financial information Identify the internal users and external users of a health plan’s financial information Distinguish between for-profit and not-for-profit health plans Discuss the common types of health plans

Welcome to the study of health plan finance. This course focuses specifically on the financing ofhealthcare through health plans such as those offered by health plans. Recall from HealthcareManagement: An Introduction that a health plan is an entity that utilizes certain concepts ortechniques to manage the accessibility, cost, and quality of healthcare delivery and financing.Many health plans assume or manage the financial risks associated with the unexpected costs ofhealthcare benefits. Because finance is closely tied to delivery systems and costs, all health plansrely heavily on financial information.

In the context of this course, finance is the effective and efficient management of money toachieve a health plan’s strategic goals and objectives. A primary strategic goal of a health plan isto offer one or more health plans that meet the healthcare needs of employers and otherpurchasers or payors.

Many health plans offer one or more products. Although in some contexts the term health planrefers to healthcare benefits provided through an employer or other group, in the context of thiscourse, a health plan is the delivery and financing system of healthcare benefits, rather than thebenefits themselves. Health plans expect to receive regular premium payments in exchange forassuming the risks associated with the uncertain costs of healthcare.

To meet its goals and objectives, a health plan must be able to:

Pay providers Bear or share the risk of not having enough money to support its ongoing operations Determine the rates to charge purchasers of its products and services Plan strategically for growth and expansion of products and services Analyze financial markets and information Manage the flow of funds into and out of the health plan Raise and manage capital

All these functions comprise health plan finance. To understand health plan finance, you must beable to interpret financial information. Financial information includes any numerical datacompiled for and from a company’s records. Health plans analyze financial information as part ofthe decision-making process involved in generating enough funds to conduct ongoing businessand to expand operations. Examples of a health plan’s financial information are listed in Figure1A-2 . We discuss many of these reports in later lessons.

Characteristics of Financial Information

Simply obtaining financial information is of little use to a health plan. The health plan’semployees must be able to interpret financial information to attain the health plan’s goals. Keycharacteristics of useful financial information include timeliness, quality, accuracy, and clarity ofthat information. Also, financial information must be appropriate. In other words, financialinformation is appropriate when it serves the needs of those who use the information. We discussthe impact of these characteristics on a health plan’s strategic planning process in The StrategicPlanning Process in Health Plans.

A health plan’s accountants, actuaries, underwriters, financial analysts, investment analysts, salesforecasters, and other staff members have a decision support role in developing and providing theplan’s managers and executives with appropriate financial information. Compilers of a healthplan’s financial information also serve in a decision support role for regulators, investors, andothers outside the plan who make decisions about the plan from their interpretation of the plan’sfinancial information. In addition, financial information developed for health plan managers andexecutives must be "actionable". That is, it must provide what is necessary for a health plan’smanagers to make decisions about the plan’s direction, growth, and ongoing survival.

Users of Financial Information1

Many organizations and people rely on the financial information contained in a company’saccounting records and reports. These interested parties generally consist of two groups: internalusers and external users of financial information.

Internal Users

Internal users of a health plan’s financial information are those individuals within the health planwho make decisions that affect plan operations. These individuals include the health plan’sdirectors, officers, managers, and others involved in planning, controlling, monitoring, andevaluating the financial implications of their decisions.

Figure 1A-2 lists several key positions typically found in a health plan and the generalresponsibilities of these positions within the plan’s financial functions. Note that actual healthplans may have different internal corporate structures than those presented. For example, onehealth plan may outsource its actuarial and underwriting functions; another health plan may haveone or more actuaries on staff and an underwriting department.

External Users

External users of a health plan’s financial information include those individuals and organizationsoutside the health plan who need financial information about the plan to make personal,corporate, investment, or regulatory decisions about the health plan. Most external users offinancial information rely on financial reports provided by the health plan. External users

typically have either (1) a direct financial interest or (2) an indirect financial interest in the healthplan.

External Users: Direct Financial Interest

Any external user who stands to gain or lose money as a result of a health plan’s financialperformance is said to have a direct financial interest in that plan. Health plan members,providers, outside agents and brokers, creditors, stockholders, and potential investors areexamples of external users with a direct financial interest in the financial performance of a healthplan.

Figure 1A-3 summarizes typical interested parties with a direct financial interest in a health plan’sfinancial performance. Plan members have a general interest in a health plan’s reliability inpaying claims. Providers are interested in a health plan’s financial condition because they want tobe reimbursed promptly for medical services rendered.

External Users: Indirect Financial Interest

External users with an indirect financial interest seek financial information on behalf of others.This type of external user includes federal and state regulatory and tax authorities, externalauditors, independent financial analysts, rating agencies, economists, attorneys, consumer groups,financial publications, and the health plan’s competitors. Figure 1A-4 summarizes the primaryactivities or scope of interest associated with external users that have an indirect financial interestin a health plan’s financial condition or performance.

Users of Financial Information

Different users of financial information often have different needs and uses for a health plan’sfinancial information. Financial information is often used to make key decisions related to ahealth plan’s long-term and short-term business objectives. Figure 1A-5 summarizes severalquestions that internal and external users hope to answer by reviewing a health plan’s financialinformation. We discuss these concerns, including how a health plan’s financial information canbe analyzed and interpreted, later in this course.

Legal Forms of Organization That Affect Health Plan Finance13

Recall from Healthcare Management: An Introduction that there is a wide variety of health planstructures and arrangements. In addition to having many options for their structure, health plansalso have several options related to their legal form of organization. These options may affectsources of capital, financial reporting requirements, tax payments, and distribution of profits.Next, we discuss for-profit status and not-for-profit status of health plans and review commontypes of health plans.

A health plan can be established on either a for-profit basis or a not-for-profit basis. Profit is theexcess of a health plan’s total income (the amount of money it takes in) over its total expenses(the amount of money it spends). All health plans, regardless of organizational structure, seek togenerate profits in order to fund ongoing operations and future growth. The choice of for-profit ornot-for profit status determines to a great extent the way a health plan approaches criticalfinancial decisions, such as funding, allocation of profits, and tax payments.

For-Profit Health Plans

A for-profit health plan seeks to produce profits for its owners to provide them with asatisfactory return on their equity investment in the health plan. An equity investment typicallyconsists of shares of stock that a health plan sells to owners or investors. If shares of stock areoffered to the general public, then the health plan is a publicly traded corporation, also called astock company. A publicly traded corporation’s shares of stock are traded in the financialmarkets. If shares of stock are not offered to the public, then the health plan is called a privatelyheld corporation. A privately held corporation has the option of "going public" if it decides thatthis would be in its best interest. For example, a privately held corporation may need to generatefunds quickly for expansion into new markets or to improve its information managementcapabilities by investing in new automated systems.

Not-For-Profit Health Plans

A not-for-profit health plan, which is organized and operated in the public interest, cannotdistribute its profits to individuals for personal gain, but must instead use its profits for the benefitof the health plan and its purposes. The distinguishing characteristic of a not-for-profit health planis that it has no owner investors, as does a for-profit health plan. Not-for-profit health planssometimes are referred to as non-profit health plans, but this term is misleading. As noted earlier,both for-profit and not-for-profit health plans aim to generate profits.

Although nearly all for-profit health plans are taxable organizations, certain not-for-profit healthplans qualify under the Internal Revenue Code for tax-exempt status. Tax-exempt organizationsdo not pay federal, state, or local taxes on earnings, although some of them may be required topay certain other taxes such as premium taxes. The criteria for qualifying for tax-exempt statusunder the Internal Revenue Code are beyond the scope of this course.

Funding Sources

A health plan can use profit to obtain additional funds, because the health plan’s ability togenerate profit instills confidence in potential investors and lenders who provide access toadditional funds. If a health plan is unable to convince investors and lenders of its ability tooperate profitably, then the health plan is likely to lose access to outside funds that are oftencritical to its ongoing operations.

In the health plan industry, for-profit health plans and not-for-profit health plans compete in thesame marketplace for funding sources. A critical success factor for any health plan is its ability toaccess funds needed to establish, maintain, and expand operations. Typically, health plans acquirefunds through one or more of the following sources of funding:

Generating profits from business operations (internal source of funds) Borrowing money (external source of funds: debt markets) Issuing stock (external source of funds: equity markets) Obtaining donations (external source of funds: donors)

Funding Sources

All health plans have potential access to the first two funding sources. However, not-for-profitcompanies do not issue stock. Some not-for-profit health plans are converting to for-profit status

or entering into joint ventures with for-profit companies to enable them to obtain needed fundsfrom investors. In some cases, not-for-profit health plans have access to private donations,whereas for-profit health plans rarely receive donations. Figure 1A-6 summarizes the optionsavailable to for-profit and not-for-profit health plans for obtaining operating funds.

Types of Health Plans

Figure 1A-7 provides a brief review of many of these structures and arrangements. Note that,within a given geographic area, some, none, or all of these organizations may exist. For acomplete discussion of the advantages and disadvantages and the legal structures associated witheach type of health plan, refer to AHM 510, Health Plans: Governance and Regulations.

Note that several of the health plans identified in Figure 1A-7 have overlapping features. A keyfactor that distinguishes the various types of health plans is the type and amount of risk that ahealth plan assumes with respect to the delivery and financing of healthcare benefits. In thecontext of this course, risk-bearing health plans, including HMOs, PPOs, and PSOs, assume thefinancial risks of delivering healthcare benefits to plan members. Generally, medical foundations,PBMs, UROs, TPAs, and MSOs are examples of health plans that do not bear the particular risksassociated with the financing and delivery of healthcare benefits. We discuss the concept of riskin Risk Management in Health Plans.

Through its wide variety of structures and organization types, health plans seek to align the oftendiffering goals of plan members and their dependents, employers and other group plan sponsors,healthcare providers, the owners of the healthcare delivery systems and financing systems, andregulatory agencies. Financial information plays a vital role in this process, because most types offinancial information either measure performance toward goals, or predict the effect of choosingone means of achieving a goal over another means of achieving the goal.

The purpose of financial information is to help the people who use it achieve their goals. Earlier,we discussed characteristics of financial information that make it useful. Now we look at some ofthe participants in health plans and how financial factors—such as the cost of services, providerreimbursement, return on assets, and return on investment—affect the goals they are seeking toachieve through health plans:

Health plan members-Health plan members and their dependents would like to receivethe best possible care in the event of illness or injury. Many also expect that preventive

care will be provided. At the same time, they would like to minimize the risk that the costof receiving care in the event of a serious illness or injury would be financiallydevastating. Also, plan members typically want to pay the lowest possible premium.

Employers-Employers and other group plan sponsors would like to enable group planmembers to access the highest quality healthcare at the lowest possible cost. They alsoprefer simplified record keeping and minimal complaints from plan members aboutaccess, quality, service, or cost.

Healthcare Providers- Healthcare providers—including physicians, hospitals, andancillary service providers (for example: laboratory, diagnostic, pharmacy, physicaltherapy, and mental health services)— want to use their specific expertise and skills toprovide healthcare services as efficiently as possible. Also, providers want access to planmembers in order to maintain or increase their market share, and providers want to berewarded financially for offering healthcare services.

Owners of a health plan- Owners of a health plan, whether they are individual orinstitutional stockholders or another corporation, want the health plan to be solvent,profitable, and poised for future growth. In return, owners and investors seek to berewarded financially for their investment in the health plan.

Regulatory Agencies- Regulatory agencies ensure that health plans adhere to the law andremain solvent so that the health plans can provide the promised healthcare benefits.Regulatory agencies also want health plans to provide all plan members with the highestpossible quality healthcare and access to that care at a reasonable cost.

These participants all have different goals. In some cases, the goals are clearly complementary.For instance, a plan member who is acutely ill is not likely to have the funds to pay for a majormedical procedure. By providing healthcare for a large number of healthy people, a health plan isable to both take advantage of economies of scale and spread out the financial risk that any oneplan member will suffer an illness or injury. Plan members want to avoid financial risk, andhealth plans and insurers are in the business of assuming and managing this risk.

Thus, a health plan gives a plan member, who is the ultimate recipient of healthcare, a means ofbalancing the goals of low expense, access to quality care, and reduced financial risk. In doing so,the health plan has an opportunity to conduct a profitable business. In other cases, goals are notobviously complementary, but many of the features of or practices employed by health plans helpalign the goals of the various participants. Let’s look at two examples of how health plan goalsintegrate to benefit more than one type of participant.

Suppose an employer becomes the plan sponsor of a group health plan offered by a health plan.Because one of the health plan’s goals is to manage costs, this particular health plan has acopayment feature. Recall from Healthcare Management: An Introduction that copayment is aspecified charge that a plan member must pay out-of-pocket for a service at the time the service isrendered. For example, each time the member visits physician, the member may have to pay $10copayment.

In the short run, copayments might appear to interfere with the plan member’s goal of receivinghealthcare at the lowest possible cost, because the plan member will have to pay the copayments.However, copayments lower the premiums that health plan must charge for a given level ofhealthcare benefits. Also, in the long run, the copayment feature lowers the cost of healthcarebecause copayments give plan members a reason to help control the number of unnecessary visitsto the doctor a copayment feature helps to lower the health plan’s costs. Thus the goals of theplan member are aligned with the goals of the employer and the health plan’s owners. At the

same time, the plan member receives quality healthcare and avoids the risk that illness will causefinancial hardship.

In another example, suppose a physician owns her own practice. She finds that, although sheenjoys helping plan members by practicing medicine, she spends much of her time on theadministrative aspects of her practice. Administrative tasks include payroll, accounting,purchasing supplies, and other business functions. A PPM company provides physicians withadministrative support services, which the PPM company can more efficiently perform, leavingthe physician more time to practice medicine and thereby better serve plan members.

By using financial information to calculate the expenses and projected income involved inoffering such services to providers, a health plan may ultimately take advantage of economies ofscale by offering administrative services to a large number of physicians. Economies of scaleresult in a decrease in the cost per plan member of administering healthcare. In turn, the healthplan’s owners may receive a higher return on their investment. Also, through the health plan, bothplan members and physicians benefit: the plan members benefit because their access to thephysician has been improved, and the physicians benefit because they are able to see more planmembers than before.

Perhaps the best example of aligned incentives is a risk-sharing arrangement in which a healthplan and its providers share the risks and rewards of higher- or lower- than expected medicalexpenses. We discuss risk management in Risk Management in Health Plans and providerreimbursement arrangements in Provider Reimbursement Arrangements and Capitation and PlanRisk.

Course Overview

Health Plan Financial Information introduced the functions that comprise health plan finance anddescribed some types, users, and uses of a health plan’s financial information. Throughout theremainder of this course, we discuss various financial aspects of health plans and their impact onplanning and operations. This discussion includes the following topics:

Risk management tools Legal and regulatory requirements Self-funding Medicare and Medicaid programs Underwriting and rating Provider reimbursement, with a particular focus on capitation Accounting and financial reporting Strategic planning Financial analysis Cost control Cash management Capital budgeting

Endnotes

1. Adapted from Elizabeth A. Mulligan and Gene Stone, Accounting and FinancialReporting in Life and Health Insurance Companies (Atlanta: LOMA, © 1997), 6-9. Usedwith permission; all rights reserved.

2. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life andHealth Insurance Companies (Atlanta: LOMA, 1997), 16.

3. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMA's Glossary of Insurance Terms,3rd ed. (Atlanta: LOMA, 1997).

4. Ibid.5. Mulligan and Stone, 3.6. Ibid., 633, 650.7. Academy for Healthcare Management, Managed Healthcare: An Introduction, 2nd ed.

(Washington, D.C.: Academy for Healthcare Management, 1999), 2-4.8. Ibid.9. Ibid.10. Kenneth Huggins and Robert D. Land, Operations of Life and Health Insurance

Companies, 2nd ed. (Atlanta: LOMA, 1992), 54.11. Mulligan and Stone, 655.12. Desoutter and Huggins.13. Adapted from Academy for Healthcare Management, Health Plans: Governance and

Regulation (Washington, D.C.: Academy for Healthcare Management, © 1999), 2-9-2-16. Used with permission; all rights reserved.

14. Academy for Healthcare Management, Health Plans: Governance and Regulation, 3-21.15. Ibid., 3-20.16. Ibid.17. Ibid.18. Academy for Healthcare Management, Managed Healthcare: An Introduction, 3-27.19. Academy for Healthcare Management, Health Plans: Governance and Regulation, 3-20.20. Ibid.21. Academy for Healthcare Management, Managed Healthcare: An Introduction, 4-8. 1-14,

Health Plan Finance and Risk Management22. Academy for Healthcare Management, Health Plans: Governance and Regulation, 3-20.23. Ibid., 3-21.24. Ibid., 3-20-3-21.25. Ibid., 3-21.26. Ibid., 3-20.27. Ibid.28. Ibid., 3-2-3-3.

AHM Health Plan Finance and Risk Management: Types of Risk

Types of Risk

Course Goals and Objectives

After completing Types of Risk, you should be able to

Distinguish between pure risk and speculative risk Define risk management Define the risks included in risk-based capital (RBC) requirements for health plans Explain how C-risks and RBC risks relate to health plan solvency Discuss the three broad strategies health plans use to deal with risk

To understand many aspects of healthcare financing, you must first understand the risks thevarious participants in health plans face. Generally speaking, risk has a direct association withcost—that is, in the long run the greater the exposure to risk, the greater the costs that follow fromthat risk. In the following sections, we explain the concept of risk and explore the methods thathealth plans use to manage the risks associated with the financing and delivery of healthcare.

The Concept of Risk1

Risk exists when there is uncertainty about the future. Individuals and businesses both experiencetwo kinds of risk—speculative risk and pure risk.

Speculative Risk

Speculative risk involves three possible outcomes: loss, gain, or no change. For example, after aninvestor purchases stock in a publicly traded health plan, the stock price will either rise, fall, orstay the same. The investor’s financial returns on that stock will follow the stock price pluswhatever dividends the health plan issues. Thus, the owner of the stock faces speculative risk tothe extent that the future returns on the stock are uncertain.

Likewise, when a health plan purchases a new information system, the health plan’s owners hopethat the initial investment in the system will result in an increase in operational efficiency and inthe level of customer service—factors that will help the health plan earn a profit (if the healthplan is for-profit) or a higher level of retained earnings (if the health plan is not-for-profit).Furthermore, the health plan’s owners hope that the total benefits that derive from the healthplan’s investment in the information system—benefits such as increased income and marketshare—exceed the benefits the health plan or its owners could have received by investing thesame amount of money in a different information system.

Again, uncertainty and risk are present in this investment decision because there is a possibilitythat this particular information system will not work as hoped, and that the health plan will incurgreater expenses and fewer benefits than anticipated from the system, thereby losing money on itsinvestment. There is also a possibility that the investment will neither lose nor gain a significantamount of money—that is, the benefits of the system as measured by increased revenue areessentially equivalent to the increases in costs associated with that system.

In this regard, many expenditures made by a health plan are much the same as an investment—the health plan is investing in itself. The health plan’s owners or stakeholders are in a positionsimilar to owners of other investments such as stocks or bonds: owners invest their money andaccept some financial risk in the hopes of seeing some benefit that translates into financial gain.

Pure Risk

Pure risk involves no possibility of gain; there is either a loss or no loss. An example of pure riskis the possibility that you may contract a serious illness. Such unforeseen illnesses will result ineconomic loss in the form of lost wages and increased medical expenses. If, on the other hand,you do not become seriously ill, then you will incur no losses from that risk. For a health plan,examples of pure risk include the possibility that its home office building will be damaged byfire, or that the health plan will be a victim of fraud, or that an employee will act in a negligentmanner and in so doing expose the health plan to financial liability. Notice that like speculativerisk, pure risk contains an element of uncertainty, but unlike speculative risk, pure risk containsno possibility of gain.

The possibility of economic loss without the possibility of gain—pure risk—is the only kind ofrisk that healthcare coverage is designed to help plan members avoid. The purpose of healthcarecoverage is to compensate, in part or in full, a plan member, either directly or indirectly, forfinancial losses resulting from unintentional illness or injury.

The coverage is not designed to provide an opportunity for the plan member to obtain a financialgain from his or her healthcare needs. In other words, healthcare coverage is not designed to be ameans of engaging in speculative risk for plan members. Instead, plan members transfer to thehealth plan the pure risk of medical costs arising from plan members’ unforeseen illnesses orinjuries.

Notice that healthcare coverage does not necessarily prevent events that are associated with purerisk: many plans include wellness programs to reduce the frequency of illnesses, but neitherparticipation in the wellness program nor the coverage itself necessarily prevents any one illness.Instead, the plan member transfers the pure risk of facing large and unexpected medical bills toanother party—for example, the health plan. The health plan itself, by charging actuariallyderived premiums for accepting this risk, engages in speculative risk, because it may eitherexperience a gain or a loss from its business, depending on the rate at which plan members utilizeservices and the health plan’s administrative and other business costs.

Risk Management

Individuals and businesses are surrounded by risks. Accepting risk is a key business function ofhealth plans, and a vital part of a health plan’s business activity involves managing those risks.Risk management is the process of identifying risk, assessing risk, and dealing with risk.2

Broadly speaking, the goals of risk management for a health plan involve assuring that theorganization survives, operates efficiently, sustains growth and effectiveness, and, in the case ofpublicly owned for-profit health plans, increases shareholder value. Health plan finance isconcerned not only with pure risk, but with a specific type of speculative risk called financialrisk. Financial risk is the possibility of economic or monetary loss—or gain—in undertaking orneglecting to undertake a certain action. Figure 2A-1 asks you to consider the risks in a typicalhealth plan situation.

In situations such as the one discussed in Figure 2A-1, the health plan, employer, provider, andplan member can benefit from using risk management to deal with the risk each faces. Becausehealth plans are presented with a large number of financial risks in the course of conductingbusiness, health plans use a variety of risk management techniques to minimize the possibility ofundesirable financial outcomes.

Risk Management

However, in order to achieve a return on financial resources, a health plan must accept thefinancial risk of engaging in business activities. Similarly, an investor typically accepts some riskin order to achieve a return in, for example, the stock market. For businesses and investors, riskand return are therefore closely related.

Another way to look at the risk-return relationship is that the greater the risk associated with aninvestment or business activity, the greater the potential return must be in order to offset the riskthe investor is taking. This direct relationship between the amount of risk and the amount of thepotential return required to make the risk financially acceptable is known as the risk-return trade-off. The risk-return trade-off is a basic consideration in decisions concerning many core businessactivities health plans undertake. For example, where regulations allow, an HMO will chargehigher premiums to a high-risk group of enrollees than to a low-risk group of enrollees, becauseas the risk-return trade-off suggests, the HMO will only accept greater risk in exchange forgreater potential returns.3

In this lesson and many that follow, we will discuss ways in which health plans manage the risksthat they face. First, however, we continue with an overview of the specific types of riskgenerated by a health plan’s business, and the relationship between those risks and the healthplan’s solvency.

Risk Categories Faced by Health Plans

In the most general sense, any activity undertaken by a business entails some risk, and ultimatelyevery risk has the potential to impact the business financially. Health plans, for example, facerisks when entering a new market, exiting a market, or deciding to continue to operate in a givenmarket. The health plan faces other risks in plan design activities, benefit coverage decisions,pricing products, choosing an information system, hiring employees, reacting to the regulatoryenvironment, or developing provider reimbursement contracts.

To manage and understand risk, managers have divided risk into different categories. The firstcategories of risk we will discuss are called contingency risks, or C-risks.

C-Risks and Solvency

Contingency risks, usually called C-risks, are general categories of risk that have direct bearingon both cash flow and solvency. Solvency is generally defined as a business organization’s abilityto meet its financial obligations on time. To continue operations, for example, a health plan mustbe able to pay those medical costs it is contractually obligated to pay as those costs come due.Thus, financial risks have a direct bearing on an health plan’s ability to stay solvent, and theability of a health plan to stay solvent is a minimum requirement for the health plan’s continuedoperation.

In accounting terms, solvency in a health plan is closely related to the amount of capital andsurplus (also called owners’ equity) that the health plan has on hand. Capital and surplus is, at themost basic level, the difference between a health plan’s assets and its liabilities:

Assets – Liabilities = Capital and surplus

For a business to be solvent, it must have sufficient liquid assets to meet liabilities that are due.Liquid assets are those assets that are either held in cash or can be easily and quickly convertedinto cash. Money market funds and checking accounts are examples of liquid assets, but an officebuilding is not a liquid asset.

For health plans, solvency also refers to the legal minimum standard of capital and surplus thatevery health insurance company must maintain. The issue of health plan solvency is extremelyimportant from a regulatory point of view, because the ability of health plans to pay the coveredmedical benefits of enrollees is a public policy priority. We will discuss regulatory standards forsolvency in the next lesson.

There are four C-risks. Each measures aspects of a health plan’s financial and managementoperations that can influence its solvency. Although C-risks were developed to apply to the lifeand health insurance industry, they have also influenced the development of methods that

managers and regulators use in assessing the level of risk faced by health plans. Following is abrief discussion of each type of C-risk:

C-1, or asset risk, is the risk that a health plan will lose money on its assets, includinginvestments in stocks, bonds, mortgages, and real estate.

C-2, or pricing risk, is the risk that the health plan’s experience with morbidity orexpenses will differ from the assumptions that were used in pricing the health plan’sproducts. For health plans, this risk is typically the most important factor in determiningwhether or not a plan is solvent.

C-3, or interest-rate risk, is the risk that interest rates will shift, causing the health plan’sinvested assets to lose value.

C-4, or general management risk, is the risk that financial losses will result from businessmanagement decisions.

Businesses that have significant assets face these C-risks to varying degrees, but the relativeimportance of each C-risk varies from business to business. For example, a typical health planfaces much different levels of exposure to asset and interest-rate risks than do life insurers orbanks. Life insurers usually collect premiums on a life insurance policy for many years beforepaying a claim on that policy. Thus, life insurers typically maintain a significant portion of theirassets in long-term investments, which causes both asset and interest-rate risks to be veryimportant factors in their profitability.

In contrast, a health plan will begin paying for medical costs relatively soon after first receivingpremiums from, for example, a group health policy. Because the health plan’s medical paymentscome much sooner and more frequently than a life insurer’s payment of a claim on a lifeinsurance policy, a larger portion of a health plan’s assets will flow into and out of short-term,liquid investments. Because these assets are liquid, they can be sold for cash more easily thanmany long-term investments, which, generally speaking, makes liquid assets less subject to assetrisk than long-term investments. Thus, the health plan faces relatively smaller asset risk thanbusinesses such as banks, because banks tend to hold long-term investments such as mortgages.

In certain business activities, however, health plans can face significant asset risk. For example,health plans typically use sophisticated computer technology to track utilization data, providerreimbursement, enrollee information, customer service, and medical costs. Tracking data is acrucial part of an health plan’s ability to manage costs and risk exposure. Additionally, manytypes of data must be tracked accurately for a health plan to meet regulatory requirements.Consequently, any threat to the value of the computers used for tracking and analysis is an assetrisk.

Although health plans face relatively less exposure to interest-rate risk and asset risk than dobanks or life insurance companies, health plans face considerable pricing risk under almost allhealth plan contracts. For most health plans, pricing risk is the most important risk theorganization faces. Pricing risk is so important because a sizable portion of the total expenses andliabilities faced by a health plan come from contractual obligations to pay for future medicalcosts, and the exact amounts of those costs are not known when the healthcare coverage is priced.

For example, suppose a health plan enters into a group contract that is renewable on a yearlybasis. The health plan will set a price (premium) in advance for the expenses it expects to incur indelivering healthcare services to the group’s plan members. Although medical costs will be paidthroughout the year, the premium cannot be renegotiated until the end of the contract year. The

plan faces considerable pricing risk during the contract because the possibility exists thatassumptions made in pricing the plan benefits at the beginning of the contract will not necessarilymatch the actual medical costs.

In any market where health plans face constraints in pricing their services, these health plans alsoface pricing risk. In competitive markets such as those in which health plans typically operate,competition itself is usually the most important constraint on pricing, because in such marketshealth plans will compete with each other for market share partly by attempting to keep theirprices (premium rates) low.

Additionally, government activities also place constraints on pricing in some markets. Forexample, as we discuss later in another lesson, the federal government develops paymentschedules for federal healthcare programs, most notably for the Medicare and Medicaid markets.Health plans operating in these markets may find it impossible to adjust the payments theyreceive for the healthcare coverage they provide. At the same time, health plans in many marketsare subject to mandated benefit laws. These laws add to the expenses health plans incur whileoperating in the market because such laws require health plans to cover healthcare expenses forcertain treatments or benefits. Thus, health plans may be constrained in both setting the paymentsthey receive and in the methods they have for reducing expenses. Both conditions can serve toincrease the pricing risk health plans face.

Finally, general management risk is also an important issue for health plans, becausemanagement decisions are critical to a health plan’s financial outcomes. Decisions related tocontrolling costs, improving customer service, designing plan benefits, and structuring providerreimbursement contracts are all critical management decisions.

Management risk also includes the risk that actual expenses will exceed the amounts budgeted forthose expenses. Accurate estimates of future expenses and liabilities allow health plans to retainsufficient liquid assets to meet obligations. Beyond solvency concerns, accurate budgets alsoallow management to use resources efficiently so that the assets generate the greatest possiblereturn. If the management of a health plan underestimates expenses for an upcoming financialperiod, the health plan may either fail to retain sufficient assets to cover current obligations, or beforced to sell long-term assets at a loss to meet those obligations, or take other financially costlysteps to stay solvent.

Management risk is always present in a business, because management constantly faces choicesconcerning how to allocate financial resources to achieve the best financial outcomes. Forexample, after satisfying regulatory requirements for solvency, an HMO’s management mustdecide the specific level of capital and surplus the HMO will maintain. If management fails toretain a sufficiently high level of surplus, then the HMO may not be able to absorb losses incurredfrom other financial risks.

On the other hand, holding excessive amounts of surplus is not risk-free, because this excess isnot being earmarked for core business functions such as developing a greater market share.Furthermore, the optimum level of surplus for any HMO will change over time as internal andexternal conditions change. Consequently, management risk is present at any level of surplus.

Some of the variables that management must take into consideration when making financialdecisions are wholly or partly within the health plan’s control. For example, a health plan’smanagement has considerable control over whether or not to contract with a given provider, and

whether or not to include that provider on the health plan’s list of primary care providers.However, the health plan has only partial control over the reimbursement rate it pays theproviders in its network, because the health plan must negotiate that rate with providers.

Many other variables, such as government laws and regulations, the general rate of inflation inthe economy, and the general rate of increase in medical costs, are often beyond the health plan’scontrol. Thus, the risk that a management decision will result in unfavorable financial outcomesincreases whenever changes in general business conditions increase in frequency or severity.

Regulatory and Antiselection Risks

In our discussion of general management risk, we pointed out that health plans have varyingdegrees of control over internal business decisions and external business conditions. For thehealth plan industry, a very important source of external risk is regulatory risk. Regulatory risk isthe risk that changes in regulations or laws may adversely affect the financial condition of ahealth plan. We will discuss some of the laws that carry regulatory risk in Risk Management inHealth Plans and Provider Reimbursement and Plan Risk, but for now you should know thatthere are a number of regulatory risks faced by health plans.

Chief among these risks is the possibility that healthcare reform may result in rate caps ormandated benefit laws. Rate caps, which are most common in markets such as Medicare wherethe government itself is the payor, limit a health plan’s ability to increase revenue in response torising medical costs, and therefore increase the risk that a health plan will become insolvent.Laws mandating certain health plan benefits or contractual obligations have the effect ofincreasing expenses for a health plan operating in that jurisdiction. Although regulatory risks suchas premium caps and mandated benefits are particularly important to health plans’ riskmanagement function, health plans also face regulatory risks that are not unique to the healthcareindustry. Tax laws, regulations and laws governing employment, building and safety codes, andother laws have a tendency to change over time, and the possibility of regulatory change carrieswith it regulatory risk.

In a health plan environment, antiselection is the tendency of people who have a greater-than-average likelihood of loss to seek healthcare coverage to a greater extent than individuals whohave an average or less-than-average likelihood of loss. Antiselection risk for health plans is thepossibility that a higher-than-anticipated percentage of people who need greater-than averagehealthcare benefits will sign up with a healthcare plan.

Antiselection can occur because individuals often know much more about their health than ahealth plan can know. People who know they are ill or believe that they are likely to become illtend to more actively seek health coverage—particularly coverage with enhanced benefits—thando healthy people who believe they will not become ill. If an health plan has designed its healthplan and premium rates assuming a utilization rate based on an average population, but attractsenrollees who are less healthy than average, the health plan faces higher-than-expected utilizationrates because of antiselection.

Antiselection also occurs when people choose between competing plans. For example, suppose alarge employer offers two health plans to its employees. Both plans cover the same range ofmedical treatments, but Plan A has relatively high deductibles and relatively low monthlyenrollee contributions. Plan B has relatively low deductibles and relatively high contributions.Enrollees who anticipate that they will make frequent and expensive trips to their doctors may be

willing to make high monthly contributions if their deductibles are low, but enrollees whoanticipate little need for medical treatment will be more likely to sign up for a plan with lowmonthly contributions. Thus, Plan B may, on average, attract less healthy enrollees than Plan A.Actuaries play an important role in recognizing the risk of antiselection and judging the financialimpact of that risk in such situations.

Regulatory Solvency and Risk-Based Capital Requirements

As we mentioned earlier, all businesses, including health plans, are concerned about their ownsolvency. In addition, health plans are interested in the general financial condition of thehealthcare industry for at least two reasons. First, all health plans are better off if the public hasfaith and confidence that health plans are financially stable and reliable. Second, health plansrecognize that regulators and elected officials see financial stability and reliability in thehealthcare industry as a public policy goal. In pursuit of this goal, lawmakers and regulators haveestablished legal solvency standards that directly impact how health plans manage risks.

However, solvency standards themselves vary widely depending on the type of health plan beingregulated. HMOs, for example, are typically regulated as insurers, and as such must comply withstate insurance laws. On the other hand, federal law exempts self-funded employer-sponsoredhealth plans from state insurance laws and regulations. Recall from Healthcare Management: AnIntroduction that under self-funded plans an employer or other group sponsor, rather than a healthplan or insurer, is responsible for paying plan expenses.

Because employees typically contribute to the financing of employer-sponsored health plans,much of the federal regulation governing the financial aspects of these self-funded plans is moreconcerned with defining the fiduciary duties of those who exercise control over the plan, ratherthan concern with setting solvency standards for the plan sponsor. We will discuss self-funding inmore detail in Fully Funded and Self-Funded Health Plans.

In the next sections of this lesson, we examine two solvency standards regulators use to setfinancial requirements with respect to risk for health plans. The first standard is from the HMOModel Act as developed by the National Association of Insurance Commissioners (NAIC). Thesecond standard is known as risk-based capital (RBC).

HMO Model Act and Solvency5

The HMO Model Act is a model law, developed by the National Association of InsuranceCommissioners (NAIC), that is designed to aid state governments in regulating the licensure andoperations of HMOs. More than half of the states have adopted the HMO Model Act orsubstantial portions of this model law.6

Under the HMO Model Act and most state laws, an entity that wishes to operate as an HMO mustobtain a certificate of authority, often called a license. A certificate of authority (COA) is acertificate issued by the state authority that regulates HMOs; the COA certifies that allrequirements have been met for the establishment of an HMO in accordance with the state’sHMO laws. Generally, the purpose of licensing is to ensure that an HMO is a solid, dependableorganization, fiscally sound, and able to meet specified quality standards for healthcare delivery.

With respect to self-funded plans, a fiduciary is a person, regardless of formal title or position,who exercises discretionary authority and control over the operation of a plan, exercises anycontrol over plan assets, or renders investment advice for a fee7

Among other requirements, the HMO Model Act sets financial requirements for HMOs seekingto obtain COAs. An HMO must have an initial net worth of $1.5 million and thereafter maintainthe minimum net worth described in Figure 2A-2. In this context, net worth is an organization’stotal admitted assets minus its total liabilities (its debts and obligations, including obligations topay for in-network and out-of-network care for its providers). An admitted asset is an asset thatstate HMO or insurance laws permit on the Assets page of a company’s Annual Statement.

We discuss financial statements in more detail in Accounting and Financial Reporting, but youshould recall from Healthcare Management:An Introduction that the Annual Statement is afinancial report that most health plans have to file to comply with state insurance regulations.

From a business and financial management standpoint, the ongoing net worth requirements listedin Figure 2A-2 contain some important elements. First, the net worth requirements set a minimumfixed level of capital and surplus for all HMOs.

Second, after an HMO has reached a certain size, as measured by premium income and medicalexpense payments, the capital and surplus requirements will vary according to the size of theHMO. HMOs that receive more premiums or have experienced higher healthcare expenditures

than other HMOs must have a higher net worth, and each HMO’s net worth requirement increasesas the HMO grows larger.

Third, an HMO must be able to accurately track and report the financial results of a number of itsoperations. These results include, but are not limited to, premium revenues, uncovered healthcareexpenditures, total healthcare expenditures less those paid on a capitated (typically a per member,per month) basis.

The HMO Act net worth requirements for HMOs attempt to reflect an important principle of riskexposure for health plans: The larger the number of enrollees in the plan, the greater the healthplan’s net worth requirement should be, assuming coverage levels remain the same. The highernet worth requirement makes sense intuitively, because in the long run a large group of enrolleeswill generate more healthcare costs than a small group will generate. Therefore, an HMOproviding coverage for the large group must have greater surplus to pay those expenses as theycome due.

A second principle reflected in the HMO Model Act is that the larger the number of enrolleescovered by an HMO, the more predictable the morbidity experience of the covered group shouldbe. For HMOs with a large number of enrollees, predictable morbidity experience tends to resultin more predictable claim expenses. This increase in predictability decreases the chance thatexpenses will be so unexpectedly high in any one period that the HMO will experienceinsolvency, assuming that the premiums are set on an actuarially sound basis. The HMO ModelAct therefore requires that plans meeting the net worth requirement through the percent-of-premium method must maintain 2% of premium revenues for the first $150 million in premiumrevenues, but only 1% of the premium revenues greater than $150 million.

Disadvantages of the HMO Model Act Solvency Standards

The HMO Model Act represents one approach to developing solvency standards. This kind ofapproach mandates a minimum level of capital and surplus for any health plan that falls under alaw based on this model act. One drawback to this type of solvency regulation is that other thanadjusting for the size of the HMO’s premiums and expenditures, this approach mandates the samesolvency requirement for all organizations that must comply with the regulation. In other words,the size of an HMO’s premiums and expenditures is assumed to reflect accurately the level of riskthe HMO faces. Our discussion of C-risks, however, suggests that two health plans that receivethe same premium income may be exposed to very different levels of financial risk depending ontheir approaches to pricing their products, investing their assets, and managing their utilizationcosts.

Furthermore, the HMO Model Act is retrospective in its assessment of risk. That is, it uses pastexpenditures and premium income to estimate future risk. For plans that are growing or shrinking,past data may be a less accurate predictor of risk than the same data would be for plans that havestable enrollment figures.

Another problem exists in terms of the assumption that the amount of premiums an HMO chargesalways directly corresponds to the level of the risk an HMO faces. In some cases involving plansthat are experiencing difficulty remaining solvent, this is a false assumption.

For example, suppose an HMO had experienced low claims in the recent past and was meeting itsnet worth requirements through the 2-percent-of-premium method. Under the HMO Model Act,

this HMO’s net worth requirement would fall slightly as a result of the HMO’s lowering itspremium revenue (that is, as a result of the HMO’s decreasing its rates to policyholders).However, lowering rates without decreasing the benefit coverage actually increases the HMO’sexposure to risk.

Thus, under these circumstances, the model act’s method of determining net worth would notnecessarily require an HMO that increased its risk of future insolvency to increase its net worthrequirement. Typically, HMOs are prudently managed, and will not lower premium rates so muchthat insolvency occurs. However, in cases where insolvency has occurred, extremely competitivepricing in the HMO’s market is often a key contributing factor in the insolvency. Retrospectivenet worth methods, such as the HMO Model Act method, can under some circumstances fail toanticipate this increased risk.

The Development of Risk-Based Capital Requirements

To tie the capital and surplus requirements more closely to the actual level of risk faced bydifferent health plans, the NAIC began, in the early 1990s, to develop risk-based capital (RBC)formulas for all life and health insurance companies. However, NAIC members recognized thatthis formula did not adequately reflect the range of risks present in the health insurance business.Further, the financial standards contained in the HMO Model Act and various states’ HMO andinsurance statutes may not apply to some provider organizations or certain other risk-bearingentities. Recognizing the limitations of relying upon a single minimum fixed level of capital andsurplus requirements, the NAIC then began a process to create a separate RBC formula for allhealth insurers and health plans that accept risk.

The RBC formula for health plans (health plan-RBC) is a set of calculations, based oninformation in the health plan’s annual financial report, that yields a target capital requirement forthe organization. The RBC formula applies to health plans in states that have adopted legislationto implement RBC requirements. The Centers for Medicare and Medicaid Services (CMS), thefederal agency that oversees the Medicare program, requires PSOs to be state licensed, and hastherefore become interested in RBC requirements as a secondary regulator.

The RBC formula assesses the specific level of risk faced by each health plan. Under RBCrequirements, a health plan’s target surplus is not simply a function of the premiums it receives orthe costs it has incurred in the recent past, but also reflects the underlying risks the health planfaces and how the health plan manages those risks. For example, as we will see in ProviderReimbursement Arrangements and Capitation and Plan Risk, health plans can use providerpayment methods to transfer some utilization risk from themselves to the providers who maketreatment decisions. In a healthcare context, utilization risk is the possibility that the rate of useof medical services by a given enrolled population will exceed the predicted rate. Higher-than-expected rates of utilization tend to result in higher-than-expected costs for the entity at risk forutilization. For health plans, utilization risk is a critical factor in the financial outcome of thehealth plan’s business, because a large portion of an health plan’s total expenditures involvemedical expenses. Higher-than-expected rates of utilization can occur simply because a givenpopulation’s legitimate need for medical services is greater than the actuarially predicted need.However, utilization risk is increased in situations where overutilization occurs. Overutilization isthe use of medical services or procedures that are not medically necessary. Because providersmake many treatment decisions, one of the central financial strategies in health plans is the use ofprovider reimbursement systems that motivate providers to avoid treatment decisions that result

in overutilization. Consequently, the RBC requirement is adjusted for any provider paymentmethods the health plan has in place that reduce the health plan’s risk.

The Development of Risk-Based Capital Requirements

The health plan-RBC formula takes into account five different kinds of risk:

Affiliate risk—the risk that the financial condition of an affiliated entity causes anadverse change in capital

Asset risk—the risk of adverse fluctuations in the value of assets Underwriting risk—the risk that premiums will not be sufficient to pay for services or

claims Credit risk—the risk that providers and plan intermediaries paid through reimbursement

methods that require them to accept utilization risk will not be able to provide theservices contracted for, and the risk associated with recoverability of the amounts duefrom reinsurers

Business risk—the general risk of conducting business, including the risk that actualexpenses will exceed amounts budgeted

You should notice that many of these RBC risk categories parallel the C-risks we discussedearlier. The system of C-risks was developed before RBC, and formed the basis for thedevelopment of RBC risk categories and the RBC formula. For this reason, the C-4 (generalmanagement risk) is related to the RBC’s business risk category. Both systems also include acategory for asset risk. Finally, the C-2, or pricing risk, is paralleled by the RBC’s underwritingrisk.

However, RBC also contains differences that reflect the nature of the health plan industry. Forexample, as we have mentioned, interest-rate risk for health plans is relatively small, so the RBCdoes not have a separate interest-risk category. Also, the RBC categories reflect the fact that thelevel of risk faced by health plans is significantly impacted by provider reimbursement methodsthat shift utilization risk to providers. We will discuss provider reimbursement methods in laterlessons, but for now you should know that such reimbursement methods, in which providersassume at least some utilization risk, have two effects on RBC risks.

First, these reimbursement methods decrease the risk that the health plans will be exposed tohigher-than-expected levels of utilization. By decreasing this utilization risk, the health plan isdecreasing its underwriting risk. Consequently, a health plan’s underwriting risk can besignificantly reduced when the health plans use these reimbursement methods.

Underwriting risk is the greatest risk component of a typical health plan’s RBC formula, andoften largely determines the health plan’s net worth requirement. The structure of providerreimbursement methods used by health plans therefore becomes a key strategy for riskmanagement in health plans. The RBC formula explicitly recognizes this. The strategy of usingprovider contracts to manage risk is also valid for health plans that are not subject to RBCrequirements, because the underlying utilization risk is important to all health plans, no matterwhat method is used to determine their minimum net worth requirements.

The second influence of provider reimbursement contracts on a health plan’s RBC formula isreflected in the credit-risk category. The credit-risk category recognizes that transferringutilization risk to providers does not eliminate the health plan’s responsibility to arrange for

medical services covered by its health plan. If these providers accept too much risk and becomeinsolvent, the health plan will incur a number of expenses, including those associated with havingto develop new provider contracts, or even new provider networks.

Even if providers do not become insolvent, but simply refuse to renew contracts at oldreimbursement rates, then the health plan’s cost of paying these providers would increase if thehealth plan wished to continue contracting with the providers. The greater the amount of risk thehealth plan transfers to providers, the larger the credit-risk factor becomes in the health plan’sRBC formula. Thus, transferring risk to providers through reimbursement contracts decreases thehealth plan’s underwriting risk, but increases the health plan’s credit risk. However, because theunderwriting risk is by far the largest risk in the RBC formula for health plans, the net effect ofusing provider reimbursement contracts to transfer risk is that the health plan’s net worthrequirement will decrease.

Health plans also use several other strategies to transfer certain risks. Transferring risk usingthese strategies can also increase a health plan’s credit risk. For example, health plans canpurchase various types of insurance to protect themselves against losses that would result if anunexpectedly large number of plan members incur catastrophic medical expenses. Credit riskcaptures the risk that the entities selling insurance to the health plan will be unable to make theagreed-upon payments should the insured-against event occur. We discuss these forms ofinsurance in more detail in future lessons.

The Structure of the RBC Formula

The RBC risks for a given health plan are assigned numerical values. These values are arrangedin a formula that generates the total amount of risk faced by the health plan. The mathematicalmodeling used to develop this formula is beyond the scope of this text, but there are twocharacteristics of this formula that you should understand.

First, numerical values for all the risks are eventually added together, because RBC attempts tocapture the total risk of financial failure faced by the health plan. Second, the formula performsmathematical operations on the separate risks before adding the risks together. The result of theseoperations is that if one of the risks is greater than the others, the influence of that large risk onthe health plan’s financial strength is emphasized. Because underwriting risk is typically the mostimportant risk faced by health plans, the underwriting risk’s influence on the health plan’sfinancial strength is often much greater than any of the other risks, and the RBC formula reflectsthis relative importance.

Strategies for Controlling Risk

The categories of risk that we have discussed so far can be used by managers and regulators toanalyze the ways in which a health plan’s operations influence the health plan’s financialstrength. In this portion of the lesson, we will examine three general strategies for controllingvarious types of risk. These three strategies are to avoid risk, transfer risk, and accept risk.

Health plans must identify and assess both their exposure to risks and the possible responses tothose risks. A basic, but important, economic principle—opportunity cost—applies to anyfinancial decision that a health plan makes in choosing among the three risk control strategies, aswell as in choosing among specific courses of action once a strategy is selected. Opportunity costis the benefit that is given up when limited resources are used to achieve one goal rather than

another.8 health plans, like all businesses, have limited resources, and in choosing riskmanagement strategies, also have to make decisions to allocate those resources.

Avoiding the Risk

Avoiding the risk involves either taking action or discontinuing an action in order to avoid or limitexposure to the risk. Many businesses avoid financial risks by choosing either not to enter certainmarkets or to exit markets in which risk is increasing.

Suppose, for example, that a health plan believes that changes in federal regulation increase therisk that payment rates in a certain Medicare market will cause that market to becomeunprofitable. A health plan may choose to avoid the risk of operating in that market by eitherwithdrawing from or not entering that Medicare market.

An important point here is that health plans do not simply avoid all risks, because their corebusiness involves accepting financial or business risks of one type or another in exchange forpremiums or other payments. In other words, avoiding risk is a useful management technique inreducing expenses and risk exposure, but in cases of speculative risks, avoiding risk also resultsin decreased chance of potential financial gains.

In our example, a decision to avoid the risk of entering a new market would allow an health planto avoid the start-up costs of developing that market and the operational costs of doing business inthat market, but would also mean that the health plan would give up the potential income it wouldreceive from operations in that market. In situations involving speculative risk, opportunity costsare always associated with any decision involving the strategic allocation of funds.

From a financial management point of view, a decision to avoid a risk often involves twoanalyses: first, an analysis of the savings that can be had by avoiding the risk, and second, ananalysis of the amount of revenue or other financial gain that that could be had by accepting andmanaging the risk. Generally speaking, the smaller the likely benefits of accepting a risk, and thelower the costs of avoiding that risk, the greater the likelihood that a health plan will elect toavoid the risk.

If a risk is a pure risk from the point of view of the health plan, then there will be no possibility ofgain in retaining the risk, and the health plan will likely attempt to avoid the risk. For example,healthcare fraud is potentially a substantial risk for health plans, and all health plans expend someresources in attempting to avoid being subject to fraud.

The decision to avoid or accept any given risk, however, often varies not only according to theactivity that generates the risk, but also the qualities of the specific health plan that iscontemplating the risk. For example, beginning operations in a new market always involves riskfor a health plan, but the same market may be more risky for one health plan than for another.The degree of risk the individual health plan faces will depend on a great many factors, such aswhether or not the health plan already operates in the market’s geographical location, whether ornot the health plan has experience operating profitably in similar markets, and whether or not thehealth plan has sufficient capital available for the purpose of entering the market.

Transferring the Risk

Transferring the risk involves shifting some or all of the financial responsibility connected to arisk from one party to another. As the concept of risk-return trade-off suggests, the party thatagrees to accept the financial risk usually does so in exchange for some type of financialincentive.

A common form of risk transfer for both individuals and businesses is insurance. Under aninsurance contract, the insurer agrees to pay a specified amount of money if certain events occurin exchange for receiving a payment (usually called a premium) from the party seeking theinsurance. For example, most physicians purchase malpractice insurance. A physician purchasingmalpractice insurance pays a premium to an insurer that agrees to pay a specified amount ofmoney (or to cover certain costs incurred) if the physician is sued for malpractice.

Health plans themselves may purchase insurance for a variety of risks, ranging from propertyinsurance to insurance that provides financial protection against catastrophic and unexpectedclaims rates. In general, health plans can use this last type of insurance to reduce the health plan’sexposure to the risk of having to pay larger-than-expected medical expenses, and in doing so, thehealth plan reduces its underwriting risk. We discuss the forms of insurance important to healthplans in more detail later.

As important as insurance is as a means of transferring risk, health plans almost always use othertypes of contractual, non-insurance risk transfer as well. For example, suppose a large employeris willing to self-fund the healthcare coverage it offers to its employees. Recall from HealthcareManagement: An Introduction that under a self-funded plan, an employer, rather than a healthplan or insurance company, remains financially responsible for paying plan expenses, includingclaims made by enrollees. In this case, the employer also decides to contract with a health plan toprovide the administrative services necessary for operating the health plan.

If the employer agrees to pay the health plan for these services based on the number of employeesthat sign up for the healthcare coverage, then the employer is transferring to the health plan someof the business risk of operating complex administrative functions. In exchange for payment, thehealth plan accepts the risk that administering the plan will be more expensive than anticipated. Inthis case, although there has been a transfer of risk, the health plan is not functioning as an insurerbecause the employer is retaining the responsibility to pay for the medical costs of the plan underits employee benefit program, and no insurance contract has been made.

Another important area in which health plans use contracting rather than insurance to transfer riskis the area of provider reimbursement. As we will see in the next few lessons, hospitals andindividual physicians can be compensated in ways that transfer some of the risk of unexpectedlyhigh rates of utilization from the health plans to the providers. For example, a health plan retainsutilization risk if it pays physicians on a per-treatment basis, because the more treatments aphysician provides to plan members, the greater the medical expense liabilities the health planfaces. However, if the health plan pays the physician a rate that is based on the number of planenrollees that choose the physician as their primary care doctor (rather than the number oftreatments the physician supplies to those patients), then the physician assumes some or all of theutilization risk.

The greatest risks faced by health plans involve utilization rates. The premium payments a healthplan receives are based in part on projected utilization rates. A central financial risk that health

plans face, then, is that the utilization rates will be higher than expected, and the cost of providinghealthcare coverage to plan members will exceed the revenue the health plans receive frompremiums or other payments. Health plans almost always transfer some of this risk to otherparties through a number of plan design elements and provider reimbursement methods.

For example, deductibles and copayments are common elements in health plans. By includingthese elements, the plan transfers a small portion of the utilization risk from the health plan to theplan member. This transfer of financial risk is important to health plans primarily because itmotivates plan members to avoid seeking unnecessary medical treatments, and thus makes theplan member a partner with the health plan in controlling utilization rates. Similarly, some typesof provider reimbursement contracts contain elements that financially motivate providers to avoidsupplying medically unnecessary treatments. We discuss these reimbursement contracts in thenext few lessons.

Accepting the Risk

The final general strategy for controlling risk that businesses as well as individuals use is toaccept the risk. To accept the risk means to assume financial responsibility for the risk. In ahealth plan environment, health plans typically accept the risks we have discussed in this lesson,particularly underwriting risk, utilization risk, and various types of business risk. A health planthat provides a healthcare plan to a group often accepts some or all of the utilization risk withinthe terms of that group contract. In this case, the group seeking coverage is transferring risk, butthe health plan is accepting risk.

By definition, accepting risk exposes an health plan to the possibility of losses. The financialoutcome of accepting risk in exchange for premiums or other payments largely depends on howwell the health plan is able to predict the costs associated with the risk, and how well the healthplan is able to manage those costs. In the next few lessons, we discuss the means by which healthplans adjust the total amount of risk they are exposed to and some of the methods health plans useto manage the costs of those risks. We also discuss how health plans predict the costs of the risksthey agree to accept, and set premiums at an appropriate level.

Early in this lesson we noted that the general goals of risk management for a health plan involveassuring that the organization survives, operates efficiently, sustains growth and effectiveness,and, in the case of publicly owned for-profit health plans, increases shareholder value. While riskmanagers seek to achieve each of these goals, they must also balance the actions of theorganization so that the achievement of one goal does not prevent the achievement of the others.A health plan that seeks to maximize growth and profit will spend considerable effort incontrolling costs at all operating levels, but will not cut expenses that are vital to the health plan’scontinued survival. For example, a health plan will bear the expense of verifying that thehealthcare providers with which it contracts have proper credentials, because for regulatory andliability-exposure reasons a health plan would not survive if it negligently contracted withunqualified providers. Similarly, a for-profit health plan will retain sufficient liquid assets toremain solvent rather than distribute all earnings to shareholders, because remaining solvent is anecessary condition of the health plan’s survival.

In general, the acceptance of risk by an health plan implies that the health plan is prepared tomanage that risk. Risk management is a process in the sense that, for many risks, the health plan’smanagement must expend resources on the control of that risk for as long as the risk is present.The next lesson will explore this process in more detail.

Endnotes

1. Adapted from Harriett E. Jones and Dani L. Long, Principles of Insurance: Life, Health,and Annuities (Atlanta: LOMA, © 1996), 3–4. Used with permission; all rights reserved.

2. Adapted from Harriett E. Jones and Dani L. Long, Principles of Insurance: Life, Health,and Annuities (Atlanta: LOMA, © 1996), 4. Used with permission; all rights reserved.

3. Susan Conant et al., Managing for Solvency and Profitability in Life and HealthInsurance Companies (Atlanta: LOMA, 1996), 35.

4. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMA’s Glossary of Insurance Terms,3rd ed. (Atlanta: LOMA, 1997).

5. Adapted from Academy for Healthcare Management, Health Plans: Governance andRegulation (Washington, D.C.: Academy for Healthcare Management, © 1999), 5-2–5-20. Used with permission; all rights reserved.

6. Garry Carneal, “State Regulation of Health Plan,” in Essentials of Managed Health Care,ed. Peter R. Kongstvedt, M.D., 2nd ed. (Gaithersburg, MD: Aspen Publishers, Inc.,1996), 454.

7. Academy for Healthcare Management, Health Plans: Governance and Regulation(Washington, D.C.: Academy for Healthcare Management, 1999), 7-36.

8. David F. Johnson and Gene Stone, Intro to Economics (Atlanta: LOMA, 1998), 3.

AHM Health Plan Finance and Risk Management: Risk Management in Health Plans

Risk Management in Health Plans

Course Goals and ObjectivesAfter completing this lesson, you should be able to

List some of the factors that may give rise to the assumption of an agency relationshipbetween health plans and their providers

Discuss some measures a health plan might take to limit the liability associated withcredentialing its providers

Explain some of the ways a risk manager can reduce or eliminate risk exposures relatedto utilization review

List some of the actions that a risk manager can take in managing the process ofproviding healthcare in a health plan environment

Risk management has been in a period of evolution almost since it first became an importantfunction in the healthcare setting. In the mid-1970s, the healthcare risk management professionemerged in response to the malpractice crisis surrounding the availability of liability insurance.1

Although, the basic concepts for healthcare risk management were adopted from the insuranceindustry, over the past two decades the discipline of healthcare risk management has taken onmany important characteristics and unique functions. Although there are clear risks associatedwith benefits administration, contracting, and other activities, the bulk of risks in health plans isassociated with the provision of healthcare services and coverage decisions surrounding that care.In addition, providers face risks associated with health plans beyond those faced by health plans.Therefore, this lesson focuses particularly on those issues.

Risk management has changed from an activity that sought solely to transfer risk through thepurchase of commercial insurance or the financing of risk through the establishment of a self-insured trust or investment fund to a profession where education, proactive risk control and riskmodification, and risk financing and risk transfer are merged into a partnership. The overall goalsof the partnership enable the organization to be responsive to the needs and demands of thehealthcare industry and to provide safe and effective care to patients. The organizational goals ofensuring financial stability in the event of an adverse outcome are still consistent with the goals ofthe healthcare risk manager, but risk managers also find that their work takes them out of thefinance department and into those clinical and operational areas where the risks are created.

Specific objectives in risk management programs relate to the organization’s desire to ensuresurvival, maximize efficiency, and sustain growth and effectiveness. This is accomplishedthrough the identification, control, management, elimination, transfer, or financing of risk.Achievement of these objectives is accomplished by interacting with internal and externalcustomers of the organization that demand low-risk, high-quality, cost-effective service.Management may have different priorities in seeking efficiency and growth, particularly as healthplans continue to dominate the marketplace.

The primary targets or strategies of management could relate to gaining market share, increasingthe overall number of relationships and contracts with payers, increasing sales or service volume,ensuring continuity of performance, maintaining the quantity of controlled resources, or otheritems expected to produce desired long-term financial results. These targets may be sought

without appropriate consideration of the inherent risks that may also be assumed by adoptingthose strategies.

The goals identified to achieve market success may not be the most efficient or effectivestrategies from a risk management perspective. To achieve favorable results from both a riskmanagement and an organizational perspective, the risk manager must recognize how the internaland external changes in healthcare created by managed care influence or enhance risk. The riskmanager should begin to plan a strategy by first identifying how the organization is influencedfrom a risk perspective due to managed care (Figure 2B-1 and Figure 2B-2). After thisassessment, the risk manager should work with administration to determine critical successfactors that will define risk management success for the organization (Figure 2B-3).

Once the key measures of success have been agreed upon, the risk manager can develop a plan toprotect the organization and help it progress. The risk manager’s role and the challenges posed bythat role will not differ significantly if the risk manager is employed by a health plan, a hospitalthat seeks to be the hub of an integrated delivery system, or a network that forms to be able tocompete under health plans. Thus this lesson has been written to focus on the key riskmanagement issues created by health plans as opposed to a specific job that a risk manager mightassume given potentially differing structures. Many of the legal and risk management challengescreated by managed care will exist regardless of the employer. The customers of the risk managerwill include not only those in administration and finance but also physicians, nurses, and externalcustomers. As health plans become more prevalent, risk managers must develop new knowledgeand utilize existing and new skills and techniques to identify the new risks created, designcreative strategies for managing those new risks, and provide education and information to anever increasing and divergent customer base.

Changes in the Healthcare Organization Related to Health Plans

Health plans initially started out as "discount medicine," but it has now evolved to actualmanagement of medical care by providing the patient with the appropriate level of care in theappropriate setting. In his book Making Managed Health Care Work: A Practical Guide to

Strategies and Solutions, Peter Boland states the following: "Managed care alter the decisionmaking of providers of healthcare services by interjecting a complex system of financialincentives, penalties, and administrative procedures into the doctor-patient relationship. Managedcare often attempt to redefine what is best for the patient and how to achieve it mosteconomically."2

This statement implies altering and directing care to gain a cost advantage, which is risky if it isat the real or even perceived sacrifice of quality. Health plan administrators, insurance providers,and risk managers are becoming increasingly aware of the development of new case lawassociated with managed care, particularly how quality or access is limited by strict utilization orfinancial restrictions and how that limitation can pose a significant financial risk to theorganization. Learning how to identify proactively these and other potential new exposuresassociated with managed care and how to control or eliminate them will be a challenge and willbe at the core of the risk manager’s responsibility.

This statement implies altering and directing care to gain a cost advantage, which is risky if it isat the real or even perceived sacrifice of quality. Health plan administrators, insurance providers,and risk managers are becoming increasingly aware of the development of new case lawassociated with managed care, particularly how quality or access is limited by strict utilization orfinancial restrictions and how that limitation can pose a significant financial risk to theorganization. Learning how to identify proactively these and other potential new exposuresassociated with managed care and how to control or eliminate them will be a challenge and willbe at the core of the risk manager’s responsibility.

Historically, health plans have faced minimal professional liability exposure, especially comparedwith other healthcare organizations. In large part, this is the result of the broad and well-publicized protection provided by the Employee Retirement Income Security Act of 1974(ERISA).3 That protection includes barring jury trials and punitive damage awards, limitingcompensation to medical expenses, and preempting actions against a health plan for the"administration" of an ERISA-qualified employee benefit plan.4 The Federal Employee HealthBenefits Act can also afford some protection for federal employee benefit plans.5 These statutoryprotections have their limits, however, and the risk manager must develop a clear understandingof the new risks that may be created under managed care and are not afforded statutory protectionand must develop strategies to manage them.

The changes in the organization relative to health plans created new operational and clinical risksand opportunities for risk management. No longer are the risks contained within the walls of aprovider organization; rather, the risks now follow the patients to whom the health plan hasagreed to provide services. This may result in making the environment more difficult to controlfor the risk manager. In addition, with the movement away from high-technology specialties,many organizations may find the need to identify and engage providers with a focus on primarycare and prevention. This group of professionals may include physicians but may also includenurse practitioners, physician assistants or extenders, social workers, and other healthcareprofessionals. Credentialing, reappointment, privilege delineation, and definition of the scope ofservice for an enhanced range of caregivers will be essential components of the risk manager’sjob.

Operational Risks Under Managed Care

Operational risks are enhanced under managed care. For example, a provider organizationbecomes more complex as it attempts to compete by becoming part of an integrated deliverysystem. New business risks can create corporate liability, both direct and indirect (vicarious). Arisk manager whose responsibility is to manage the risks of the health plan must be mindful of thebusiness and clinical risks created. Health plans can pose the following risk concerns that will benew challenges for the organization’s risk manager:

Coordinating the appropriate amount and level of care, by appropriate providers, throughutilization management activities.

Negotiating arrangements with selective providers with proven skills and competence toprovide comprehensive services identified in the contracts.

Ensuring that the financial incentives provided by the contract are sufficient to sustain theorganization and that the potential for catastrophic financial risk is understood andappropriately funded for or transferred. (Relative to financial risk management, the riskmanager should also be cognizant of the potential double-edged sword created by the useof financial incentives to providers. In a positive sense, these types of incentive structurescan help support the provision of efficient, effective, and appropriate service. They canalso, however, be seen as a reward system that inappropriately incents physicians to denyneeded care to patients in exchange for increased compensation.)

Understanding the nature of the new clinical risks created and proactively designingsystems or structures to eliminate or control them.

Figure 2B-4 illustrates the relative risk for health plan structures based upon the degree ofinfluence and relationships that the health plan maintains with its providers.6 It is only through ananalysis of the health plan’s business and an understanding of the relative risk associated withthat business that one can develop a comprehensive risk management plan to ensure that all riskscreated are eliminated, managed, controlled, or transferred.

Direct Liability

Corporate negligence claims arising from health plans pose new risks for the risk manager.Corporate liability claims are based on the premise that the healthcare entity or health plan has alegal duty to protect the patient from harm. This responsibility can be deemed to be abrogatedwhen negligent providers are employed by the health plan and render care to patients that is

determined to be negligent. The need to develop rigorous screening procedures for potential staffmembers and to follow those procedures is an important risk management function in this newenvironment and should be carefully monitored to verify adherence.

Under the doctrine of corporate negligence, a health plan and its physician administrators maybe held directly liable to patients or providers for failing to investigate adequately the competenceof healthcare providers whom it employs or with whom it contracts, particularly where the healthplan actually provides healthcare services or restricts the patient’s/enrollee’s choice of physician.Health plans and their physician administrators may be held liable for bodily injury topatients/enrollees resulting from improper credentialing of physicians or for economic orcompensatory damages to providers as a result of credentialing activities (e.g., unlawful exclusionfrom provider networks or staff decertification). The doctrine of corporate negligence may alsoapply to other health plan activities besides credentialing, such as performance of utilizationreview.

Under the theory of negligent or improper design or administration of cost control systems, ahealth plan and its physician administrators may be held liable when they design or administercost control systems in a manner that interferes with the rendering of quality medical care orcorrupts medical judgment. To date, most litigation involving allegations of negligentadministration of a cost control system have involved utilization review activities of health plans.

Health plans and their physician administrators are also susceptible to antitrust liability forviolations of federal and state laws, which generally prohibit the unlawful restraint of trade,monopolies, price fixing and discrimination, group boycotts, illegal tying arrangements, exclusivedealing, and other arrangements that are anticompetitive. Antitrust problems may arise whenentities engage in collective actions that reduce competition in a given market. Antitrust problemscan arise early in a market where health plans encourage the combining of the services of formercompetitors to facilitate service delivery. A balancing test must be performed to ensure that thebenefits gained by combining outweigh the danger posed by limiting competition of those entitiesoutside the agreement. Health plan networks are also likely to face an increased number ofantitrust lawsuits from providers and competitors as they gain increased market share. The largera health plan becomes in a particular area, the fewer opportunities available to the provider who isnot part of the network.

In addition, health plans and their physician administrators face corporate exposure to directliability for various forms of discrimination, for example discrimination in benefit design,underwriting, claims adjudication, credentialing, treatment, employment, and contracting. Thefollowing pieces of legislation may give rise to of discrimination in specific health plans:

The Family and Medical Leave Act of 1993 The Americans with Disabilities Act of 1992 The Civil Rights Act of 1991 The Age Discrimination in Employment Act of 1967, including the Older Workers

Benefit Protection Act of 1990 Title VI of the Civil Rights Laws of 1964, as amended (1983), including the Pregnancy

Discrimination Act of 1978 The Civil Rights Act of 1966, Section 1981 The Fifth and Fourteenth Amendments of the U.S. Constitution

In addition, health plans and their physician administrators face corporate liability for invasion ofprivacy of providers for improper dissemination of information regarding credentials orcompetence to the National Practitioner Data Bank or other third parties or of patients/enrolleesfor improper dissemination of their records or information pertaining to their health. They mayalso be sued by providers, patients, or employees for defamation, particularly in connection withtheir peer review activities. In such an event, however, they may be entitled to qualified immunityunder the Health Care Quality Improvement Act of 1986 (HCQIA).

Vicarious Liability

Under the theory of vicarious liability or ostensible agency, hospitals have been held vicariouslyliable for the acts, errors, and omissions of their independent contractors. By definition, aprovider is an independent contractor in independent practice associations and direct contractmodels. Therefore, the health plan should not be responsible for negligent acts unless the healthplan has given the impression that these providers are acting as agents of the health plan. Thedecisions of the courts to uphold claims based on ostensible agency depend on many factors,applicable state statutes, the ability of the plaintiff’s attorney to demonstrate the apparent agencyrelationship, and other aspects of the provider-health plan relationship as viewed by the courts.

Because "appearance" or perception seems to be the major issue driving the ostensible agencyargument, it might be wise for the risk manager to consider some of the circumstances that mightlead the public to assume that an agency relationship exists and to make the necessaryarrangements to control these potential exposures. Factors that may give rise to the presumptionof the existence of an agency relationship include:

Supplying the provider with office space Keeping the provider’s medical records Employing other healthcare professionals, such as nurses, laboratory technicians, and

therapists, to support the physician provider Developing promotional or marketing materials that allow a relationship to be inferred

The risk manager may wish to review documents provided to patients to ensure that the physicianis described as an independent practitioner and that there is a clear distinction between thoseservices provided by the health plan and those provided by the physician.

Clinical Risks

Managing clinical risks has been an activity of pivotal importance for the healthcare riskmanager. This activity continues to be important, but there have been changes in its complexityunder health plans. Specific risks that require control and relate to the provision of clinical careinclude risks associated with credentialing, risks associated with clinical decision making (e.g.,rationing of care), risks associated with utilization review, and risks associated with adhering toexternally imposed standards of care.

Credentialing

Credentialing is a risk management function that considers who the healthcare provider is in thehealth plan and what the provider can do.7 In an effort to facilitate the credentialing process andreduce administrative burdens and costs, some entities may choose to participate in a jointcredentialing process. This process might include a consolidation of credentialing procedures and

a sharing of the information requested as part of the process. It will be important to haveappropriate releases signed by the professional being credentialed so that there can be nosubsequent claims for breach of confidentiality.

In general, a credentialing process must be developed that allows for the successful selection andretention of high-quality providers who understand and support the mission and vision of theorganization or network with which they work.

CredentialingMeasures that might be instituted to prevent or limit liability associated with credentialing includeestablishing realistic criteria, ensuring that the data being measured and evaluated are accurate,conveying and evaluating the criteria on a consistent basis, and creating a paper trail clearly tyingquality to the economic credentialing process. 8 The following is a checklist for risk managers tokeep in mind when setting up a credentialing process:9

Review Credentialing Policies and Procedures- Review credentialing criteria forcompliance with state statutes, standards for health plans, Joint Commission onAccreditation of Healthcare Organizations standards, Medicare conditions ofparticipation, National Committee for Quality Assurance, and court decisions.

Review Application Forms Review application forms for compliance with standards andlocal, state, and federal regulations.

Review Protocols Review protocols for investigating and verifying an applicant’scredentials. Do these protocols minimize the risk of inadequately screening and verifyingthe credentials of practitioners?

Observe Methods Observe the methods by which these protocols are applied inreviewing individual applicants. Are protocols applied equally to all applicants whetherthey are well known or not?

Evaluate Organizational Structure Evaluate the organizational structure of thecredentialing process. Are checks in place to minimize the involvement of directeconomic competitors in the credentialing process? Does the structure minimize the riskof creating antitrust liability?

Review Due Process Provisions Review due process provisions to ensure thatpractitioners who are denied medical staff membership or have had privileges restrictedare afforded a fair hearing in accordance with federal and state laws and standards.

Require Practitioners To Report Require all practitioners to report claims, disciplinaryproceedings, or adverse actions taken against them at other facilities or hospitals. Ensurerisk management access to these records.

Ensure HCQIA Compliance Ensure that HCQIA regulations are complied with and thatinformation from the National Practitioner Data Bank is used appropriately incredentialing and privileging determinations.

Establish Rapport Establish rapport with practitioners to facilitate open communication,education, and resourcefulness regarding risk management issues.

Review Policies, Procedures, Bylaws, and Contracts Review policies, procedures,bylaws, and contracts to ensure that all credentialing criteria are clearly stated.

Review credentialing policies and Procedures Review credentialing policies andprocedures of other hospitals, facilities, and credentialing services whose credentialingdecisions are used instead of an internal process.

Clinical Decision Making

One of the most frequently verbalized fears relative to health plans is that it will create a systemwhereby care is predicated on a person’s ability to pay or upon an externally imposed system ofvalues that dictates which medical conditions are appropriate for specific types of intervention. Ingeneral, when these issues and concerns are voiced they relate to the denial of interventionsdeemed to be extraordinary or experimental to patients with terminal conditions or conditionswhere the treatment may not result in a cure but may only serve to delay inevitable furtherance ofthe disease. Although much of the discussion thus far seems to be fueled more by fear than fact,making care decisions based on reasons other than best medical judgment is risky and thus shouldbe avoided. Risk managers can assist in limiting these types of risks by determining that policiesare in place that clearly indicate that care decisions are not predicated on the ability of the patientto pay or the willingness of the payer to reimburse but rather are based on sound medicaljudgment that is rendered consistent with appropriate professional standards of care. Many ofthese decisions also are linked to an area of well-developed case law in health plans, that lawrelated to utilization review activities.

Utilization Management Issues

Controlling the parameters of care through a well-detailed utilization review process is animportant component of cost controls associated with health plans. Court cases havedemonstrated that a plan’s utilization review process is an operational exposure with the potentialfor considerable financial risk. A well-structured utilization review program is designed to limitthe potential risks associated with attempts to structure care around predetermined criteria. Theprogram should allow for retrospective, concurrent, and prospective review of care providedunder the health plan. It should be remembered that underutilization presents real threats toquality and risk just as overutilization presents threats to cost control.

Merging Case Law

The seminal case describing the liability that can attach to an organization with inappropriateutilization criteria is Wickline v. State of California.10 This case addressed the legal implicationsof preadmission certification of treatment and length of stay authorization. In this case, suit wasbrought against the state of California alleging that its agency for administering the medicalassistance program was negligent when it only approved a 4-day extension of the plaintiff’shospitalization when an 8-day extension was requested by the physician. Plaintiff’s attorneyalleged that the discharge was premature, resulting in the ultimate amputation of the plaintiff’sleg. The physician requesting the 8-day extension did not appeal the decision of the state agency.Neither the hospital nor the physician was the defendant in this decision.

A jury returned a verdict in the plaintiff’s favor on the grounds that the plaintiff had sufferedharm as a result of the negligent administration of the state’s cost control system. The trial court’sdecision was reversed by the appellate court, which found that the state had not been negligentand therefore was not liable. The court held that the state was not responsible for the physician’sdischarge decision and that a physician who complies without protest with limitations imposed bythird party payers when the physician’s medical judgment dictates otherwise cannot avoidultimate responsibility for the patient’s care. The court did acknowledge, however, that an entitycould be found liable for injuries resulting from arbitrary or unreasonable decisions thatdisapprove requests for medical care. The court emphasized that a patient who requires treatmentand is harmed when care that should have been provided is not provided should recover for the

injuries suffered from all those responsible for the deprivation of such care, including, whenappropriate, healthcare payers. The court went on to say that third party payers can be held legallyaccountable when medically inappropriate decisions result from defects in the design orimplementation of cost containment mechanisms. The court concluded from the facts at issue inthis case that the California cost containment program did not corrupt medical judgment andtherefore could not be found liable for the resulting harm to the plaintiff.

In another case, Wilson v. Blue Cross of California, plaintiffs alleged that their son’s suicide wasdirectly caused by the utilization review firm’s refusal to authorize additional days of inpatienttreatment.11 The patient had been admitted for inpatient psychiatric care for depression, drugdependency, and anorexia. His physician recommended 3 to 4 weeks of inpatient care, but theutilization review firm only approved 10 days. The patient was discharged and committed suicideless than 3 weeks later by taking a drug overdose. The trial court granted summary judgment infavor of the defendants. The appellate court reversed this decision, concluding that the insurercould be held liable for the patient’s wrongful death if any negligent conduct was a substantialfactor in bringing about harm. Testimony of the treating physician indicated that, had thedecedent completed his planned hospitalization, there was a reasonable medical probability thathe would not have committed suicide. The court concluded that whether the conduct of theutilization review contractor’s employee was a substantial factor in the patient’s suicide was aquestion of fact precluding summary judgment and remanded the case for further review. Onretrial, the jury entered a verdict in favor of the defendants.

Litigation for utilization review decisions may also be brought under theories of bad faith andbreach of contract based on the contractual nature of the relationship between the health plan andits patient members

Reducing Utilization Management Exposure

The risk manager attempting to work with providers in the organization can provide the followingadvice to assist physicians in the reduction or elimination of exposures related to utilizationreview:

Devise a comprehensive utilization management program. Devise a comprehensiveutilization management program that integrates with quality and risk management.Individuals performing utilization management functions should utilize patient outcomeindicators as a means of identifying quality of care or risk problems.

Physicians must exercise independent medical judgment that meets with thestandard of care. Physicians must exercise independent medical judgment that meetswith the standard of care. Utilization management decisions should not influence thephysician’s clinical decisions in any way that the physician would consider truly harmfulto the patient.

Providers must advise the health plan of their medical judgment. Providers mustadvise the health plan of their medical judgment. The physician needs to be aware of eachplan’s utilization review process and to advise the plan of his or her medical judgment inclear terms. If a disagreement arises, the physician may need to support the validity of theclinical recommendations with documentation as to the medical necessity. Includingdiagnostic test results and providing an opinion as to the possible adverse outcomesshould the request be denied will also be helpful.

Develop a "fast-track" second opinion program. Develop a "fast-track" secondopinion program. Providers need to support the development of a system that can quickly

render a second opinion in case of disagreement surrounding clinical judgment. Ideally,the second opinion should be rendered by a healthcare professional whose skill andtraining are commensurate with those of the provider whose judgment is beingquestioned.

The patient should be informed of any issues that are being disputed. The patientshould be informed of any issues that are being disputed relative to the physician’srecommended treatment plan and the health plan’s coverage decision. Alternativeapproaches and the potential cost and outcome of those approaches should be discussedwith the patient. Also, the patient should be informed that, if the plan continues to denycoverage, the patient may be responsible for payment. The patient should continue to beinformed throughout the appeal process.

Exhaust the appeals process. Exhaust the appeals process. In the event that the treatingphysician firmly believes that the health plan has made an incorrect decision, then thebest defense in cases of treatment denials is staunch patient advocacy. The physicianshould request to speak to the medical director in charge of the utilization decision andexplain the rationale behind the intended treatment. If a plan continues to deny coveragefor a service that the physician feels is necessary, the process that allows for a secondopinion fails to support treatment, and the physician continues to believe that the denialof coverage is in error, then the decision should be appealed aggressively. All avenues ofappeal should be exhausted. If unsuccessful, the physician should inform the patient oftreatment opinions without regard to coverage. The patient must ultimately decidewhether to continue treatment at his or her cost. If the patient should wish to proceed athis or her own expense, the physician should have the patient sign an informed consentsignifying awareness that such expenses may not be covered by the health plan.

Ascertain that insuring agreements include coverage for utilization review activities.

Externally Imposed Practice Guidelines or Standards of Care

Many clinicians are particularly concerned about the development of practice guidelines that seekto define appropriate services that should be provided to a patient given a specific condition. Insome instances, these guidelines are used to support utilization management decisions; in others,they may be developed in attempts to define best practice. Although developers often argue thatbest practice determinations are predicated on an evaluation of effectiveness, some providersbelieve that under health plans best practice really means lowest cost. To avoid the risks that arelikely to be associated with the use of guidelines, clinicians should be assured that the existenceof a guideline does not in and of itself create a standard of care and that guidelines, although theymay be instructive, do not set standards of care (although well-developed guidelines shouldarticulate agreed-upon standards of care). Risk managers should advise clinicians that, despite theexistence of a guideline, their skill and judgment based on a careful assessment of the patient’scondition can and should preempt the recommendations of a guideline. Case law, at least to date,supports this position.

Multisite Challenges

The sheer number of sites where clinical care may be provided or that have affiliation or networkagreements makes it essential that the risk manager create tools that can empower staff at thesesites to understand and manage their own risks. Risk management will increasingly become aresponsibility of all staff who will rely on the risk manager for support and advice but willultimately be responsible for on-site control of risks inherent in the operation of their business.

Tools that are developed should focus on those proactive strategies that enable all healthcareprofessionals working in a particular area to identify issues unique to their area that may give riseto risk and to modify those risks in a manner that will allow for a safer environment with staffincreasingly aware of the risks inherent in providing care in a specific area or setting. Tools thatcontain specific questions about an area can be developed and are useful for assisting managerand clinicians in recognizing and managing their own risks.

Capitation

Health plan contracts create both opportunity and risk for healthcare organizations. Under manycontracts the reimbursement from payers is capitated, with the healthcare organization receiving afixed sum per member per month regardless of the intensity of services that the member receives.Understanding the financial risks assumed under these contracts and either funding for those risksor transferring them to a third party require many of the same skills that the risk manager uses tomanage the clinical risks that are part of all healthcare organizations. Once the total risk beingassumed is quantified, the risk manager, working with the chief financial officer or health planadministrator, can evaluate the best ways either to fund for or to transfer this risk.

Financial Incentives and Cost Control Programs

Incentive payment systems link provider compensation to the provision of cost effectivehealthcare. An incentive system is meant to encourage providers to render only care that isnecessary and appropriate. Financial incentives can take a variety of forms, and depending on theoutcome of care patients may view the incentive programs as having influenced their providers’medical decision making.

Cases are beginning to emerge that allege that physicians whose salaries are based in part on anincentive structure that predicates payment for services based on utilization of services maketreatment decisions based more on their financial reward than on the well-being of the patient. Itis imperative that financial incentives be structured in such a way that they do not have theappearance of encouraging this type of behavior.

Whether the cost control program of the health plan creates a financial incentive for physicians toprovide inadequate treatment was raised in a recent legal opinion.12 The case involved a delay inthe diagnosis of cervical cancer due to the failure of the primary care physician to order a Papsmear. In this case, a health plan participant brought suit against the health plan alleging that thecontractual agreements between the health plan and its providers encouraged physicians not torefer patients to specialists. The court found that the plaintiff had offered evidence establishingthat the cost control system contributed to the delay in diagnosis and treatment. A formal opinionon this issue was never rendered, however, because the case was settled during trial for anundisclosed amount.

In another well-publicized case, Fox v. HealthNet, a California jury awarded nearly $90 millionto the estate of a breast cancer patient arising from the refusal of the health plan to pay for a bonemarrow transplant: $77 million was awarded as punitive damages.13 The health plan consideredthis procedure experimental and would not pay for any experimental treatment until it was proveneffective. According to reports in the press, testimony at trial included that of two women forwhom the health plan had approved identical treatments as proof that the treatment might haveworked.14 Furthermore, it was shown that the physician executive who denied payment for thebone marrow transplant received bonuses based on the denial of costly medical procedures. The

jury concluded that the health plan acted in bad faith, breached its contract of care with itssubscriber, and intentionally inflicted emotional distress.

This case represents a good example of how denial of access to treatment can expose a healthplan to liability. It also demonstrates how the emotional impact and negative publicity associatedwith the denial of treatment, even if the treatment has not been proven effective, can influence theultimate decision and the damage award. In a health plan environment, the primary carephysician, in conjunction with the health plan, acts as a gatekeeper in determining what hospitalor specialty physician services should be provided. The failure to meet the applicable standard ofcare in making these decisions can expose the primary care physician and the health plan toliability. In the Fox case, the treating physician recommended the treatment with the support ofthe two other health plan physicians who had used it for the two witnesses in the case, and thehealth plan, as gatekeeper, refused to pay for it.

These cases reveal that courts are willing to impose liability on health plans when inappropriatemedical decisions result from defects in the design or implementation of the cost containmentprograms, breach of contract, or bad faith in the denial of payment. The impact of a health plan’sfinancial incentives to contain costs has also been tested. If financial incentives result ininadequate treatment being rendered, the health plan could be held liable. These cases indicatethat members will seek redress if harmed as a result of the administration of cost controlprograms which deny them access to care, which delay care, or which deny payment fornecessary care.

Avoiding Liability Associated with Cost Control Programs

The design and administration of cost control programs should promote efficient care but mustnot corrupt the medical judgment of the physician. If a health plan overrides the medicaljudgment of the physician, it could be held liable for the consequences of the treatment ordischarge decision. To avoid liability in this regard, a health plan needs to ensure that its financialincentive and cost control programs include procedures that accomplish the following:

Utilize medical necessity criteria that meet acceptable standards of medical practice Review all pertinent records in determining the necessity of treatment Contact the treating physician before certification is denied Allow sufficient time to review the claim before denial Ensure that medical personnel approving payment denials are appropriately trained, have

met established minimum qualifications, and have the requisite knowledge to assess theappropriateness of care

Maintain policies and procedures that ensure that operations do not interfere with thephysician-patient relationship regarding the duration and level of medical care

Carefully document procedures used to deny certification of care (coverage restrictionsneed to be adequately described in materials given to health plan members, especiallywith respect to experimental or investigational treatments)

Devise a mechanism for communication of programs to members, especially financialincentive programs

Risk Financing

The professional liability and business risks that are associated with health plans have fairlyconsistently been insurable under standard insurance contracts. Many creative products and

concepts are being developed for the control or minimization of the financial risks that areinherent in capitated contracts or for the balance sheets fluctuations that are possible during aperiod of time when there is considerable volatility in the financing of healthcare services. Theconcepts underlying the financing of all these risks are the same and are consistent with the riskfinancing skills that were practiced by many risk managers before the emergence of health plans.

Utilizing the Risk Management Process to Control the Risks of Health Plans

The risk management process is generally structured around loss reduction techniques (whichinclude the identification of risk, the elimination of risk whenever possible, and the control ormanagement of risk when it cannot be entirely eliminated) and loss transfer (techniques whichinclude determining the economic risk associated with various types of loss and selection of thebest methods either to finance risk internally or to transfer those risks to a third party, generallythrough the purchase of insurance). These processes can be successful in managing the emergingrisks that are created by a managed healthcare system. Obviously, the techniques will need to betailored to the specific needs of each organization, particularly as health plans becomeincreasingly dominant.

Because it is essential that the risk manager understand the scope of potential risk in the hospital,health network, or integrated delivery system, the first step will be to develop effectivecommunication links with those parts of the organization that are responsible for the strategicgrowth of the hospital into a health plan partner or into the hub of a health plan network.Anticipating risk and being able to plan for it will greatly enhance the likelihood that risks createdby the new delivery model will be capable of being controlled. Educating all staff, includingadministration and healthcare providers, about the emerging risks that are associated either withthe delivery system created by health plans or with the clinical delivery system that is moredecentralized because of health plans will be an important function for the risk manager. The riskmanager may achieve the greatest success by developing tools that can be used by others to assessand manage their own risk. Making each member of the healthcare team responsible formanaging the risks created by this complicated new healthcare delivery model will be the onlyway to ensure success.

Conclusion

Risk managers must continually monitor emerging risks and design comprehensive strategies formanaging them. Unlike the traditional role of the risk manager in a hospital, where a singleperson or a designated risk management staff is central to the risk management effort, in a healthplan or integrated delivery system everyone will have to become engaged in the process ofproactively identifying and managing risks. A brief checklist follows that will assist the riskmanager in managing the process of providing healthcare in a health plan environment:

Design department-, unit-, or function-specific assessment tools that can be used easilyby managers and clinicians to assess risks associated with specific environments oractivities. Make risk management everyone’s responsibility!

Continually monitor case law and developing trends in health plans and design a systemto provide information about new developments to all staff working in the health plan ornetwork.

Never underestimate the importance of a rigorous credentialing process that allows forthe careful screening of all healthcare providers—physicians and advanced practitioners.

Make certain that this process is in compliance with state and federal law and that itmeasures both credentials and competence.

Verify that a comprehensive process exists for utilization management activities.Ascertain that decisions about patient care are based on the best interest of the patient, notprimarily the financial interest of the provider or the health plan.

Develop a system that allows risk managers to be involved in the assessment of potentialnew business opportunities or entities before their becoming part of the organization ornetwork. This will allow for a clear understanding of the risks to be assumed and for thedevelopment of a plan to control, eliminate, or transfer those risks.

Develop the risk management role as one of a consultant whose advice and expertise aresought whenever issues of potential liability arise.

Endnotes

1. B. Youngberg, Essentials of Hospital Risk Management (Gaithersburg, Md.: Aspen,1990).

2. P. Boland, Making Managed Health Care Work: A Practical Guide to Strategies andSolutions (Gaithersburg, Md.: Aspen, 1993).

3. Employee Retirement Income Security Act of 1994, 29 U.S.C. Section 1001 et. seq.4. Corcoran v. United Healthcare, Inc., 965 F.2d 1321 (5th Cir. 1992), cert. denied, 113

S.Ct. 812 (1992).5. Federal Employees Health Benefits Act, 56 U.S.C.A., Section 8901 et. seq.6. R.J. Hester, “Health Plan Liability Concerns,” in 1992 Health Care Law Update (Florida

Bar Lecture Program, 1992).7. B. Youngberg, Managing the Risks of Health Plan (Gaithersburg, Md.: Aspen, 1996).8. C.S. Doyle, Managing the Risks of Health Plan, Journal of Healthcare Risk Management

14 (1995): 3–7.9. S. Hagg-Rickert, Medical Staff Credentialing and Privileging Determinations: The

Emerging Role of the Risk Manager, Perspectives in Healthcare Risk Management 11(1991): 2–4.

10. Wickline v. State of California, 192 Cal.App.3d 1630, 239 Cal. Rptr. 810 (Ct. App.); cert.granted, 727 P.2d 753, 231 Cal. Rptr. 560 (1986); review dismissed, case remanded, 741P.2d 613, 239 Cal. Rptr. 805 (1987).

11. Wilson v. Blue Cross of California, 271 Cal. Rptr. 876 (Cal. Ct. App. 1990), reviewdenied, No. S017315, 1990 Cal. LEXIS 4574 (Cal. 1990).

12. Bush v. Dake, File No. 86-25767 No-2 (Mich. Cir. Ct. 1987).13. Fox v. HealthNet, No. 219692 (Cal Super. Ct. 1992).14. Los Angeles Times (7 April 1994): D-1.

AHM Health Plan Finance and Risk Management: Provider Reimbursement and Plan Risk

Course Goals and ObjectivesAfter completing this lesson you should be able to

Discuss the three main drivers of complexity in the healthcare regulatory environment Describe the influence of the Department of Health and Human Services, the Department

of Labor, the Office of Personnel Management, and the Department of Defense on thehealthcare environment

Explain the financial effects that mandated benefit laws and regulations have on healthplans

Our discussion of provider reimbursement and plan risk begins with a review of theoverall regulatory environment in which health plans operate. Next, we discuss specificfederal and state laws and regulations that affect the healthcare environment.

The Regulatory Environment

The regulatory requirements that apply to healthcare financing, contracting, and delivery in theUnited States are numerous and complex. Many general business laws and regulations governinglabor, taxes, and contracts apply to health plans much as they apply to other businesses. Inaddition, healthcare in general, and health plans in particular, are subject to a vast array ofindustry-specific laws and regulations. Broadly speaking, there are three main drivers ofcomplexity in the healthcare regulatory environment.

1. The number of agencies that are sources of regulations or that have regulatory authorityover health plans.

Agencies in both the federal and state governments regulate various aspects of healthcare in theUnited States, and in each level of government, multiple agencies have at least some regulatoryauthority. State departments of health and departments of insurance typically share responsibilityfor regulating many aspects of healthcare. The division of this responsibility between the twoagencies, however, varies from state to state. Various agencies typically administer federalprograms that affect health plans. For instance, the Department of Health and Human Services,through the Centers for Medicare and Medicaid Services (CMS), administers Medicare andMedicaid. A comprehensive list of government agencies that regulate health plans on all levelswould be extremely long, because health plans are subject to tax, labor, and other general lawsjust as any business is. Generally, the larger the number of agencies that have regulatory authorityover an industry, the more complex the industry’s regulatory environment. The more complex theregulatory environment, the more expensive a business’s compliance operations, all other factorsbeing equal.

2. The relative complexity of both the practice of medicine and the management of healthplans.

The complexity of modern medicine directly affects the ways in which health plans are regulated.Because health plans are corporations, they cannot practice medicine in most states. Thus, healthplans provide health plans that bridge the gap between providers, payors, and members. In doingso, health plans must consider the regulations that affect each of these groups and the goals thatthese groups have. For instance, the Food and Drug Administration (FDA) has a great deal of

influence on the use of specific drugs and on federal health law. As a result, the FDA influenceshealth plans by determining the medical options available to the health plans’ providers. In somemarkets, laws mandate that specific benefits be covered by health plans in those markets. Healthplans that are subject to those laws must cover the cost of the mandated benefits, and thesemandates must be reflected in provider contracts. Furthermore, health plans operating in morethan one state must comply with the regulatory and licensing requirements of each state in whichthey operate.

3. The importance of healthcare to the public.

The public has an interest in healthcare and the contracts that provide it. Legislative andregulatory bodies reflect these public concerns about healthcare. Generally, the greater the publicinterest in an industry, the more likely it is that legislative bodies will design and pass laws toregulate that industry.

The Regulatory Environment

Ideally, healthcare laws and regulations serve the public interest by performing two broadfunctions.

First, they provide protection to consumers of healthcare. Individuals seeking healthcare are oftennot in a strong position to judge the financial stability of a health plan, and sometimes lack theinformation necessary to compare the various health plans available. Many regulations aredesigned to protect consumers from these disadvantages. For example, as we saw in RiskManagement in Health Plans, solvency regulations are designed to help assure that health plansare sufficiently financed to meet their obligations to plan members.

Second, laws and regulations that are both well designed and consistently applied set standards ofconduct for the parties involved in the business of healthcare, and these standards foster acompetitive, but fair, marketplace environment.

From a financial standpoint, however, the laws and regulations that achieve these ideal goalsgenerate costs. For example, licensing requirements for providers and health plans protectconsumers and foster public confidence in the healthcare professions. Part of the cost of thisprotection is that health plans face licensing requirements—and licensing costs—in every state inwhich they enroll plan members.

Complex regulatory environments also generate multiple markets, and therefore multiplehealthcare delivery systems. For example, in a given geographical area, Medicare, Medicaid,commercial, large group, small group, and individual markets will be influenced, and in somecases created, by government laws and regulations. Changes in laws and regulations in such areascan cause healthcare resources to shift in and out of health plans or shift from less attractivehealth plan markets to more attractive markets.

Beyond generating administrative and compliance costs for health plans, laws and regulationsalso frequently increase the risk for one party or another in a health plan contract. For example,mandatory coverage of certain illnesses in effect mandates the transfer of the financial riskassociated with that illness from the individual plan member to one or more other parties involvedin the healthcare contract.

Generally, the distribution of risk among the health plan, the plan sponsor, and the providers isone of the central processes of risk management in health plans. The method that a health planuses to reimburse its providers is a key factor in determining the amount of financial risk that aprovider assumes and the amount by which the health plan reduces its underwriting risk. In thissense, provider contracting is closely tied to risk and to risk management tools, such as those wediscussed in previous lessons.

The concept of the risk-return trade-off causes health plans’ financial risk managers to seek anappropriate balance between achieving returns that meet its owners’ (or stockholders’)expectations and maintaining appropriate levels of solvency. Healthcare providers and healthplans both face financial risk in the course of conducting business. As businesses, health plansinvest financial capital with the expectation of achieving a return. Similarly, providers invest theirlabor, and often some capital of their own in the course of providing care, and in return expect tobe financially rewarded.

The various types of provider reimbursement methods therefore indicate not only how theprovider will be paid for providing services, but also who will bear the risk that providing theseservices will be more expensive than anticipated, and who will benefit if expenses are lower thananticipated. There are almost as many provider reimbursement methods as there are providercontracts, but reimbursement methods do fall into general categories. We discuss these categoriesin this assignment and a future lesson. Keep in mind that what often distinguishes these providerreimbursement methods from each other is how risk is divided among the parties to the healthplan contract.

Regulations addressing the delivery of healthcare services mandate many of the elements thatmust be included in contracts between health plans and providers and, in doing so, often serve toassign the risks associated with providing these services. In the following sections, we present anoverview of the sources of health plan regulation and some of the mandates imposed byregulations.

Sources of Laws and Regulations1

Laws and regulations applying to health plans come from both the federal government and stategovernments. At both the federal and the state level, legislatures enact statutes, governmentalagencies develop regulations, and courts interpret laws and establish case law, all of which affecthealth plans.

Federal Government

At least four federal agencies establish rules and requirements that affect health plans:

1. the Department of Health and Human Services,2. the Department of Labor,3. the Office of Personnel Management, and4. the Department of Defense.

The Department of Health and Human Services (HHS)

Acting primarily through the Centers for Medicare & Medicaid Services (CMS), HHS serves as apurchaser and regulator of healthcare. In addition, CMS is responsible for administering the

Medicare program and the federal government’s role in the Medicaid program. We discussMedicare and Medicaid in more detail in future lessons.

The Department of Health and Human Services is also responsible for issuing regulationspertaining to the Health Insurance Portability and Accountability Act (HIPAA) of 1996. Theseregulations directly affect health plans that offer insured products to employer group health plansand individuals. Recall from Healthcare Management: An Introduction that HIPAA standardizesan approach to the continuation of healthcare benefits for individuals and members of small grouphealth plans and establishes parity between the benefits extended to these individuals and thosebenefits offered to employees in large group plans. This act also contains provisions designed toensure that prospective or current enrollees in a group health plan are not discriminated against onthe basis of health status.

The Department of Labor (DOL)

The DOL is the federal agency with primary responsibility for administering the EmployeeRetirement Income Security Act (ERISA) of 1974, including recent amendments made byHIPAA. Although ERISA set the standards for the health benefit plans that many employers andsome unions establish for their employees or members, ERISA does not directly regulate healthplans. Because employer group plans often contract with health plans to provide health benefits tothe plans’ enrollees, health plans that sell to this market must design health plan benefits thatmeet ERISA requirements.

Under ERISA, various documentation, appeals, reporting, and disclosure requirements areimposed on employer group health plans. For example, every employer group health benefit planthat is subject to ERISA must have a written plan document that describes in detail the benefitscovered by the plan as well as the rules governing eligibility and the procedures by which theplan may be modified.

In addition, ERISA requires plans to furnish every participant with a summary plan description(SPD), which outlines the most important parts of the lengthier plan document. Plan descriptionsare often at the heart of disputes over whether a health plan is obligated to cover a particularservice or course of treatment. For this reason, the plan documents of a health plan may haveimportant legal and financial consequences for the plan.

The Office of Personnel Management (OPM)

The OPM administers the Federal Employees Health Benefits Program (FEHBP), which providesvoluntary health insurance coverage to federal employees, retirees, and dependents. The FEHBPis the largest employer-sponsored health plan in the United States. The OPM sets thresholdstandards that plans must meet in order to participate in the FEHBP.

In addition, ERISA requires plans to furnish every participant with a summary plan description(SPD), which outlines the most important parts of the lengthier plan document. Plan descriptionsare often at the heart of disputes over whether a health plan is obligated to cover a particularservice or course of treatment. For this reason, the plan documents of a health plan may haveimportant legal and financial consequences for the plan.

The Department of Defense (DOD)

The DOD administers the Military Health Services System (MHSS), which provides medical careto active-duty military personnel, their families, and retirees not yet eligible for Medicare.Although its budget is substantial, the MHSS is not yet a major force in the regulation of HMOsand PPOs because of the structure of its health plan contracting initiatives and the limited numberof contractors involved in its programs.

State Governments

As we mentioned earlier, health plans are often regulated by more than one agency in a givenstate. Typically, a department of insurance oversees the financial aspects of health plan operationsfor those health plans that do not fall under the ERISA preemption. In some states, the statedepartment of health regulates the healthcare delivery system, including oversight of access toand quality of care. Other state agencies also may be involved in setting standards for some healthplans, because states are also purchasers of healthcare for their own employees and for low-income state residents through Medicaid contracts.

The National Association of Insurance Commissioners (NAIC) is a non-governmentalorganization that consists of the commissioners or superintendents of the various state insurancedepartments.2 The NAIC assists states in their attempts to achieve some uniformity of laws andregulations applying to health plans and health insurance. The NAIC does this through thedevelopment of model acts. The model acts themselves do not carry the force of law, but statelegislatures often pattern their own laws or regulations after the NAIC model laws.

States may, however, alter any portion of a model law or regulation before it is adopted.Consequently, details of licensure and other requirements frequently vary from state to state, andhealth plans operating in more than one state must design their plans and provider contracts tocomply with applicable laws in each jurisdiction in which the health plans operate.

Provider Contracting Laws and Regulations

The federal and state agencies and regulators discussed earlier in this lesson set the regulatoryenvironment in which providers and health plans must negotiate contracts. In this regard,healthcare laws and regulations that require health plans to pay certain benefits or cover certainconditions or treatments have an impact on the health plan-provider contracts. The costs ofcomplying with such laws and regulations affect provider contracts at least indirectly in acompetitive market, because resources used to meet compliance costs are no longer available aspotential surplus for either providers or health plans.

In addition, many laws more directly affect provider contracts by mandating elements withinthose contracts. The large number of legislatures and agencies involved in passing and enforcingthese laws make a full discussion of them beyond the scope of this text. However, the followingsections briefly discuss some of the types of laws affecting provider contracts.

Credentialing Standards

An important feature of many health plans is that health plans either limit plan members’ choiceof provider or give incentives for plan members to select from panels of preferred providers.Because plan members may be injured if a health plan selects providers who are incompetent or

unqualified to provide quality care, courts have held that health plans have a duty to usereasonable care in credentialing providers.

Recall from Healthcare Management: An Introduction that credentialing is a review processconducted to determine the current clinical competence of providers and to ensure that providersmeet the organization’s criteria. Various organizations, including the National Committee forQuality Assurance (NCQA), URAC and the American Association of Preferred ProviderOrganizations (AAPPO), have adopted standards for conducting provider credentialing. Thesestandards are not mandatory for health plans, but courts sometimes find that health plans havesatisfied their duty to use reasonable care in their credentialing activities if they comply withthese standards.

The NCQA standards list the kinds of information health plans should obtain about providersduring the initial credentialing process and suggest that health plans recredential all providersevery two years. The NCQA has also established standards for health plans that contract withthird parties to credential or verify the credentials of providers. In addition, some states haveenacted laws that specify the criteria health plans should consider in making credentialingdecisions. Compliance with these laws may help an health plan show that it has satisfied itsstandard of care.

Fair Procedure Laws

Fair procedure laws, also called due process laws, are laws that require health plans to disclosethe criteria they use in

1. selecting or deselecting the providers with which they contract, and2. explaining to rejected or deselected providers why they were not selected, and the process

by which a provider can challenge the health plan’s decision.

Direct Access Laws

Several states have passed direct access laws, which are laws that allow health plan members tosee certain specialists without first being referred to those specialists by a primary care provider.Direct access laws specify which type of specialist plan members must be allowed to see withoutreferral. As of 1997, 14 states had direct access laws, and 9 of those states specifiedobstetricians/gynecologists. Other direct access laws allow visits to dermatologists (Florida andGeorgia) and chiropractors (New York).4

Even in jurisdictions where there are no direct access laws, some plans allow enrollees to seecertain specialists without referral. However, in the absence of direct access laws, plans canrequire such referrals. In such cases, primary care provider contracts can require the primary careprovider to manage some portion of the plan members’ utilization of such specialists. Directaccess laws reduce the primary care providers’ ability to manage utilization of these specialists.Because both the specialists and the primary care providers have different roles under these lawsthan they might otherwise have, direct access laws can influence the content of contracts betweenthe health plan and providers.

Any Willing Provider Laws

About half of the states have passed any willing provider (AWP) laws, which require that healthplans allow any provider to supply services to plan members, so long as the provider is willing tomeet the same terms and conditions that apply to the providers that are in the health plan’snetwork. In other words, AWP laws mandate that an health plan allow providers to become partof its network or reimburse those providers at the health plan’s negotiated-contract rate, so longas the non-contract provider is willing to perform the services at the contract rate.

Any willing provider laws vary by state. Some state AWP laws allow plan members to chooseany provider, whether the provider is in the health plan’s network or not. Several AWP lawsrequire that a health plan send contract proposals to all providers in the health plan’s service area.Other AWP laws confine themselves to relatively narrow categories of providers—pharmacies,for example— or they include a much wider range of providers.

Provider groups tend to be in favor of AWP laws. They maintain that health plans that control ahigh percentage of the healthcare market in local areas may put providers who do not contractwith them at a competitive disadvantage, and may further reduce competition by reducing thenumber of providers in the market.

In contrast, health plans are opposed to AWP laws because such laws tend to remove anymotivation a provider may have to contract with the health plan. A health plan can significantlyreduce healthcare costs in a health plan’s population by contracting with providers who agree toprovide services to the health plan’s plan members at reduced rates. In exchange, the health planeffectively makes available to the provider a larger volume of patients than the provider wouldotherwise have.

Fair Procedure Laws

Particularly in the case of hospitals, which have high fixed costs, and in the case of physicianswho are in individual practice and may not have marketing expertise, a dependably large volumeof patients can be a valuable benefit. The greater the perceived benefit of patient volume, themore motivated providers will be to agree to reduce their fees, and the greater the cost reductionsthe health plan will be able to achieve for its plan members, all other factors being equal. Further,health plans seek to enter into contracts with providers who share the health plan’s utilizationmanagement philosophy and who provide excellent care.

By allowing all providers access to the health plan’s patient base, AWP laws remove providers’incentive to contract with the health plan at reduced rates and make more difficult the healthplan’s attempt to build a provider panel that includes only the top-quality providers in a givenmarket. As a result, health plans have challenged AWP laws in court. Usually the legal basis forthese challenges is that an applicable federal law, such as ERISA or the HMO Act, pre-emptsstate statutes. Insight 3A-1 highlights the recent finding of the US Supreme Court regarding theapplicability of ERISA to AWP challenges.

Insight 3A-1

In Kentucky Association of Health Plans v. Miller, the issue the Supreme Court decided iswhether Kentucky’s broad law violates the Employee Retirement Income Security Act (ERISA)or whether the state law is a valid regulation of the business of insurance. In the January 14, 2003

hearing before the court, the attorney for the Kentucky Association of Health Plans argued thathealth plans need to use limited provider networks to deliver quality health care at a reasonablecost. The state argued that the Kentucky law is a legitimate consumer protection measure thatgives consumers access to providers of their choice.

On April 2, 2003, the US Supreme Court, in a unanimous decision, affirmed the Sixth Circuitdecision that found that Kentucky’s “any willing provider" laws are saved from ERISApreemption by the ERISA saving clause because the laws regulate insurance. In the decision, theSupreme Court held that for a state law to be deemed a law which regulates insurance, and thusbe saved from ERISA preemption, it must satisfy two requirements: 1) it must be specificallydirected toward entities engaged in insurance; and 2) it must be substantially affect the riskpooling arrangement between the insurer and the insured.

Mandated Benefits

Mandated benefit laws are state or federal laws that require health plans to arrange for thefinancing and delivery of particular benefits, such as coverage for a stay in a hospital for aspecific length of time. In some cases, such as laws that require health plans to supplychiropractic services, mandated benefit laws also have the effect of requiring health plans tocontract with specific types of providers.

In recent years, the number of state laws mandating coverage has increased significantly. Thetypes of illnesses or procedures covered, and the degree to which they are covered, vary fromstate to state. Even within individual states, mandates vary according to the type of health plan.Figure 3A-1 lists some examples of procedures or services that fall under at least some mandatedbenefit laws. In addition to state mandates, some mandates arise from federal law.

From a financial standpoint, mandated benefits have the potential to influence health plans in thefollowing ways:

They increase the cost of a health plan’s health plan to the extent that the plan must covermandated benefits that would not have been included in the plan in the absence of the lawor regulation that mandates the benefits.

Health plans must contract with providers, including specialists, to provide the requiredlevel of mandated benefits. To the extent the mandated benefits change the benefitstructure of the health plan’s health plan, the health plans may have to contract withproviders with which the health plans would not have contracted otherwise.

Health plans must be able to track and process data that demonstrates that the health planis complying with the law. The health plan must also gather and analyze cost data to beable to adequately price the increased benefits. To the extent that this data tracking andanalysis represents an increased load on the health plan’s information and managementsystems, costs will increase.

Mandated benefit laws may have the effect of causing a higher degree of uniformityamong the health plans of competing health plans in a given market. Individual healthplans that seek to differentiate their products from those of their competitors incompetitive markets will have less flexibility in benefit design.

Because self-funded plans typically are exempt from state mandates, in some markets,large group employers may be motivated to begin self-funding in order to avoid payingpremium increases in other healthcare plans that are subject to state mandates. In othermarkets, self-funded plans may be pressured to add benefit coverage to match the

mandated benefits of other plans. In either case, mandated benefit laws may at leasttemporarily influence the structure of the market balance between self-funded and othertypes of plans.

A full discussion of all the mandated benefit laws that states have passed is beyond the scope ofthis text. The following sections discuss some common and representative mandates.

Mental Healthcare Coverage5

Concern that coverage for mental illnesses was not being treated on a par with physical illnessesmotivated lawmakers to enact a mental health parity requirement that subsequently wasincorporated into HIPAA. The federal mental healthcare coverage requirements bar group healthplans from having more restrictive annual and lifetime limits or caps on mental illness coveragethan for physical illness coverage if the health plan has annual payment limits or aggregate dollarlifetime caps. The federal mental healthcare coverage law does not mandate coverage for mentalillness; it seeks to ensure that—if a health plan covers mental illness—the caps and limits arecomparable to caps and limits for physical coverage. More than 15 states have enacted their ownmental healthcare coverage laws.

These laws, similar to HIPAA, vary from mandating coverage of treatment for severe disorders orbiologically based illnesses such as schizophrenia, manic-depression, or bipolar disorder tomandating parity for coverage of mental illnesses comparable to caps and limits for physicalillnesses.6 Some state laws require that all terms and conditions of coverage (i.e., copayments,deductibles, etc.) be the same for both mental and physical illnesses.

Some state mental health parity laws exclude substance abuse treatment from their mandates forcoverage of mental illnesses. Other state laws provide extensive coverage for mental illnesses.For example, the Vermont mental health parity law, which includes in its definition of mentalillness any disorder listed in the International Classification of Diseases Manual (ICDM), requirescoverage for the treatment of a wide variety of mental illnesses, including substance abuse.

In addition, as in several other state laws, the Vermont law prohibits separate deductibles,copayments, coinsurance, and other similar types of cost-sharing arrangements for mental andphysical illnesses.7 Generally, health plans must ensure that they comply with the mental healthparity requirements of the federal law as well as any more stringent requirements imposed by thestates in which they operate.

Length of Stay Laws8

Some state mental health parity laws exclude substance abuse treatment from their mandates forcoverage of mental illnesses. Other state laws provide extensive coverage for mental illnesses.For example, the Vermont mental health parity law, which includes in its definition of mentalillness any disorder listed in the International Classification of Diseases Manual (ICDM), requirescoverage for the treatment of a wide variety of mental illnesses, including substance abuse.

In addition, as in several other state laws, the Vermont law prohibits separate deductibles,copayments, coinsurance, and other similar types of cost-sharing arrangements for mental andphysical illnesses.7 Generally, health plans must ensure that they comply with the mental healthparity requirements of the federal law as well as any more stringent requirements imposed by thestates in which they operate.

The Texas State Liability Law

In addition to laws that increase health plans’ costs by imposing administrative or compliancerequirements, some laws expose the health plan to financial liability for its actions or the actionsof its providers. Providers and health plans may be liable for damages if they fail to performduties imposed upon them by these laws. A tort is a violation of a legal duty to another personimposed by law, rather than contract, causing harm to the other person and for which the lawprovides a remedy.

The business of healthcare is sufficiently complex that health plans face a certain level of riskfrom tort actions.

Although it would be impossible to list all laws that could subject a health plan to tort action, onestate law recently passed by Texas has the potential to significantly increase financial risks facedby health plans through tort actions, and in doing so, increase health plans’ costs of doingbusiness in Texas. The Texas state liability law (SB 386) states that any health plan entity is“liable for damages for harm to an insured or enrollee proximately caused by the health caretreatment decisions” made by the health plan’s employees or agents. In other words, if aphysician providing care to a health plan’s plan member harms the plan member through medicalmalpractice or other negligence, the health plan, as well as the provider, is liable. Medicalmalpractice is a type of negligence that occurs when a patient is harmed because a provider failedto exercise reasonable care in providing medical treatment.

Traditionally, health plans have not been liable in cases of physician malpractice, particularlywhen the physician was not a full-time employee of the health plan. The reasoning behind notholding the health plan responsible is that, in the United States, corporations are not allowed toengage in the practice of medicine; only individuals may be licensed to practice medicine.Because only individuals have the authority to practice medicine, malpractice was a tort forwhich only individual providers were liable. Thus, in provider contracts with health plans, therisk of malpractice was borne by the providers (or the insurance companies supplying thephysicians with malpractice insurance), and not the health plans. Under the Texas law, a healthplan cannot use the corporate practice of medicine doctrine as a defense.

Malpractice costs make up 5% to 6% of the total healthcare costs in the United States.Determining whether or not healthcare providers who contract with health plans are agents of thehealth plan and whether or not health plans are liable for the actions of these agents aresignificant financial issues for health plans. Currently the Texas law is being challenged in court,in part on the same basis as any willing provider laws—that is, that federal laws such as ERISApre-empt state laws.

Endnotes

1. Adapted from American Association of Health Plans, “The Regulation of Health Plans: AReport from the American Association of Health Plans,” Washington, D.C., February 3,1998, 1–2. Used with permission; all rights reserved.

2. Harriett E. Jones and Dani L. Long, Principles of Insurance: Life, Health and Annuities(Atlanta: LOMA, 1996), 58.

3. Adapted from Academy for Healthcare Management, Health Plans: Governance andRegulation (Washington, D.C.: Academy for Healthcare Management,© 1999), 12-6.Used with permission; all rights reserved.

4. Adapted from Academy for Healthcare Management, Health Plans: Governance andRegulation (Washington, D.C.: Academy for Healthcare Management, © 1999), 5-32–5-33. Used with permission; all rights reserved.

5. Adapted from Academy for HealthcareManagement, Health Plans:Governance andRegulation (Washington, D.C.: Academy for Healthcare Management, © 1999), 5-25–5-26. Used with permission; all rights reserved.

6. “State Report: A Health Law Score Card,” Business & Health (February 1998): 54.7. “States Move on Health Plan Legislation,”Employee Benefit Plan Review (September

1997): 49.8. Adapted from Academy for Healthcare Management, Health Plans:Governance and

Regulation (Washington, D.C.: Academy for Healthcare Management, © 1999), 5-26–5-27. Used with permission; all rights reserved.

9. “State Wrap-Up 1997: Health Plan Targeted for Restrictions, Mandates,”BusinessInsurance (June 30, 1997): 1, 15, 16, 19.

AHM Health Plan Finance and Risk Management: Provider Reimbursement Methods

Course Goals and Objectives

After completing this lesson you should be able to:

Discuss the advantages and disadvantages of traditional, salary, fee-for-service, anddiscounted fee-for-service provider reimbursement methods

Explain how utilization risk is distributed in each of the provider reimbursement methods Define churning, upcoding, and unbundling and recognize which provider reimbursement

systems are designed to solve these problems Explain the purpose of using the relative value scale and resource-based relative value

scale systems Define global fees, withholds, risk pools, and bonuses and explain how they are used by

health plans to motivate providers to manage overutilization Discuss the methods that health plans use to reimburse hospitals

Although laws and regulations influence the structure of provider reimbursement contracts inhealth plans, laws and regulations are by no means the only influence on these contracts. Providercontracts in managed care have also evolved over time in response to market forces. Marketforces include the presence of competitors in the market, the level of demand for healthcareservices, and the availability (or level of supply) of those services. Market forces, in turn, aredriven by the goals of the various parties involved in healthcare: the people who receive the care,the providers of the care, the entities that pay for the care, and the entities that manage thedelivery of that care. In the long run, each of these must interact with the others to attain its goals.

Within this context, the managed healthcare market has generated many different ways ofbalancing the cost of healthcare with access to care and the comprehensiveness of health benefits.Ultimately, variety in healthcare plans is a response to the demands of plan members andsponsors. Not all sponsors and plan members demand the same level of comprehensiveness;consequently, different groups of consumers will find different plans attractive. All other factorsbeing equal, however, plan sponsors and members prefer to pay the lowest possible price for thehealthcare benefits they receive, and the market will tend to reward health plans and providerswho can achieve the same long-term goal: cost efficiency in delivering quality healthcare.

Not all provider reimbursement methods are equally efficient in aligning all of the short-termgoals of the participants with this long-term goal of cost efficiency. When the short-term financialgoals of the participants are in conflict with this long term goal, health plans face variousinefficiencies that can ultimately lead to higher costs and lower quality care.

Because different healthcare consumers have different needs, however, there is no onereimbursement system that works most efficiently for all providers and types of health plans in allhealth plans. Each reimbursement system has strengths and weaknesses. Health plans arose as asystem for aligning the financial goals of the participants, with each type of reimbursementmethod implicitly addressing the weaknesses of other methods. This lesson describes commontypes of provider reimbursement methods in health plans and outlines the advantages anddisadvantages of each type.

Provider Reimbursement Methods

The rapid growth and dynamic market conditions within the health plan industry have caused thedevelopment of a large number of provider reimbursement methods. New variations on thesemethods are developed (or mandated by regulatory bodies) each year. Generally, physicianreimbursement in health plans is typically based on one of the following methods:

Salary Per treatment or per service fee schedule (commonly known as fee-for-service) Per plan-member rate (that is, the provider is paid a certain amount for every plan

member during a defined period) Percent-of-premium schedule (the health plan pays providers a percentage of all the

premiums received in exchange for covering plan members, and providers agree toprovide all necessary medical treatment for those plan members)

In this lesson, we discuss a number of health plan reimbursement methods both in terms of thesecategories, and in terms of how these methods divide financial and utilization risks betweenproviders and health plans. We begin by outlining how physicians and hospitals were traditionallypaid before managed care, because the weaknesses of traditional physician reimbursement led torising healthcare costs. These rising costs led to a market response: health plans. Health plans are,in this sense, a response to some of the inefficiencies of traditional medicine’s financialstructures, including physician reimbursement.

Traditional Provider Reimbursement

Before health plans became widely established, provider reimbursement typically involved anindividual patient paying an individual provider after the provider rendered healthcare services.Typically, patients with health insurance first had to pay their providers, and then submit a claimto the insurer. If the insurer denied the claim, the responsibility for paying for the care remainedwith the patient. Although this traditional method of payment allowed individuals who soughthealthcare considerable freedom of choice in physicians and treatment options, it also presentedseveral financial disadvantages.

Financial Disadvantages of Traditional Physician Reimbursement

From a financial point of view, traditional physician reimbursement is subject to three types ofdisadvantages. First, this reimbursement method concentrates, rather than spreads, the financialrisk for a patient and that patient’s physician when the patient faces a serious illness, particularlyin cases where the patient either has no insurance or is underinsured. By concentrating risk, thismethod, in effect, concentrates the costs of healthcare. In other words, an underinsured individualwho had a serious illness often faced a choice of either receiving inadequate care or sufferingsevere financial hardship in paying for treatment.

Providers themselves risked not getting paid for their services. Providers under thisreimbursement system also faced a potential ethical and financial dilemma. These physicians hadto decide either to provide (1) different levels of treatment, based not on the seriousness of theillness, but on the wealth of the patients with the illnesses, or (2) the same level of treatment to allpatients, but charge different rates to different patients for the same treatment.

Financial Disadvantages of Traditional Physician Reimbursement

Second, traditional physician reimbursement fails to reward physicians who attempt to containhealthcare costs, even in cases where the patient has adequate indemnity insurance. Thus,healthcare costs tend to increase relatively rapidly under this system. As long as a patient canafford additional care, a physician is financially rewarded for providing more and more services,even if the costs of those services outweigh their benefits. Most patients do not have the expertiseto judge the benefit of a treatment in relation to the cost of the treatment, so patients who canafford extra services are motivated to purchase the services “to be on the safe side.” In the longrun, those patients may pay for and undergo treatments or tests that are unnecessary. In addition,such choices increase the total cost of healthcare in the economy and cause the resources withinthe healthcare system as a whole to be allocated inefficiently.

Third, traditional provider reimbursement often involves operational inefficiencies. To providethe best possible care, a physician must stay current with professional advances in medicine. Atthe same time, a physician would have to perform or manage all administrative and marketingfunctions of the practice. Few physicians do all of these things equally well, so the practices ofeven skilled physicians are subject to administrative inefficiencies that can result in eitherincreased costs to patients or decreased profit for the physicians. Physicians who practice alone orin small clinics also may have difficulty achieving economies of scale in their administrative andfixed costs, which drives up the cost of providing each treatment.

Health plans seek to avoid these three problems through the use of managed care techniques. Thestructure of provider reimbursement methods in health plans involves a large number of complexdetails, particularly with respect to determining a fair rate of reimbursement, given that the exactlevel of care required by a population of plan members cannot be known in advance.

However, the methods themselves are easier to understand if you keep in mind that each methodaddresses some or all of the three problems that we have just discussed. To solve these problems,provider reimbursement methods seek to align the long-term goal of financial efficiency with theshort-term financial goals of those involved in the healthcare system. In most cases, managed careachieves at least part of the realignment of participants’ goals through the use of strategies thatredistribute risk among the participants in healthcare plans.

Salary Reimbursement Method

Under a salary reimbursement method, or budget method, providers are paid an agreed-uponsalary in exchange for providing healthcare services. Such a system requires an administrativeentity to pay the salaries. Staff model HMOs, many government healthcare facilities, and somehospitals use salaries as a way of paying physicians.

Compared to traditional physician reimbursement, the salary system automatically carries with itseveral potential benefits. First, it separates some of the administrative functions of healthcarefrom the practice of medicine, at least to the extent that the physicians and other providers do nothave to perform all of the business functions necessary in private practice. These administrativefunctions can be done efficiently for a large number of providers at once, thus lowering theadministrative cost per plan member and achieving economies of scale.

Also, salaries eliminate much of the financial incentive providers might otherwise have toperform services that are not medically necessary. In other words, because the physician is notbeing paid on a per-treatment basis, simply performing more services will not financially benefitthe physician. In addition, because provider reimbursement is a sizable portion of a health plan’stotal costs, salaries help to stabilize expenses for the health plan or other entity employing theproviders, and at the same time stabilizes the income of the providers.

Cost stabilization is often a feature of prospective reimbursement, which is any system that paysproviders at a predetermined rate in advance of the providers’ supplying treatments or services. Asalary is a prospective reimbursement method, as are many of the health plan reimbursementmethods we will discuss. Traditional provider reimbursement and other forms of paying providersper treatment are not prospective. Many prospective reimbursement methods tend to giveproviders incentives to avoid overutilization, because under these types of prospectivereimbursement providers are typically not paid more simply for providing more services.

A salary system also has some disadvantages. Although cost stabilization prevents unexpectedlyhigh reimbursement costs, it may also hinder cost reduction. Unless the salary system isaugmented with another type of incentive plan, providers who work efficiently and effectively arenot necessarily paid more than those who do not. Some providers under a salary system may feelmotivated to do less work, because the incentive system itself provides no motivation to workharder. Therefore, positive levels of quality, productivity, and resource utilization have to beencouraged in other ways.

One method of doing so is to create a salary range for providers, so that all provider-employeesare paid at least a minimum amount, and can earn up to a maximum amount by being moreproductive or efficient. Similarly, providers or groups of providers can be given a bonus inaddition to their salaries after a profitable period. In this way the providers’ employer encourageshigh productivity and efficient practices by returning some of the income and cost savings to theproviders who are successful in achieving desirable results. Such incentive methods can also beadministratively complex. They must be designed carefully so that providers are not simply paidmore to do more, but are paid more to work more effectively.

For example, an incentive program that measures the level of a physician’s workload by countingthe number of diagnostic tests the physician orders is encouraging the physician to orderdiagnostic tests, which may or may not indicate that the physician is practicing more effectivemedicine. Both salary and nonsalary reimbursement systems can share this problem. Often, theproblem is addressed in part by having physician review panels analyze the effectiveness oftreatments rendered by individual physicians.

Under a straight salary system, providers accept some service risk. Service risk is the risk thatplan members will demand more services from the physician than had been anticipated when thesalary schedule was designed.

For the most part, however, the risk in a salary system rests with the entity paying the providers.Providers avoid the risk that their incomes will fluctuate, and they avoid many of the business andfinancial risks they would face as independent practitioners. Furthermore, they avoid the risk thatunexpectedly high utilization rates will drive costs above the income generated by the healthplan’s premiums. The providers’ employer, whether a health plan, a governmental entity, or ahospital, in effect accepts the risk that, in the short term, costs will exceed cash flows. Like anyother business entity, the health plan or other healthcare employer will still be obligated to pay

provider salaries for as long as the employer is operating. Similarly, if plan premiums ormembership levels fall below the plan’s targets, the health plan or other employer must, at least inthe short term, continue meeting the same labor costs.

The health plan that operates a salary system also faces an increase in risk of liability in manyjurisdictions: as employees, the physicians are the agents of the health plan. Because an employeris typically seen as having greater control over the actions of its employees than it would haveover the actions of independent contractors, a health plan that employs physicians may facegreater liability for its physician-employees’ acts of negligence.

Fee-for-Service Reimbursement Methods

In fee-for-service (FFS) reimbursement methods, providers are paid per treatment or per servicethat they provide. After providing a given service or treatment, the provider bills the plan for thattreatment. Typically, FFS payment agreements contain a no-balance-billing clause. No balancebilling means that the physician agrees to accept the payment made by the health plan as fullpayment for the service and will not bill the plan member for that service. No balance billing isalso often used in combination with reimbursement systems other than FFS. No balance billing isattractive to plan members and plan sponsors because it reduces the possibility they will faceunexpected healthcare costs. Instead, their healthcare costs are defined through premiums,copayments, and other elements that are specified in the contract offered by the health plan.

One of the benefits of FFS reimbursement is that it is relatively easy to initiate, especially inmarkets where health plan penetration is low. Using FFS can allow an health plan to acquire alarge panel of providers, which allows plan members considerable freedom to choose theirpersonal physicians or other providers. This freedom is highly valued by a sizable portion of thepopulation. Especially in markets where a health plan is attempting to establish itself, the healthplan will appear more attractive to potential plan members if becoming a member does notrequire them to switch doctors. We discuss the disadvantages of FFS in the next section.

Discounted Fee-for-Service

One of the first methods developed to control the costs of traditional provider reimbursement wasto determine what the usual, customary, and reasonable (UCR) fees were for each type oftreatment, then negotiate with providers to pay a discount on the UCR fee. Although UCRs weredeveloped by indemnity insurers, a discount on standard fees is also used by health plans. Indiscounted fee-for-service (discounted FFS) reimbursement methods, the health plan reimbursesthe provider on a per-treatment basis at a level below the provider’s usual charge for that service.Variations on this basic arrangement are common today.

The advantage for the health plan under discounted FFS reimbursement is that the fees arediscounted. The discounted FFS concept can also be coupled with a fee schedule. Under feeschedules, the health plan determines a maximum value for each procedure or treatment, and paysthe provider the lesser of the providers’ requested fee or the maximum value. Fee schedules offerthe advantage of allowing the health plan to develop uniform fees for the same service deliveredby different providers.

Providers are willing to accept a discounted or negotiated fee that is less than their usual feebecause doing so allows them access to the health plan members—that is, a larger customer base.Even providers who are not seeking to expand their plan member bases may join panels to avoid

losing plan members that they already have. Finally, unlike salary reimbursement systems,providers who supply more services under FFS automatically receive higher reimbursement, thusremoving any motivation the provider might have to provide too few services.

From the health plan’s point of view, the main disadvantage with FFS reimbursement methods isthat, while physicians are financially rewarded for providing more services, there is no guaranteethat more services necessarily translate into better plan member care in all cases. Although thenumber of physicians or other providers who engage in fraud by supplying excessive services isrelatively small, physicians or other providers who are rewarded for supplying more services willtend to supply them. For this reason, an FFS reimbursement system will encourage providers tobill more services, leading to greater healthcare costs.

Both FFS and discounted FFS systems may fail to prevent excessive services—and thereforeexcessive costs—when those excessive services take one of three forms: churning, upcoding, andunbundling. Churning involves a physician or other provider’s either seeing a plan member moreoften than is necessary, or providing more treatments and tests than are necessary. Churningultimately adds to the costs of the plan and therefore increases the cost of healthcare coverage tothe plan member and the employer (or other payor). A plan member therefore has motivation toavoid churning, but may not have the knowledge necessary to tell whether or not a treatment orreturn office visit is necessary. Thus, churning almost always has to be prevented by the healthplan’s management practices. Health plans often do so by tracking claims frequency by treatmentcode and by individual providers. When some treatments appear to be billed at greater-than-expected rates, the cause can be investigated.

Upcoding is the practice of a provider’s billing for a procedure that pays more than the procedureactually performed by the provider.1 The tendency to upcode can result in code creep, which isthe condition of frequently billing for more lucrative services than those actually performed. Ifupcoding becomes common within an health plan’s health plan, the health plan’s costs can risesignificantly.

Unbundling is the practice of a provider’s billing for multiple components of a service that werepreviously included in a single fee, when the total reimbursement for the multiple componentservices would be higher than the single fee. Many health plans use claims software that canrecognize unbundling and will automatically rebundle the component services. Like churning,upcoding and unbundling are essentially impossible for the plan member to detect and may bedifficult for employers or other payors to detect as well. Therefore, health plans seek to preventpractices such as churning, upcoding, and unbundling through quality control and cost controlmanagement functions.

Another motivating factor in some cases of overutilization involves the risk of malpracticeliability that physicians face. The risk of being found guilty of malpractice is a pure risk for aphysician—it is a loss without possibility of gain. The presence of pure risk motivates those whoface it to try to avoid that risk. Some providers will be motivated by malpractice liability risk topractice defensive medicine. Defensive medicine is an attempt to minimize malpractice risk bysupplying extra services, such as multiple diagnostic tests, even if those services are not likely tobenefit the plan member. As payment methods, neither FFS nor discounted FFS guard against thepractice of defensive medicine.

Discounted FFS and FFS reimbursement methods also are subject to another disadvantage thatwe discussed under traditional reimbursement methods. Providers who are compensated under

these systems and who attempt to control costs may find themselves paid less than physicianswho make little effort to control costs. Thus, the health plan can in some cases find itselfcompensating inefficient providers at a higher rate than it compensates efficient providers.

Relative Value Scale

Under any FFS system, a health plan will be motivated for administrative and financial reasons todevelop uniform fees to reimburse all providers who perform the same service. An importantmethod of determining uniform fee reimbursement is the use of relative value scales (RVS).Under a relative value scale (RVS) system, a health plan assigns weighted values to each medicalprocedure or service performed by a provider based on the cost and intensity of that service. Eachtype of procedure is given a code number.

For example, an appendectomy would have a different code from a tonsillectomy, and anappendectomy without complications of a peritonitis infection would have a different code froman appendectomy performed on a plan member with severe peritonitis. Usually, RVS codenumbers are based on the current procedural terminology (CPT) codes, which were developed byand are updated annually by the American Medical Association. To determine the actual payment(in dollars) to a provider who performs a service defined by a CPT code, the weighted value ofthe code is multiplied by a money multiplier. In practice, RVS codes have tended to rewardprocedural services, such as surgical procedures, more than cognitive services, such as officevisits or research done by a physician on a plan member’s condition.

To address the potential imbalance in the RVS payments for procedural versus cognitive services,a variation of the RVS system was developed. The resource-based relative value scale (RBRVS)system is a means of determining provider reimbursement that attempts to take into account allresources that providers use in providing care to plan members, including procedural,educational, mental, and financial resources. 2 The Centers for Medicare and Medicaid Services(CMS) requires the use of RBRVS for Medicare billing. This requirement has encouraged the useof RBRVS as a uniform billing methodology, even outside Medicare markets.

Both RBRVS and RVS share with UCR fees an administrative advantage when used as part of anFFS reimbursement system. Because physicians using these systems bill for their servicesaccording to precise codes, tracking treatment rates is much easier and more exact for the healthplan’s quality and cost management functions. The use of RBRVS also provides a coherentstarting point for fair compensation to various providers who may be providing different types ofservices. Therefore, RBRVS can be useful to a health plan that is developing reimbursementschedules for various types of providers in a comprehensive health plan.

One disadvantage that RBRVS shares with other FFS systems is that RBRVS rewards providersfor rendering more services, but does not put them at financial risk for overutilization. The healthplan retains overutilization risk under a reimbursement system that uses RBRVS in the absence ofany other incentive system. Consequently, the health plan must manage the risk of overutilizationeither through a separate incentive system that motivates providers to control costs, or throughadministrative measures, such as clinical practice guidelines, that seek to manage providerbehavior. The health plan must also establish safeguards to minimize upcoding under RBRVSsystems.

Global Fees

Another method of provider reimbursement uses global fees. A global fee is a single fee that theprovider is given for all services associated with an entire course of treatment given to a planmember. For example, global fees are common in obstetrics. The global fee would be paymentfor prenatal visits, the delivery itself, and a defined period of post-delivery care. Global fees alsocan be set up for non-emergency surgical procedures, or certain types of office visits where theservice or treatment is well defined. Thus, the provider or providers (for example, a hospital inthe case of surgeries) must manage the costs of the components of a plan member’s course oftreatment, because the cost of these components cannot be billed separately to the health plan.

A global fee therefore transfers some of the risk for overutilization of care from the health plan tothe providers. In doing so, a global fee rewards providers who deliver cost effective care. Globalfee systems do not completely eliminate all motivation a provider may have to engage inchurning, because the provider is still being paid according to the number of treatmentsperformed. However, global fees do eliminate unbundling and upcoding within specifictreatments, because the single global fee covers the entire course of treatment.

Global fees can be more administratively complicated to develop initially than straightforwardFFS systems, particularly when global fees provide compensation to more than one provider. Forexample, if a global fee is paid for an appendectomy, then a fair method must be devised fordividing that fee among the surgeon, anesthesiologist, and other providers involved in thattreatment. Global fees for physician services or for individual providers, however, are similar tobundling. To operate efficiently, global fees require that a health plan have a claims system thatrecognizes the component services contained within the global fee, so that the health plan will notpay both the global fee and make individual payments for the same component services billedunder individual codes.

The global fees themselves must reflect how difficult and time-consuming each course oftreatment is relative to other courses of treatment. The health plan and the provider, as parties tothe reimbursement contract, will have fewer conflicts if the global fee for a given treatment isfair— that is, neither excessively high nor too low to cover the costs the provider incurs inproviding the treatment. Ideally, the global fee system balances the reimbursement for eachtreatment with the relative reimbursement for other treatments. This balance is important in termsof managing utilization, because if the global fee for one procedure is financially more attractivethan the fee for a second procedure, then the fee system may inadvertently encourage upcoding.

Global fees expose providers to the risk that the cost of treatment for some plan members mayexceed the global fee. Under such conditions, a provider may be reluctant to provide additionalservices. Consequently, a system must be in place to assure that plan members receiveappropriate care. Two commonly used systems are quality management on the part of the healthplan, and various forms of insurance or contractual elements that protect the provider againstfinancial losses in cases that require exceptionally expensive treatment. We discuss these forms ofinsurance and contractual elements in more detail in future lessons.

In the long-run, a global fee system, like any other provider reimbursement system, works best ifit aligns the financial goals of the providers with the financial goals of the health plan, employer,and plan member. The financial goals must also be aligned with the central goal of providingexcellent care. Some characteristics of provider reimbursement systems that help achieve thesealignments are listed in Figure 3B-1.

Provider Incentive Methods: Withholds, Risk Pools, and Bonuses

Withholds, risk pools, and bonuses are all means of motivating providers to manage costs bymaking a portion of their reimbursement dependent on how well the providers and the health planmanage costs. In all three methods, an assumed or budgeted cost is developed, and a portion ofthe providers’ income is subject to enhancement (or loss), depending on whether costs are heldbelow the budgeted amount during a specific period.

Withholds

In a withhold arrangement, a percentage of the providers’ reimbursement is not paid to theproviders until the end of a financial period; claims that exceed the budgeted costs for care duringthat period are charged against the withheld funds, and after such claims are paid, the remainingmoney in the withhold is distributed to the providers. If providers hold costs below the amountbudgeted for that period, then the entire amount of money in the withhold is usually distributed tothem. If the cost overruns exceed the withhold, then the deficits are usually the responsibility ofthe health plan. Withholds usually range from 10% to 20% of total provider reimbursement forthe period.

Risk Pools

A risk pool is an arrangement in which a fund is created at the beginning of a financial period,any claims approved for payment are paid out of that fund during the period, and at the end of theperiod, any remaining risk pool funds are paid to providers. If costs exceed the funded risk pool,the providers and the health plan pay the deficit according to percentages agreed upon at thebeginning of the contract period.

Bonus Arrangements

Bonus arrangements, which pay providers over and above their usual reimbursement at the endof a financial period, are based on the performance of the health plan as a whole, a group ofproviders within the plan, or an individual provider. Bonuses provide financial incentives toproviders to minimize unnecessary costs. Bonuses may be based on a percentage of a provider’sreimbursement or a percentage of the savings experienced by the health plan. Bonuses based onsavings achieved by the plan as a whole have the advantage of being somewhat easier toadminister, but, in such cases, the achievement of savings and the bonus for each provider will bebased partly on events outside the provider’s control.

Under a bonus reimbursement arrangement, the providers are not at financial risk to make up anydeficit experienced by the plan. Beyond the possibility of losing their bonus, providers are not atrisk when the plan faces deficits. As we noted previously, providers in a risk pool arrangementare usually responsible for sharing a plan deficit even if the deficit is greater than the funded riskpool.

The central motivation for forming risk pools, withholds, and bonus arrangements is to transfersome of the financial risk associated with overutilization to providers, who at least partly controlutilization rates. In this way, providers are motivated to control utilization by managing itthemselves.

Hospital Reimbursement Methods

Hospitals are an important player in provider reimbursement systems. Often a health plan willreimburse hospitals using one reimbursement method, and the providers associated with thehospital will be paid using a different method. Also, a single hospital may be reimbursed underseveral different payment systems, which will vary from health plan to health plan, and fromprivate plans to government plans such as Medicare and Medicaid. Before continuing ourdiscussion of hospital reimbursement methods, refer to Figure 3B-2, which provides definitionsfor some key terms used in hospital reimbursement.

Straight Charges

The simplest (albeit least desirable) payment mechanism in healthcare is straight charges, underwhich a hospital submits its claim in full to a health plan and the plan pays the bill. It is alsoobviously the most expensive, after the option of no contract at all. This is a fallback position tobe agreed to only in the event that the health plan is unable to obtain any form of discount at all,but it is still desirable to have a contract with a no-balance-billing clause in it for purposes ofreserve requirements and licensure.

Straight Discount on Charges

Another possible arrangement with hospitals is a straight discount on charges, under which ahospital submits its claim to a health plan in full, and the plan discounts it by the agreed-topercentage and then pays the claim. The hospital accepts this payment as payment in full. Theamount of discount that can be obtained will depend on the factors discussed above. This type ofarrangement is not infrequent in markets with low levels of health plan penetration but isuncommon in markets with high levels of health plans.

Sliding Scale Discount on Charges

Sliding scale discounts are an option, particularly in markets with low health plan penetration butsome level of competitiveness among hospitals. Under a sliding scale discount on charges, thepercentage discount on a hospital’s bill is reflective of the hospital’s total volume of admissionsand outpatient procedures. Deciding whether to combine these two categories or deal with themseparately is not as important as making sure that the parties deal with them both. With therapidly climbing cost of outpatient procedures, savings from reduction of inpatient utilizationcould be negated by an unanticipated overrun in outpatient charges.

An example of a sliding scale is a 20% reduction in charges for 0 to 200 total bed days per yearwith incremental increases in the discount up to a maximum percentage. An interim percentagediscount is usually negotiated, and the parties reconcile at the end of the year based on the finaltotal volume.

How a health plan tracks the discount is also negotiable. A health plan may vary the discount on amonth-to-month basis rather than yearly. Alternatively, the health plan may track total bed days,number of admissions, or whole dollars spent. Whatever the health plan finally agrees to shouldbe a clearly defined and measurable objective.

The last issue to look at in a sliding scale is timeliness of payment. It is likely that the hospitalwill demand a clause in the contract spelling out the health plan’s requirement to process claims

in a timely manner, usually 30 days or sooner. In some cases a health plan may negotiate a slidingscale, or a modifier to the main sliding scale, that applies a further reduction based on the plan’sability to turn a clean claim around quickly. For example, the health plan may negotiate anadditional 4% discount for paying a clean claim within 14 days of receipt. Conversely, thehospital may demand a penalty for clean claims that are not processed within 30 days.

Straight Per-Diem Charges

Unlike straight charges, a negotiated straight per-diem charge is a single charge for a day in thehospital, regardless of any actual charges or costs incurred. In this most common type ofarrangement, a health plan negotiates a per-diem rate with the hospital and pays that rate withoutadjustments. For example, the plan will pay $800 for each day regardless of the actual cost of theservice.

Hospital administrators are sometimes reluctant to add days in the intensive care unit or obstetricsto the base per diem unless there is a sufficient volume of regular medical-surgical cases to makethe ultimate cost predictable. In a small health plan, or in one that is not limiting the number ofparticipating hospitals, the hospital administrator is concerned that the hospital will be used forexpensive cases at a low per diem while competitors are used for less costly cases. In such cases,a good option is to negotiate multiple sets of per diem charges based on service type—forexample, medical-surgical, obstetrics, intensive care, neonatal intensive care, rehabilitation, andso forth—or a combination of per diems and a flat case rate (explained later) for obstetrics.

The key to making a per diem work is predictability. If the health plan and the hospital canaccurately predict the number and mix of cases, then they can accurately calculate a per diem.The per diem is simply an estimate of the charges or costs for an average day in that hospital,minus the level of discount.

A theoretical disadvantage of the per diem approach, however, is that the per diem must be paideven if the billed charges are less than the per diem rate. For example, if the health plan has a per-diem arrangement that pays $800 per day for medical admissions, and the total allowable charges(billed charges less charges for noncovered items provided during the admission) for a 5-dayadmission are $3,300, the hospital is reimbursed $4,000 for the admission ($800 per day × 5days).

This is acceptable as long as the average per diem represents an acceptable discount, but it hasbeen anecdotally reported that some large, self-insured accounts have demanded the lesser of thecharges or the per diems for each case—that is, laying off the upper end of the risk but harvestingthe reward. Such demands are to be avoided because they corrupt the integrity of the perdiemcalculation.

A health plan may also negotiate to reimburse the hospital for expensive surgical implantsprovided at the hospital’s actual cost of the implant. Such reimbursement would be limited to adefined list of implants, such as cochlear implants, where the cost to the hospital for the implantis far greater than is recoverable under the per diem or outpatient arrangement.

Sliding Scale Per-Diem Charges

Like the sliding scale discount on charges discussed above, the sliding scale per diem charge isalso based on total volume. Under sliding scale per-diem charges, a health plan negotiates aninterim per diem that it will pay for each day in the hospital; depending on the total number ofbed days in the year, the plan will either pay a lump sum settlement at the end of the year orwithhold an amount from the final payment for the year to adjust for an additional reduction inthe per diem from an increase in total bed days. It may be preferable to make an arrangementwhereby on a quarterly or semiannual basis the plan will adjust the interim per diem so as toreduce any disparities caused by unexpected changes in utilization patterns.

Differential by Day in Hospital

Charging according to differential by day in hospital refers to the fact that most hospitalizationsare more expensive on the first day. For example, the first day for surgical cases includesoperating suite costs and operating surgical team costs. This type of reimbursement method isgenerally combined with a per-diem approach, but the first day is paid at a higher rate, such as$1,000, and each subsequent day is $600.

Diagnosis-Related Groups

As with Medicare, a common reimbursement methodology is by diagnosis-related group (DRG),which is a statistical system of classifying inpatient stays into groups for the purpose of payment.There are publications of DRG categories, criteria, outliers, and trim points—that is, the cost orlength of stay that causes the DRG payment to be supplemented or supplanted by anotherpayment mechanism—to enable a health plan to negotiate a payment mechanism for DRGs basedon Medicare rates or, in some cases, state regulated rates. First, though, the plan needs to assesswhether it will be to its benefit.

If it is the plan’s intention to reduce unnecessary utilization, there will not necessarily beconcomitant savings if it uses straight DRGs. If the payment is fixed on the basis of diagnosis,any reduction in days will go to the hospital and not to the plan. Furthermore, unless the healthplan is prepared to perform careful audits of the hospital’s DRG coding, it may experience codecreep. On the other hand, DRGs do serve to share risk with the hospital, thus making the hospitalan active partner in controlling utilization and making plan expenses more manageable.Generally, DRGs are better suited to plans with loose controls than plans that tightly manageutilization. Insight 3A-2 explains a Medicare demonstration program, combining DRG paymentwith incentive, or bonus payments for quality.

Insight 3A-2

THE PREMIER HOSPITAL QUALITY INCENTIVE DEMONSTRATION:REWARDING SUPERIOR QUALITY CARE

OverviewThe Premier Hospital Quality Incentive Demonstration is part of the CMS Hospital QualityInitiative, originally launched in 2003 by the Centers for Medicare & Medicaid Services (CMS)and the Department of Health and Human Services (HHS). The Premier Hospital QualityIncentive Demonstration, a three-year project launched with Premier Inc., a nationwide

organization of not-for-profit hospitals, will recognize and provide financial rewards to hospitalsthat demonstrate high quality performance in a number of areas of acute care.

CMS is pursuing a vision to improve the quality of health care by expanding the informationavailable about quality of care and through direct incentives to reward the delivery of superiorquality care. Through the Premier Hospital Quality Incentive Demonstration, CMS aims to see asignificant improvement in the quality of inpatient care by awarding bonus payments to hospitalsfor high quality in several clinical areas, and by reporting extensive quality data on the CMS website.

Quality of Care MeasuresUnder the demonstration, top performing hospitals will receive bonuses based on theirperformance on evidence-based quality measures for inpatients with: heart attack, heart failure,pneumonia, coronary artery bypass graft, and hip and knee replacements. The quality measuresproposed for the demonstration have an extensive record of validation through research, and arebased on work by the Quality Improvement Organizations (QIOs), the Joint Commission onAccreditation of Healthcare Organizations (JCAHO), the Agency for Healthcare Research andQuality (AHRQ), the National Quality Forum (NQF), the Premier system and other CMScollaborators.

Hospital Scores Hospitals will be scored on the quality measures related to each conditionmeasured in the demonstration. Composite quality scores will be calculated annually for eachdemonstration hospital by “rolling-up” individual measures into an overall quality score for eachclinical condition. CMS will categorize the distribution of hospital quality scores into deciles toidentify top performers for each condition.

Financial AwardsCMS will identify hospitals in the demonstration with the highest clinical quality performance foreach of the five clinical areas. Hospitals in the top 20% of quality for those clinical areas will begiven a financial payment as a reward for the quality of their care. Hospitals in the top decile ofhospitals for a given diagnosis will be provided a 2% bonus of their Medicare payments for themeasured condition, while hospitals in the second decile will be paid a 1% bonus. The cost of thebonuses to Medicare will be about $7 million a year, or $21 million over three years.

Improvement Over BaselineIn year three, hospitals that do not achieve performance improvements above demonstrationbaseline will have adjusted payments. The demonstration baseline will be clinical thresholds setat the year one cut-off scores for the lower 9th and 10th decile hospitals. Hospitals will receive1% lower DRG payment for clinical conditions that score below the 9th decile baseline level and2% less if they score below the 10th decile baseline level.

Adapted from: Premier Hospital Quality Incentive Demonstration, Fact Sheet. Centers forMedicare & Medicaid Services, Washington, DC February, 2004.

Service-Related Case Rates

Similar to DRGs, service-related case rates are a cruder reimbursement mechanism. Underservice-related case rates, various service types are defined and the hospital receives a flat peradmission reimbursement for whatever type of service to which the patient is admitted—forexample, all surgical admissions cost $6,100. Service types include medicine, surgery, intensive

care, neonatal intensive care, psychiatry, and obstetrics. If services are mixed, a proratedpayment, such as 50% of surgical and 50% of intensive care, may be made.

Case Rates and Package Pricing

Whatever mechanism a plan uses for hospital reimbursement, it may still need to address certaincategories of procedures and negotiate special rates. Case rates are rates that are established on acase by case basis. The most common of these is obstetrics. It is common to negotiate a flat ratefor a normal vaginal delivery and a flat rate for a Caesarean section or a blended rate for both. Inthe case of blended case rates, the expected reimbursement for each type of delivery is multipliedby the expected (or desired) percentage of utilization.

For example, a case rate for vaginal delivery is $2,000, and a case rate for Caesarean section is$2,600. If expected utilization is 80% for vaginal delivery and 20% for Caesarean section, thenthe case rate is $2,120 ($2,000 × 0.8 = $1,600; $2,600 × 0.2 = $520; $1,600 + $520 = $2,120).With the recent legislative activity regarding minimum length of stay for obstetrics, flat caserates, regardless of either length of stay or Caesarean section versus vaginal delivery, are clearlythe preferred method of reimbursement, other than capitation.

Although common, case rates are certainly not necessary if the per diem is all-inclusive, but ahealth plan will want to use them if it has negotiated a discount on charges. This is because thedelivery suite or operating room is substantially more costly to operate than a regular hospitalroom. For example, a health plan may negotiate a flat rate of $2,100 per delivery. The downsideof this arrangement is that the health plan achieves no added savings from decreased length ofstay. The upside is that it makes the hospital a much more active partner in controlling utilization.

Another area for which a health plan would typically negotiate flat rates is specialty procedures attertiary hospitals for medical procedures such as coronary artery bypass surgery or hearttransplants. These procedures, although relatively infrequent, are tremendously costly.

A broader variation is package pricing or bundled case rates. Package pricing or bundled case raterefers to an all-inclusive rate paid for both institutional and professional services. A health plannegotiates a flat rate for a procedure, such as coronary artery bypass surgery, and that rate is usedto pay all parties who provide services connected with that procedure, including preadmission andpost-discharge care. Bundled case rates are not uncommon in teaching facilities where there is afacility practice plan that works closely with the hospital.

Reimbursement Methods for Ancillary Service Providers

One of the primary means by which health plans have achieved greater financial efficiency thantraditional medicine is through economies of scale. For health plans, this typically involvesdeveloping a network of providers, including individual physicians and hospitals. health plansseeking to provide comprehensive health plans must also contract with a variety of providers forancillary services. Ancillary services is an umbrella term for a variety of healthcare servicesoutside of surgery, primary care, and most hospital treatment, and typically these services areprovided by non-physicians. Many ancillary services are diagnostic: laboratory tests, radiology,and magnetic resonance imaging are all examples of services often considered ancillary by healthplans. Similarly, many kinds of physical and behavior therapy, dialysis, home health care, andeven pharmacy services are considered ancillary services.

One characteristic of most ancillary services that has important contractual and financialimplications for a health plan is that few plan members seek these services without first beingreferred to the ancillary provider by a physician. For this reason, the utilization rates for ancillaryservices are partly controlled by physician behavior. Consequently, utilization rates and the coststhat a health plan experiences for ancillary providers depend on the type of network the healthplan manages, and the reimbursement methods it uses for its physicians and hospitals.

An important feature of health plans that have large health plans is that these plans developsignificant data over time concerning quality outcomes by type and intensity of treatments,including ancillary services. Thus, these health plans are able to provide physicians withindicators for determining whether a referral to ancillary services should be made in a given case.The health plans’ case managers may also help control utilization and maximize quality of careby consulting with physicians and ancillary providers at the beginning of a case to determine theappropriate frequency and intensity of use of ancillary services.

Reimbursement methods for ancillary service providers tend to fall into the same generalcategories as those we have already discussed for physicians and hospitals: FFS, discounted FFS,case rates, per diems, and capitation are all used. Within the limits of the utilization controlsmentioned above, these reimbursement systems distribute utilization risk between the contractingparties much as the same reimbursement methods distribute risk between physicians and healthplans.

Reimbursement methods for ancillary services may also be influenced by the structure of thehealth plan that negotiates the contract with the ancillary service providers. A closed panel plan,for instance, may operate the ancillary service itself. A closed panel plan, as well as many openpanel plans, may also contract for services with the ancillary service providers or provider groups.

As we have seen, in choosing methods of provider reimbursement for PCPs, specialists, hospitals,and ancillary service providers, health plans and the providers themselves must consider anumber of factors, including the

Type of providers Type of service being performed by the providers Degree to which transferring utilization risk to the providers is possible and desirable

Different methods of reimbursement have different implications in terms of who is responsiblefor controlling utilization risk and who is responsible for controlling a significant source offinancial costs that a health plan incurs. Capitation, which is already an important reimbursementmethod for many physicians and hospitals, is becoming more common in ancillary serviceprovider contracts. We discuss capitation in the next lesson.

Endnotes

1. Peter R. Kongstvedt, M.D., “Compensation of Primary Care Physicians in Open PanelPlans,” in The Managed Health Care Handbook, ed. Peter R. Kongstvedt, M.D., 3rd ed.(Gaithersburg, MD: Aspen Publishers, Inc., 1996), 141.

2. Academy for Healthcare Management, Managed Healthcare: An Introduction, 2nd ed.(Washington, D.C.: Academy for Healthcare Management, 1999), 2-18–2-19.

Portions of this section are adapted from Peter R. Kongstvedt, M.D., “Negotiating andContracting with Hospitals and Institutions,” in Essentials of Managed Health Care, ed.Peter R. Kongstvedt, M.D., 2nd ed. (Gaithersburg, MD: Aspen Publishers, Inc., © 1997),169–173. Used with permission.

AHM Health Plan Finance and Risk Management: Capitation in ProviderReimbursement

Course Goals and ObjectivesAfter completing this lesson you should be able to:

Describe percent-of-premium capitation and PMPM capitation Explain the differences among and uses of PCP, specialty, full professional, and global

capitation arrangements Explain how carve-outs are used in conjunction with some capitation contracts Discuss contact capitation Describe some of the key information requirements for developing a capitation

reimbursement system

As we mentioned in a previous lesson, capitation is a provider reimbursement system that paysprospectively for healthcare services on the basis of the number of plan members who arecovered for specific services over a specified period of time rather than the cost or the number ofservices that are actually provided. Under capitation, the provider is actually compensated perperson—often referred to as per capita—rather than per service delivered. Typically, capitationpayments to providers are made at monthly intervals.

Capitation is per capita, prospective reimbursement, as compared to fee-for-service (FFS)reimbursement, which is service based and retrospective. As such, capitation transfers thefinancial exposure for identified services from the health plan to the provider.

For the provider, capitation also carries with it some potential advantages. If the providermanages utilization costs so that those costs are less than capitation payments, the providerretains the savings. In other words, in exchange for accepting financial risk of higher-than-expected utilization costs, the provider receives the right to share in any savings that occur whenactual costs are less than expected. Capitation reimbursement is also paid in advance, withoutclaim delays, which makes the provider’s cash flow more stable. Stable cash flows reducebusiness risk for providers, enabling them to pay from a predictable income any salaries orexpense obligations they have.

Capitation is central to health plans and has far-ranging effects on many aspects of contemporaryhealthcare delivery. A movement away from FFS and toward capitation represents a fundamentalshift in risk distribution in a health plan. Along with other aspects of health plans, capitation hasbeen largely responsible for a transformation in the U.S. healthcare delivery system. Inresponding to capitation and health plans, nearly every healthcare organization in the UnitedStates has had to change its organizational strategies and operations.1

From the health plan’s perspective, capitation motivates providers and provider organizations toprovide services that improve members’ health status and to limit services that are unnecessary ornot cost-effective. Capitation increases physicians’ awareness of the financial costs associatedwith their treatment decisions and encourages them to be cost conscious by aligning theirfinancial incentives with their role in making treatment decisions.

Capitation, like other health plan programs, also usually ties members to specific providers andprovider networks, limiting a member’s choice of providers to the plan’s provider panel inexchange for cost-effective care. In this lesson we will explore what capitation is and how it isused. We will also discuss the benefits and drawbacks of using capitation as a reimbursementmethod. We begin by providing a broad overview of capitation.

The next part of the lesson includes a discussion of some of the more complex issues involved inunderstanding capitation and creating capitation rates for specific types of providers, services, andsituations. These issues vary according to the size of the plan and the way in which the risk ofhigher-than-expected utilization is divided among the health plan, providers, and stop-lossreinsurers. We will discuss reinsurance in the next lesson.

Capitation Overview

A capitation rate is an amount paid to a provider or provider organization, typically monthly, ona per plan member (per capita) basis. This is often referred to as the per member per month(PMPM) rate. The total reimbursement amount a provider receives is a function of the number ofplan members for whom the provider has responsibility, rather than the number and type ofservices actually rendered to those plan members.

The basic elements used in determining a simple capitation rate are

Services covered by the capitation contract (e.g., primary care provider visits) Expected rate of utilization for each of these services Average fee for each of these services

health plan (or a provider organization that wishes to capitate its member providers) can calculatea simple monthly capitation payment (or PMPM amount) by multiplying the average number ofservices used by a member in one year by the average fee-for-service equivalent payment perservice, and then dividing by the number of reimbursement periods per specified time period (forexample, if the reimbursement period is one month, then the number of reimbursement periods inone year is 12). Figure 4A-1 shows a sample calculation of a simple monthly capitation rate.

Expected utilization requires a determination of the expected average utilization of each serviceby plan members. Determining the expected average utilization requires at least a year’s worth ofexperience from a population of credible size. FFS equivalents will also vary by the type ofservice.

Determining the Services Covered by Capitation

To develop a capitation rate, a health plan or provider group must define the services covered bythe agreement between the health plan and the providers. This is typically done by clinical area(for example, primary care services), medical specialty (obstetrics-gynecology), or service type(outpatient diagnostic testing). Under some circumstances, some specified services covered by aplan will not be capitated.

Typically, the reason for not capitating specific services is that the plan does not have a credibleblock of business with respect to that service. For example, services that are rendered only in thecase of unusual illnesses may be needed so infrequently that it is impossible to predict accuratelythe average number of plan members who will use the service each year, and it is thereforeimpossible to develop an accurate PMPM rate. In such cases, the providers will be reimbursedaccording to another payment system, such as discounted FFS.

Covered services that are outside the capitation rate are typically defined at the procedure orservice level (using CPT codes), or at the patient diagnosis level (using codes found in theInternational Classification of Diseases, tenth edition, which are known as ICD-9 codes).Additionally, some health plans may reimburse providers on a discounted FFS basis until athreshold number of plan members designate that provider as their caregiver. Contractualprovisions that allow capitated providers to be paid on a discounted FFS basis until the provider’senrollment meets or exceeds a threshold number are called low-enrollment guarantees.

For example, a health plan may pay a pediatrician under a discounted FFS schedule if fewer than100 children covered by the plan use that pediatrician as their PCP. If the pediatrician servesmore than 100 children covered by the plan, then the pediatrician will be reimbursed according tothe capitated rate. Low-enrollment guarantees cause a capitation contract to transfer less risk toproviders than it would otherwise.

In order to develop a capitation rate, a health plan (or provider group) must have data on (or makeassumptions about) the expected utilization of the services covered. This is the most complex partof the capitation development (or analysis). Typically, health plans rely on internal or consultingactuaries, who in turn rely on data obtained from multiple health plans.

The importance of acquiring accurate utilization data has implications for health plan andprovider information systems and data collection. We will discuss some of these issues later inthis lesson.

Other Capitation Issues

Fee-for-service equivalents for each service included in a health plan’s benefit design arenecessary to develop PMPM rates. Typically, FFS equivalents are based on a benchmark(discounted) fee schedule or by using a relative value scale and relevant conversion factor. Ineither case, the FFS equivalents reflect the local or regional market.

The capitation rate for any given provider is also influenced by the presence of noncapitationcontractual elements that apply either to the reimbursement agreement between the health planand providers, or to the design of the healthcare plan itself. These elements, which we willdiscuss in more detail later in this lesson, include withholds, risk pools and reconciliations, andmember eligibility.

Types of Capitation: PMPM and Percent-of-Premium

The basic capitation described previously and in Figure 4A-1 is a simplified model of the PMPMtype of capitation. In practice, capitated PCPs often work under a PMPM contract. PMPMcapitation is the most common type of capitation.

The second type of capitation uses a percent-of-premium approach to reimbursementarrangements. Percent-of-premium arrangements are capitation contracts in which thereimbursement to providers is a percentage of the premium payment the health plan receives forproviding healthcare coverage to plan members. Like PMPM capitation, percent-of-premiumarrangements transfer the risk of overutilization from the health plan to the provider. UnlikePMPM capitation, which sets reimbursement at a specific dollar amount per plan member, thedollar amount paid to providers under percent-of-premium arrangements will vary according tothe amount of premiums the health plan receives.

Types of Capitation: PMPM and Percent-of-Premium

Additionally, percent-of-premium arrangements transfer some of the risk associated withunderwriting and rating from the health plan to the provider. In other words, under percent-of-premium arrangements, the providers share some of the risk that the health plan has set premiumstoo low to cover the actual costs of providing covered benefits to plan members. Of course, incases where the premiums have a sound actuarial basis and the plan members’ morbidityexperience falls within the predicted range, providers share in profits generated by the premiumrates. The exact amount of underwriting risk being transferred in any given percent-of-premiumarrangement will vary according to the percentage of the premium that is being paid to theproviders as well as according to the adequacy of the premium rates.

During the period that a percent-of-premium contract is in place, it tightly binds the providerorganization to the health plan. For instance, if the health plan finds it necessary —forcompetitive reasons—to decrease premiums, the provider organization will receive smallerpayments because those payments are based on a percentage of the premiums. In contrast, aPMPM capitation rate will result in the same payment to providers no matter what premium ratethe health plan receives from the plan payor. Because 85% or more of the premium received by

the health plan may be transferred to providers through a percent-of-premium arrangement(depending upon which clinical and administrative services are included), the providerorganization may bear much of the risk for the financial and underwriting decisions made by theplan.

For this reason, percent-of-premium arrangements are much more attractive to providers whenthese arrangements include provisions that set a limit on the underwriting risk that the providersaccept. One method of limiting this risk that is therefore a critical part of the large majority ofcommercial group health plans’ percent-of- premium contracts is to set a minimum capitationpayment, such as a PMPM “floor.” Such floor rates evolve out of actuarial considerations andmarket forces, but their purpose is to limit the underwriting risk providers accept. Under suchcontract provisions, the health plan guarantees a minimum capitation rate will be paid toproviders regardless of any premium decreases. In situations where premium rates are establishedby an external organization, such as state or federal governments, a floor rate is not as critical.

Capitation Variations by Medical Service Grouping

Both PMPM capitation and percent-of-premium arrangements pay providers prospectively ratherthan on a per-service basis. Both also can be used as the reimbursement methodology for manydifferent types of providers and provider groups.

Within either type of capitation, variations occur based on what kind of providers and medicalservices are covered under the capitation contract. The following list describes some of thecommon types of variations:

PCP capitation PCP capitation, also called partial capitation, is a capitation payment thatreimburses the provider for primary care services only. Typically, the PCP will referpatients to specialist providers for services such as radiology, surgery, and laboratorytests.

Specialty capitation Specialty capitation uses capitation reimbursement to pay individualspecialists or single-specialty groups to provide a contractually defined set of services toa health plan’s members.

Full professional capitation Full professional capitation, sometimes called fullprofessional services capitation, is a capitation payment that covers all physician services,including primary care and specialty services. Typically, this method of reimbursement isused to compensate provider groups of various types, such as clinics and multispecialtyIPAs, and these groups in turn accept responsibility for the costs of all physician servicesrelated to a patient’s care.

Global capitation Global capitation, also called full-risk capitation, is a capitationpayment that covers all physician and facility services, including hospital inpatient andoutpatient services, primary and specialty care, and some ancillary services.

We discuss each of these capitation variations in turn and how elements within capitationcontracts can be used either to adjust the amount of risk a provider accepts through the contract,or to adjust the amount of compensation a provider receives to reflect the provider’s or plan’sperformance.

PCP Capitation

Primary care provider (PCP) capitation is, by far, the most common type of capitation. In healthplans that capitate their PCPs, new enrollees are required to select a PCP who will serve as theirmain connection to the health plan. PCPs include family practitioners, general practitioners,general internists, and, for children, pediatricians.

Primary care services usually include a range of office-based services as well as physician visitsto hospitalized plan members. Although plan members can receive emergency care without firstseeing a PCP, for other services beyond the scope of primary care, members must be referred tospecific providers by the PCP. Services that typically require referral include specialist services,lab and X-ray services, and hospital admissions. Healthcare plans in which PCPs serve in this roleare known as gatekeeper model plans.

Thus, under a gatekeeper model, PCPs, whether they are capitated or not, manage the risk ofoverutilization of specialty services and diagnostic tests.

Most primary care capitation arrangements do not make the provider financially responsible forthe cost of major diagnostic tests (such as an MRI) that a PCP might order. This is because asingle expensive test that is rarely required can be much more expensive than many months ofaverage PMPM payments—and so its inclusion in the covered services list creates adisproportionately large financial risk for the physician.

In cases where the PCP’s capitation contract does not make the PCP responsible for the cost ofspecified expensive tests or procedures, the utilization risk for such costly services is borne by anentity covering a large volume of members and services. Such entities are capable of acceptingmore risk than individual PCPs are able to accept. Examples of this type of entity include a largegroup practice, an independent practice association (IPA), an integrated delivery system (IDS), orthe health plan itself. Provider organizations accepting such risk might act as the health planwould, if responsible for these services, and screen for the appropriateness of, and require priorapproval for, these services.

Specialists and other providers to whom members are referred by PCPs are usually paid under aseparate capitated or discounted FFS contract with the health plan. If PCPs are reimbursed on adiscounted FFS contract, then the charges for these outside lab and X-ray services will be paid bythe health plan, which in turn typically subtracts that payment from the monthly capitationdisbursement to the PCP.

In addition, most PCP capitation contracts have separate risk pools tracking the PCPs’ members’use of specialty and hospital services. Methods for reducing the PCPs’ reimbursement whenreferrals exceed expected levels, and methods of providing PCPs’ bonuses when referral rates arelower than expected, serve as means by which a PCP can be financially motivated to avoidmaking unnecessary referrals.

PCP capitation contracts also, however, usually include provisions intended to protect the PCPagainst the financial consequences of having a patient (or patients) with a catastrophic illness,and/or from high member utilization caused by forces beyond the PCP’s control. We discussthese provisions, called stop-loss protection, in the next lesson.

Specialty Capitation

Just as capitation for PCPs typically requires members to select a PCP, capitation for specialiststypically requires that members be tied to specialists in some way so that the specialist’s PMPMreimbursement can be determined.

In some health plans, women designate an obstetrics-gynecology (OB-GYN) provider, in muchthe same way as they would designate a PCP. This designation makes it possible for the plan toreimburse that OB-GYN provider on a capitated basis. Aside from plans where a womandesignates an OB-GYN provider, tying each member to specialists when the member enrolls isonly possible if the plan design is aligned with the capitation reimbursement model.

For example, the plan may tie the enrollee’s choice of a PCP to a specific referral circle, which isa geographically distinct group of physicians, usually those with privileges at a local hospital, forall specialty referrals. Similarly, the choice of a PCP can link the member to a multispecialtygroup practice, an IPA network, or an IDS. This type of arrangement ties the members to a groupof specialists in advance of the members’ need for specialty care, which allows for capitation ofthose specialists.

Certain highly specialized physician services (such as neurosurgery or organ transplants)generally would be excluded from the capitation. Capitation of specialized provider servicestends to become more difficult for services that are both very expensive and very infrequent.

Figure 4A-2 explains in general terms why the high cost and low utilization rates of someservices influence all providers in capitated contracts and why, for some specialty services, highcost and infrequent utilization are important factors in limiting single specialist capitation.

For some specialty-specific treatments (e.g., neurosurgery), PMPM rates are extremely small(less than $0.10 PMPM) because, despite high costs for some cases, utilization rates areextremely low. Although the population utilization rate may be low, a specialist who happens toexperience even a small number of very expensive cases risks very high losses under such acontract.

This potential for unexpectedly high costs in some specialty care situations makes traditionalcapitation less attractive to specialists than it is to PCPs. Given these risks, specialty physiciansand health plans usually choose some form of discounted FFS (or other service-specific) paymentsystem. The specialist and health plan can also agree upon case-specific reimbursements forcertain types of cases. For example, a case-specific reimbursement might cover professionalservices associated with a coronary artery bypass graft (CABG) or childbirth.

Given these factors, single-specialty capitation is much less common than PCP capitation.

Some physicians, particularly internists with specialty board certifications, may provide a mix ofservices that health plans consider primary care and specialty care. In most health plans with PCPcapitation, a physician must choose whether to participate as a PCP or a specialist. A PCP cannotself-refer for specialty services—services beyond those typically provided by a PCP. Likewise, aspecialist cannot receive specialty capitation and be the member’s primary contact with the plan.These provisions, while developed to avoid financial conflicts of interest, can impede continuityof care in some situations, and point to a limitation of the PCP capitation model.

Full Professional Capitation

Specialists are more commonly capitated as part of a physician’s group that is reimbursed throughfull professional capitation. Full professional capitation is a provider reimbursement method thatcapitates physician groups that provide both primary and specialty care. Full professionalcapitation payments cover all physician services and associated diagnostic tests and laboratorywork. Typically, under full professional capitation, a health plan capitates an entire physiciangroup such as an IPA (with a network composed of PCPs and physicians from most specialties)or a multispecialty group. In turn, the physicians as a group determine how individual physicianswill be remunerated.

In an IPA, individual physicians may be paid on a subcapitation basis, a discounted FFS basis, anRVS-based fee schedule, an RBRVS-based fee schedule, or some combination of these methods.Subcapitation is a provider reimbursement method in which a provider entity (in our example, anIPA) receives either full professional or global capitation from a health plan and then separatelysubcontracts with a physician, physician group, or other provider organization for specific clinicalservices, using a capitated payment to reimburse the subcontractor. Only specialties that havehigh volume and predictable cost patterns are normally considered for subcapitation.

The capitated entity’s purpose in entering subcapitated arrangements is to minimize the utilizationrisk it bears in its capitation contract with the health plan, and to align the incentives of thesubcapitated specialty providers with those of the capitated entity. For example, if an IPAreceives capitation reimbursement from a health plan, the IPA accepts utilization risk under thatcapitation contract. By subcapitating providers, the IPA transfers some of its utilization risk tothose providers.

The type of capitation—PMPM or percent-of-premium—received by the provider entity does notdictate the type of capitation the entity uses to subcapitate its individual providers. For example,an entity receiving percent-of-premium full professional capitation can subcapitate individualphysicians using either a PMPM or percent-of-premium capitation methodology. If, however, thesubcapitation is PMPM and the full professional capitation is percent-of-premium, then thecapitated entity is incurring the risk that the percent-of-premium payments it receives from thehealth plan will be insufficient to meet the entity’s fixed PMPM obligations to its subcapitatedphysicians.

If the capitated entity in a full professional capitation arrangement pays any of its providers usingFFS or RVS-based payments, there must be a year-end budget reconciliation comparingcapitation payments received by the entity from the health plan against fees paid to individualphysicians by the entity.

In a multispecialty group practice accepting full professional capitation, individual compensationmay be based on salary plus a bonus; some FFS, RVS, or RBRVS basis; or an internalsubcapitation.

Multispecialty groups—or even PCP groups —may also accept a full professional capitation andthen subcapitate or otherwise externally contract for certain (or, in the case of a PCP practice, all)specialty care not available internally.

Because capitated reimbursement is structured around spreading risk, provider organizations havean advantage over individual specialty physicians in capitated contracting as long as the provider

organization has enough volume to prevent any one physician from shouldering adisproportionate share of risk. This advantage in capitation contracting is a factor in the growth ofmany physician groups

Global Capitation

Global capitation, also called full-risk capitation, is a capitation system that pays a providerorganization to provide substantially all of the inpatient and outpatient services—includingclinical, primary, specialty, and ancillary services —that the health plan offers. As a consequenceof accepting a global capitation contract, the provider group accepts much of the risk thatutilization rates will be higher than expected. However, out-of-network care that is renderedoutside the plan’s geographical area is usually excluded from the reimbursement and is theresponsibility of the health plan. At a minimum, health plans also retain responsibility formarketing, enrollment, premium billing, actuarial, underwriting, and member services functions.

Global capitation is usually accepted and administered by an IDS, although other providerorganizations also enter into global capitation contracts. Recall that an IDS is a providerorganization that is fully integrated operationally and clinically to provide a full range ofhealthcare services, including physician, hospital, and ancillary services. Integrated deliverysystems are typically built around a hospital or hospital system. The physicians might beemployed directly by the IDS, or they might be affiliated through a physician-hospitalorganization (PHO) or a contracted network. Alternatively, a large multispecialty physicianpractice or a physician contracting organization called an IPA might accept global capitation andsubcontract with hospitals for inpatient services.

Generally these entities seek to improve operating efficiencies by creating economies of scale andreducing overhead. They also implement broad policies and procedures that include system-wideapproaches to quality management and improvement. From a strategic perspective, they create aregional (or “brand”) identity, and they market a quality-oriented and customer focused image toconsumers.

However, under global capitation direct contracting arrangements, IDSs essentially have toreplicate internally (or externally contract for) many of the functions a health plan otherwiseperforms. Again, however, IDSs face significant challenges in securing sufficient capital todevelop operational and informational systems infrastructures and in developing expertise in planmanagement. In most markets, health plans have more experience performing most of thesefunctions.

In some states, providers must obtain a license and meet solvency requirements in order toparticipate in global capitation or other arrangements that require the provider organization totake on substantial risk. Securing a license involves time and financial investment and can presenta significant barrier for provider organizations seeking global capitation arrangements.

Another implication of global capitation is the need to divide reimbursement among thehospital(s), physicians, ancillary providers, and primary care and specialist physicians.Developing this type of agreement among a large number of providers can be a complex process.In fact, this complexity is often a barrier to provider groups’ developing such arrangements withhealth plans. As is the case with health plan provider payment systems, the system an IDS uses todivide payments among providers must be understandable to all the participating providers. In

addition, those providers must agree that the system is fair, or in the long run the providers willnot wish to renew their contracts.

Dividing the global capitation payment may be much easier when one entity secures the globalcapitation contract and then negotiates subcontracts for specific services—be it a physicianorganization contracting with a hospital for inpatient services, or vice versa.

Capitation and Plan Management: Carve-Outs and Disease Management Programs

Carve-outs are services that are excluded (or carved out) from a capitation payment, a risk pool,or a health benefit plan. Typically, a health plan will offer these carved-out services to enrollees,but will manage these services separately. In practice, the term carve-out has also come to refer todiscrete programs covering entire categories of care—such as mental health, pharmacy benefits,and even specific diseases—that are usually administered by independent organizations.

Examples of the first type of carve-out are specific services such as childhood immunizations orexpensive lab and radiology services that are excluded from PCPs’ capitated reimbursementpayment or from the PCPs’ risk-pool calculations. The specific services carved out, if any,depend on the contract. The excluded services may be

Provided by the PCP and reimbursed by the plan on a fee-for-service basis (e.g.,childhood immunizations)

Handled by another provider (e.g., through a separate lab and X-ray contract) Absorbed by the health plan (e.g., expensive services excluded from a risk-pool

calculation)

In the type of carve-out in which entire categories of care are administered by independentorganizations, the organizations are typically reimbursed under a capitated PMPM contract.

For example, mental health services have often been carved out by health plans, which contractwith a specialty health plan, typically called a managed behavioral health organization or MBHO.In so doing, the health plans assume that distinct administrative and clinical expertise is requiredto effectively manage mental health services. Over time, however, this trend in managing mentalhealth services has slowed, and many health plans are integrating mental health care with medicalcare.

Pharmaceutical coverage is another area that has frequently been carved out by health plans.Pharmacy costs have grown at a significantly faster rate than overall healthcare costs. To managethe growth in these costs, healthcare plans have contracted with pharmacy benefit managers(PBMs), which are specialty health plan firms that specialize in managing pharmaceutical costs.These firms develop systems that profile physician prescribing patterns, check for negative druginteractions, and negotiate significant discounts from drug manufacturers.

One method commonly used to control utilization and cost is the use of formularies. A formularyis a listing of drugs, classified by therapeutic category or disease class, that are consideredpreferred therapy for a given health plan population and that are to be used by a health plan’sproviders in prescribing medicines. Drugs are placed on the formulary because of theireffectiveness for a given condition and, usually, because the PBM has been able to negotiate

significant volume discounts from the manufacturers of the drugs. In many cases, PBMs’expertise and buying power make them costeffective subcontractors.

The most rapidly growing area related to carve-outs, however, is disease management (DM).Under DM, carved-out services are often very narrowly defined in terms of specific diseases,such as diabetes, asthma, AIDS, and cancer. DM programs include data-driven models foridentifying plan members with specific diseases, and structured programs of interventionsdesigned to manage the disease, improve patients’ functional status, improve quality of care, andsave money otherwise spent on avoidable emergency room visits and hospitalizations.

In addition to saving plan costs, DM programs can also reduce the risk accepted by providers whoare capitated, because the risk of having to provide high-cost treatments for these diseases iscarved out of the capitation contract. DM carve-outs need not be transferred to an outside entity.Instead, a health plan or a capitated provider organization will sometimes develop an internal DMprogram for patients with a given, usually chronic, disease.

Contact Capitation

Contact capitation is a form of payment in which specialists receive a flat, predetermined feeonce a referred patient begins to receive treatment from them for a given condition. This issimilar to a case rate—a flat fee paid to the provider in order to care for a patient with a givencondition—which we discussed in the last lesson.

In general, contact capitation works as follows. A plan (or an IPA or IDS that accepts eithercapitation for all physician services or global capitation contracts) sets aside a PMPM amount(actuarially determined and adjusted for members’ age and sex) for each specialty. Every time aPCP refers a member to a specialist and the specialist sees the member, the specialist begins toreceive a share of those funds on a monthly basis. The method used to determine the size of theshare and the number of months the specialist receives the contact capitation payment vary byorganization.2, 3

The monthly payment for each specialist is determined by taking the number of active contactcapitation patients for that specialty and dividing it into the total specialty pool for that month.The specialist collects a proportionate share plus the member copayment. A contact capitationpatient could be active for as little as two months or as long as a year, depending on the plan andthe specific model used.

Some contact capitation contracts make no payment adjustment for different types of conditions,implicitly making the assumption that physicians in a given specialty in a given area workingwithin a specific managed care model have a similar case mix on average. Other contracts mayuse a simple case mix adjustment that sets an amount of “extra credit” for each sicker or olderpatient. Finally, some contracts call for adjusting relative payments according to each patient’sdiagnosis or diagnosis and age and sex.4

Even under such a system, however, the essential model for contact capitation remains thesame—to divide a pool of accumulated specialty-specific PMPM contributions by either the totalnumber of active contact capitation patients or the active con- tact capitation patients’ totalnumber of relative value units within an RVS or RBRVS system.

Contact capitation rewards the provider for controlling the costs of each case, which ultimatelylowers healthcare costs. Because providers who are reimbursed through contact capitation arepaid for each case they see, however, the risk of overutilization still exists unless some control isin place to monitor how many cases are presented to these providers. Often, the control is agatekeeper PCP whose own reimbursement is not affected by the number of cases the gatekeeperrefers to providers who are reimbursed through contact capitation.

Using Withholds, Risk Pools, and Year-End Reconciliations in Capitation Contracts

In health plan markets, most health plans structure provider reimbursement so that, even in theabsence of capitation, providers are sharing some of the financial risk associated with theirtreatment decisions. Withholds, risk pools, and periodic tracking and reconciliation of theseaccounts are all means of transferring some financial risk to providers who have some controlover utilization costs. Although these methods are used in a variety of reimbursement contracts,they are often used in conjunction with capitation contracts as well.

Withholds and Risk Pools

Recall from a previous lesson that in a withhold arrangement, a percentage of the providers’reimbursement is not paid to the providers until the end of a financial period. Claims that exceedthe budgeted costs for care during that period are charged against the withheld funds, and aftersuch claims are paid, the remaining money in the withhold is distributed to the providers.Withholds, along with risk pools, serve as a means of motivating providers and provider groupsto be cost- and quality-efficient.

Historically, they have been a common feature of IPA model HMOs, which are HMOs thatcontract directly with independent physicians in private practice. In IPA model HMOs, PCPs aregenerally capitated, specialists are paid on a discounted FFS basis, and hospitals are typicallyreimbursed using per diems. The details that follow are based on that type of model.

Health plans may create several risk pools—for example, in hospital utilization and various typesof specialty care—within a given healthcare plan. A full professional capitation arrangementmight include a risk pool for hospital utilization, but would not include a specialty risk poolbecause the capitation payment incorporates a fixed fee for specialty care. Similarly, in a globalcapitation arrangement, all services, outpatient and inpatient, are reimbursed on a fixed-fee basis.The provider organization assumes the utilization risk, absorbs any deficits, and keeps any“surplus.”

Again, within a capitation environment, the purpose of withholds and risk pools is the same as inany other provider reimbursement method: to financially reward providers who controlutilization. For example, if a network’s PCPs are capitated, then they are financially rewarded fortransferring to specialists those patients who generate high costs. This motivation exists whetheror not the patient is best served by seeing a specialist. But if a withhold or risk pool isincorporated into the PCP’s contract, then some portion of the expense for the specialists can bededucted from the withhold or risk pool. This deduction puts the PCP at risk for overutilization ofspecialists, and therefore motivates the PCP to avoid making unnecessary referrals.

Withholds are amounts withheld from physicians’ reimbursement pending year-end analyses ofutilization and associated costs for diagnostic testing, specialty care, and/or inpatient utilization.In capitation contracts, the typical range for withhold amounts is 10%–20% of the capitation

payments. Hospitals often share in the risk pool for inpatient utilization, but they may or may nothave a portion of their payments similarly withheld. A portion or all of the withhold amounts maycover any shortages in the targeted risk pool funds. If there are surpluses, physicians can receivenot only the withhold amounts, but also bonuses based on a share of the surplus.

The process of designing a withhold provision starts with the health plan and physicians whonegotiate actuarially defined risk pool targets. The targets are typically set as PMPM amounts forspecialty care and days per 1,000 members per year for inpatient care. The target amounts areage- and gender-specific and are summed to generate the actual risk pool amounts. At the end ofthe year, PCPs with specialist costs and/or inpatient utilization costs that are over budget will losesome of their withhold amounts. PCPs with lower specialist costs and lower inpatient utilizationcosts will receive the withholds, plus a bonus.

Physicians generally share risk with other physicians (for both the specialty and hospital riskpools), as well as with the local hospital (for the hospital risk pool only). There may be severallevels of pooling of risk—an aggregate level that determines the maximum payout level perphysician and a local (or individual) level that determines a specific physician’s payout.

At its simplest, the risk pool arrangement may reflect the individual experience of a physician.Alternatively, the health plan may combine the utilization experience of a small number ofphysicians who practice independently into what is called a pool of doctors, or risk pod. A riskpod is a small group of physicians practicing independently within a geographic region who aretreated as a group for the purposes of measuring performance or setting compensation. A risk podwill typically contain approximately five to ten physicians. Physicians within larger groups, suchas referral circles or IPAs, may have their utilization pooled and compared to budgeted amounts.

Generally, PCPs and specialists share the specialty risk pool. The hospital and physicianstypically will share in the risk pool for inpatient services (a "shared risk" arrangement). In othercases, physicians may share the hospital risk pool (surplus or deficit) with the health plan.

Just as capitation contracts must clearly define those services that are (and, in some cases, that arenot) covered by the capitation payment, the same applies to risk pools. In general, only thoseitems that are within a physician’s control should be part of the risk pool calculation, because theprimary purpose of a risk pool is to reward physicians for avoiding overutilization.

Thus, for a risk pool to achieve its purpose, the physicians in the pool must be able to manage theutilization rate of the covered services. For example, emergency hospital services are sometimesexcluded from risk pool arrangements for capitated physicians, because physicians cannot controlthe number of emergency hospital visits plan members will make. However, physicians do havesome control over the overutilization of hospital inpatient days for patients who are not receivingemergency care, so utilization of these inpatient services would be included in the risk pools.

Other important considerations are the numbers and types of risk pools, the risk pool targets, andhow items charged against the risk pool will be priced. For instance, many services haveprofessional and facility charges associated with them. Generally both charges will be included.

Risk pools are typically evaluated and "settled" at (or as of) the end of a specified period, usuallyone year, though this may vary. In any case, as the year progresses, providers should receivemonthly or quarterly reports showing their performance on a year-to-date basis. The reporting, at

a minimum, will make physicians aware of any high utilization trends, and will provide afinancial motivation for them to change their practice patterns before the year is complete.5

Bonuses and Quality of Care

Health plans have tended to shift away from reimbursement systems that use both withholds andbonuses based on utilization rates alone and to shift toward reimbursement methods that consistof a base payment plus a bonus that is based on both utilization and quality of care measures.

The new bonus is based on a multidimensional model incorporating utilization and financialfactors as well as quality of care targets, data collection targets, and patient satisfaction measures.6,7

These evaluations include a variety of quality and customer service related factors including:

Member satisfaction survey ratings Member transfer rates Medical chart reviews Available office hours and scheduling ease for members Performance on specific Health Plan Employer Data Information (HEDIS) measures such

as immunization rates for children–or other similar measures (for instance, cholesterolscreening, flu vaccination)

Drug formulary adherence

A health plan or delegated provider organization can design bonus amounts so that they vary fordifferent levels of performance, and base the bonus paid on a percent of capitation or on a PMPMrate. In such bonus arrangements, however, it is important that the bonus amounts generated byquality-of-care measures do not exceed the total level of surplus available for distribution throughthe bonus.

Quality-related bonus arrangements such as those described above can be applied to PCPs,specialists, and hospitals–whether or not the base payments are actually made on a capitatedbasis. PCPs paid on a discounted fee-for-service basis, specialists paid on a discounted FFS orcase-rate basis, and hospitals paid on a percentage-of-charges, per diem or DRG (case rate) basismay gain bonuses based on a similar combination of related factors. However, as a general rule,providers who accept relatively greater risk (as in capitation contracts) should receive a largerproportional bonus than the bonus received by providers who accept less risk through FFScontracts, all other things being equal.

Year-End Reconciliations

A reconciliation, or a settlement, is the process by which the health plan assesses providers’performance relative to contractual terms and reimbursement. Most agreements call forreconciliations, or settlements, to be performed at year-end. Consequently, they are often calledyear-end reconciliations. However, they may be done quarterly or at any other frequency agreedto by the contractual parties. Typically, a reconciliation includes a:

Formal measure of utilization and other performance criteria

Calculation of the risk pool utilization relative to budget Reconciliation of any surpluses or losses against monies withheld Payment to the providers of any withholds and/or bonuses due

Year-End Reconciliations

To assure that all the claims for a given period have been reported, utilization calculationsgenerally require that at least three months and possibly as much as six months have passed fromthe closing of the evaluation period. The time required to receive all (or nearly all) claims for agiven period is known as the run out period. From a business point of view, the health plan mustbalance the additional accuracy gained from waiting an extra month for any claims straggling inagainst the importance to providers of the health plan’s reporting results as soon as possible. Inany case there will almost always be missing data–for instance, claims incurred but not reported(IBNR) from out-of-network providers. Therefore, contract provisions should address situationsinvolving the absence of final data.

Capitation for Different Organizations and Types of Services

Capitation as a form of payment can be applied to services provided by a variety of differentorganizations and health care professionals. The two most common types of providers receivingcapitation are physicians and hospitals–sometimes separately, sometimes together. In this sectionof the lesson, we discuss the capitation arrangements made most commonly by physicians,hospitals and integrated delivery systems (IDSs). Figure 4A-3 summarizes different providers andthe types of services that are often capitated.

Given all these variations and details, it should be no surprise that physicians increasingly rely onprofessional administrative expertise in negotiating contracts with health plans. A group practicemay employ (or contract) with an internal practice administrator. But physicians also rely onIPAs, management service organizations (MSOs) and PHOs to help them gain access to memberscovered by a variety of health plans and to negotiate the best possible contract terms. To enablethese organizations to negotiate the best arrangements, physicians may even give them singlesignature authority, which enables the IPA or PHO to sign a binding contract with a health plan.

Capitation for Hospitals

Hospitals are sometimes paid on a capitation basis for inpatient and/or specific outpatientservices. Because hospitals operate in-house laboratories and radiology services, and may ownsatellite locations providing these services, they may be capitated for outpatient lab and x-rayservices, even if they are not capitated for inpatient care or other outpatient services.

However, as we mentioned earlier in this assignment, the most common reimbursement methodsfor hospitals have been per diems (negotiated fees paid per day) and case rates (for instance,DRG-based payments).Capitation for Hospitals

Per diem payments are usually set at a rate that motivates hospitals to provide cost-effective careto patients who are in the hospital. However, they may also provide financial motivation forhospitals to keep patients for as many days as possible. In practice, risk pools are also used tocontain inpatient utilization. Inpatient risk pools may be structured so that physicians and thehealth plan or physicians and the hospital share this risk and any savings or overruns.

In the interest of maintaining their autonomy, many hospitals form PHOs, hospital systems andintegrated delivery systems that can accept global capitation payments. Then the hospital – as amajor player in these networks or IDSs – can capture more of the premium dollar and retain moreof the savings generated by reducing both costs per day and bed days per 1,000 enrolled planmembers. Providers and hospitals, however, face many challenges in seeking to form IDSs. IDSsrequire significant start-up capital, as well as expertise in managing a large healthcare entitycomposed of many different types of providers. Furthermore, such IDSs still must be able tonegotiate a successful global capitation or global percent-of-premium contract, and once acontract is in place, these global payments must be equitably divided among participatingproviders.

Information Requirements for Capitation

Health plans have achieved much of its financial efficiency by developing the means to gather,analyze and exchange information. With respect to provider reimbursement, timely, relevantfeedback to providers is essential for controlling costs and monitoring quality—two essentialfunctions in health plans. To perform these functions and set reimbursement rates on the basis ofutilization, a health plan must have a sophisticated information system.

A simple example of information requirements for health plans is member processing. To developcapitation rates, health plans must identify and capture demographic information for everycovered member, because, at the most basic level, capitation contracts reimburse “per memberper month” based on a member’s age and gender.

Health plans and provider organizations that subcapitate other providers must have means ofreporting utilization and costs on a per member basis. Without the systems infrastructure andaccompanying data they would be unable to manage their business. Timely, accurate datasupports day-to-day plan management and financial control.

Although health plans generally own operational models and information systems that canprocess and analyze the information necessary to operate complex health plan functions, manyproviders such as hospitals and physicians still face the challenge of building information systemsthat reflect health plan requirements. The fast pace of change in provider organizations and thelevel of consolidation that has developed as a consequence of instituting health plan practicesleaves many organizations still adjusting, trying to figure out how to link incompatible systems.

As providers sign capitated contracts under which they accept more and more of the risk (e.g.,global capitation and percent-of-premium arrangements), they are accepting roles and financialrisk traditionally held by insurance companies and health plans. The challenge for providers is tomerge these new roles and requirements with their traditional expertise in healthcare delivery.

Key Capitation-Related Information System Components

Ideally, a provider information system within a health plan system will include the followingelements:

A member information and eligibility module. This module contains basicdemographic information about plan members and includes on-line or frequent disk ortape updates from health plans. These updates include demographic information, healthplan, plan type, copayment levels, deductibles, and coordination of benefit (COB)information.

A patient utilization module allowing for real-time collection of all patient encounterinformation including diagnosis, service and procedure codes, and any relevant billinginformation (e.g., copayment levels, deductibles).

An ability to track and reconcile member eligibility (member additions, changes, andterminations) and capitation payments made by multiple health plans, each with multipleproduct lines (e.g., commercial, Medicare, Medicaid, POS vs. closed access).

Import and export capabilities for periodic transfer of data (e.g., eligibility data,utilization data, referrals, and authorizations) to and from the health plan.

Periodic audits using medical charts to verify the accuracy and completeness of on-linedata capture.

Key Capitation-Related Information System Components

In addition, provider organizations at risk for specialist and/or hospital utilization must have theability to track incurred but not reported (IBNR) claims, especially if they will subcontract andreimburse some services on a FFS basis. Generally these systems involve matching referrals toclaims paid and the systems must be able to accrue an estimated amount due for those referrals ata given point in time without accompanying claims.

In percent-of-premium capitation systems, health plans must be able to obtain information onplan members. In the large majority of cases, the health plan will be charging different premiumrates to different groups, which means that the information system must track which membersfrom which groups sign up with a given provider. Then the health plan and provider must use thisdata to determine how the percent-of-premium payment can be divided as fairly as possibleamong the various capitated providers.

Accuracy and timely data capture enables effective reporting, which in turn facilitates bettermanagement and improved planning. Reports showing utilization per member per month (and, ifapplicable, IBNR claims), gives provider organizations information on actual utilization relativeto budgeted amounts. 8

Accuracy and timeliness are important elements in data management because they help bothproviders and health plans avoid significant losses. Data should be reportable by health plan, byproduct line (for example, commercial, Medicare, Medicaid)–and possibly by the same age andsex categories used for capitation payments.

In the case of percent-of-premium capitation contracts, both the health plan and the capitatedproviders will be motivated to analyze costs by employer group to make sure that the health planis properly rating and underwriting each group. In cases where a group’s premiums do notadequately reflect the actual risk the group represents, then both the health plan and the providersare unintentionally accepting greater-than-expected risk through the percent-of-premiumreimbursement contract.

Other internal reports might examine the cost side: physician time/cost per visit, non-physicianclinician time/costs per visit, visits per member per year, and overhead. Together such data wouldenable the organization to monitor clinical productivity and to provide timely feedback tophysicians on variations in practice patterns.

Utilization Benchmarks and Historical Data

To develop capitation rates, health plans must gather utilization data and then use it to makeassumptions about future utilization. The more accurate the utilization assumptions, the morerealistic the capitation rate. More realistic capitation rates benefit both the health plan and theproviders, since it reduces the financial risk faced by each.

In addition, health plans typically have either in-house or external consulting actuaries availableto support their efforts. Providers, provider organizations, and IDSs also contract with actuarieswho provide the expertise that the providers need to negotiate knowledgeably.

Actuaries are experts in studying and modeling utilization and the effects of variations in costsharing (copayment levels and deductibles), benefits (inclusions and exclusions), and plan designvariations (gatekeeper versus open access, in-network only versus in-network and out-of-networkbenefits, etc.). Actuaries are also responsible for generating the standard age- and sex-specificPMPM cells in capitation reimbursement tables. We discuss underwriting and rating in moredetail in lesson 7, 8, and 9.

FFS Equivalents and Pricing Per Expected Service

In developing or analyzing a capitation rate, obtaining fees for each expected type of servicerendered by providers is important. Information used to determine these fees can come frommany different sources. But, in general, there are two main issues with fees: (1) their levels, and(2) the relative pricing of services (within and between specialties).

Physicians analyzing a contract are very interested in the effective fees they will receive for eachunit of service, and frequently want to adjust individual fee assumptions. After year-endsettlements, physicians who are analyzing their contracts will want to know the fee-for-serviceequivalent fees they received for each unit of service.

FFS Equivalents and Pricing Per Expected Service

The issue of relative fees for different services becomes more complex when the capitationcontract covers physicians from different specialties–physicians in a multispecialty practice orthose who are part of an IPA or an IDS with a full professional or global capitation contract. Useof a relative value unit (RVU) scale, such as the resource-based relative value scale (RBRVS)used by Medicare, or other scales available commercially, can help with this challenge.

With a relative value scale each service is assigned a relative weighting, then a factor (the“conversion factor”) is applied to convert the relative fees to actual (or theoretical) amounts forspecific services. Thus providers or a health plan can use an RVU scale to develop a capitationrate, analyze a rate or allocate a capitation payment among physicians within a single-specialtygroup or among physicians in a multispecialty group.9

Once FFS equivalents have been chosen, they should be adjusted for the expected membercopayment levels.

Member Tracking and Eligibility Issues

In plans with capitated payment arrangements, tracking eligibility is an important issue forproviders and health plans. Because of their dealings with employer groups, health plans areaccustomed to retroactive member additions and deletions. Providers, however, may be lessaccustomed to additions and deletions, and can be more exposed (financially) under capitation.

Two situations are particularly problematic in provider reimbursement. One is when a member isadded to a PCP’s panel because he or she needed to see a PCP, and visits the office the samemonth that the PCP receives the first capitation payment for that member. If the member had beenon the plan but had not previously selected a PCP, the provider typically can collect retroactivecapitation payments from the health plan.

The second problematic situation occurs when a member is retroactively terminated after theprovider has been paid one or more monthly capitation payments for the member, possibly afterthe member has received services from the provider. Although some health plans absorb thecapitation expenses instead of passing them to the provider, many do not. Those health plans thatdo not absorb the expenses pass the expenses to the provider by retroactively adjusting theprovider’s capitation payment–and then, if any services have been rendered, the physician mustpursue payment from the (former) member.

The Challenge of Capturing Capitated Encounters

Unlike fee-for-service reimbursement, where a claim has to be filed for the provider to receive apayment, in a simple capitated environment there is no direct financial incentive for providers toaccurately document the specific services received by patients on each visit (typically referred toas an “encounter”). Data collection in a capitated environment is thus sometimes inaccurate.

However, any systematic underreporting of utilization leads to an overestimation of the effectivereimbursement received per unit of care (the “fee for service equivalency” calculated by dividingtotal capitated payments by the number of services delivered). Underreporting therefore makesthe provider organization appear to be achieving better financial results than it actually is under agiven contractual capitation arrangement. Data that fails to capture all utilizaion will erroneouslyindicate that the capitation rate is excessively high. This in turn may cause the health plan to seeklower capitation rates. Providers will have no data to demonstrate that these lower rates would beinadequate.

While underreporting of encounters may at first appear to be in the health plan’s financialinterest, no one is well served for long if decisions are being made on the basis of flawed data.Furthermore, most health plans retain claims payment responsibilities rather than delegating thoseresponsibilities to other parties. Health plan’s that retain claims payment responsibilities alsoretain the responsibility to gather information from and share results with providers.

To correct information-reporting problems, an effective information system must be in place atthe provider location. The system must capture data and regularly transmit it to the health plan sothat utilization and financial analyses are based on the most accurate data available. In fact, somehealth plans make an incentive payment (e.g., an extra 1% bonus on capitation payments) toproviders who submit complete and timely encounter data.

Variations and New Directions for Provider Reimbursement

Health plans are an evolving form of healthcare delivery and financing. Capitation, as a financialreimbursement model that exerts a powerful influence on care delivery, continues to evolve aswell. Some examples of capitation variations and provider reimbursement concepts are listedbelow. Most are still at the conceptual stage, while some have been put into practice in at least alimited way.

These provider reimbursement concepts can be organized in the following categories:

Payment arrangements affecting PCPs (PCP capitation with FFS for preventive care, andreimbursement for the gatekeeper role)

Payment arrangements affecting both PCPs and specialists (specialists receive primarycare capitation, capitation for specialists and FFS for PCPs, and “Open Access” plans andreimbursement)

Payment arrangements affecting specialists

We discuss each of these concepts in the following sections.

PCP Capitation with FFS for Preventive Care

To create a special incentive for PCPs to provide immunizations and other preventive services,health plans may choose to pay physicians for these services on a discounted fee-for-servicebasis, even if the PCPs are capitated for other services.

For example, the HEDIS reporting formats show plan performance on providing eye exams forpeople with diabetes, flu shots for older adults, and childhood immunizations, among othermeasures. Paying PCPs for providing these services on a discounted fee-for-service basisencourages physicians to perform these services, which, in turn, improves the quality of patientcare. The claim generated enables the plan’s information system to capture each service provided.

Reimbursement for the Gatekeeper Role

Primary care physician capitation payments theoretically cover the expected utilization ofmembers with the PCP receiving a discounted FFS-equivalent for each service. However, there isan additional category of work involved in the PCP role—patient care management. In responseto physicians’ concerns that they were not being paid for this role, some plans have designatedpart of the capitation payment to PCPs as a PMPM payment for administrative tasks related to thegatekeeper role.

Specialists Receiving Primary Care Capitation

Individuals with chronic conditions are often treated predominantly by specialist physicians whoare experts in treating these conditions. In some of these situations, quality of care is significantlyimproved by having specialists closely involved, monitoring these members and treating theirconditions, even when the members require services otherwise considered “primary care.”

However, a capitated health plan using a gatekeeper model typically requires these individuals tosee their PCP first for a referral to the specialist. A relatively large percentage of complaintsreceived by health plans that use gatekeeper models grow out of these situations because thesemembers are regular users of healthcare services, and frequently both they and their doctors feelfrustrated by the constraints of the gatekeeper system. (These situations are less frequent forhealth plans that do not capitate PCPs, and in “open access” plans that allow self-referral tospecialists.)

One possibility is to make the specialist the PCP of record. In some cases, the specialistsmanaging these patients are, in fact, internists with a subspecialty–for instance, endocrinology orcardiology. However, patients with chronic illnesses use healthcare services more than theaverage member and so the typical capitation payment would be far too low.

Another possibility is to allow the specialists acting as PCPs to self-refer for specialty care. Butthis is almost always impossible in a gatekeeper model because most plans make physicianschoose at the outset whether to be listed as either a PCP or a specialist, and nearly all plansprohibit self-referrals as a means of controlling overutilization.

Some health plans have devised special arrangements by modifying health plan contractualpolicies to accommodate these members and their special requirements. These modificationsinclude reimbursing providers who treat them through a discounted fee-for-service arrangement,or using a capitation rate that reflects the physicians’ level of contact and interaction with planmembers who have chronic conditions.

Capitation for Specialists, FFS for PCPs

Typically, PCPs are capitated in gatekeeper models, but the majority of specialists are not. Someplans, however, are experimenting with reimbursement systems that pay PCPs on a FFS basis andspecialists through capitation contracts. 10

The reasoning behind the creation of this payment system is that specialty care is very expensiverelative to primary care, and therefore plans should encourage PCPs to provide as many of thecovered services as they can. By paying them on a FFS basis, and capitating specialists, healthplans can minimize their costs. Once capitated, specialists need not get prior authorization toprovide a given treatment. Thus they gain a level of autonomy by assuming the risk for highutilization.

Open Access Plans and Capitation

Open access health plans are plans where members can self-refer to any network specialist. Thisplan design makes it harder to accurately capitate PCPs because members will self-refer tospecialists for services otherwise included in PCP capitation payments. PCPs will also bereluctant to accept a specialty care risk pool arrangement if they do not control referrals.

This plan design lends itself to discounted fee-for-service reimbursement for PCPs, who thenhave an incentive to treat conditions rather than encouraging members to see a specialist.Specialists can be paid on a discounted FFS basis, or through capitation arrangements.

Endnotes

1. From P. Boland, “The Power and Potential of Capitation,” The Capitation Sourcebook,ed. P. Boland (Berkeley, CA: Boland healthcare, 1996).

2. Kevin Kennedy and Daniel Merlino, “Alternatives to Traditional Capitation in HealthPlan Agreements,” Healthcare Financial Management (April 1998): 47–50.

3. Judith Horowitz, “Contact Capitaiton: An Alternative for Specialist Capititation,”Healthcare Financial Management (Novemember 1997): 54–55.

4. Bradley Munson, Douglas Cave, and Kurt Heumann, “New Payments and Incentives inContact Capitation: An Orthopedics Case Study,” Health Plan Interface, April 1998, 75–81.

5. Kevin Kennedy, “Evaluating and Negotiating a Profitable Capitation contract,”Healthcare Financial Management, February 1997, 44-49.

6. N. A. Hanchak, N. Schlackman, and S. Harmon-Weiss, “U.S. Healthcare’s Quality-BasedCompensation Model,” Health Care Financing Review 17, no. 3 (Spring 1996): 43–59.

7. James Hager, “Aligning Performance and Payment Criteria,” in The CapitationSourcebook, ed. P. boland (Berkeley, CA: Boland Healthcare, 1996).

8. G. Baker, H. Shupe, and L. Bonham, “Financial Controls and Reporting for Capitation,”in The Capitation Sourcebook, ed. P. Boland (Berkeley, CA: Boland Healthcare, 1996).

9. M. Berlin, L. Berlin, and M. Budzynski, “RVU Costing Application,” HealthcareFinanical Management (November 1997), 73–76.

10. S. Kullman, “Capitation is for Specialists, Not for Primary Care Physicians,” Health Plan(August 1997), 99–109.

AHM Health Plan Finance and Risk Management: Risk Transfer in Health Plans

Course Goals and ObjectivesAfter completing this lesson you should be able to

Distinguish between the terms stop-loss insurance and stop-loss reinsurance from theinsurance industry perspective

Explain the differences between specific stop-loss and aggregate stop-loss Discuss the advantages and disadvantages to a health plan of transferring risk by

obtaining stop-loss coverage Discuss the advantages and disadvantages to a health plan of providing stop-loss

coverage to providers and employer groups

Capitation and Plan Risk discussed capitation as a system that distributes risk among the partiesto a health plan provider reimbursement contract. This lesson explores the management strategyof transferring risk. Health plans, employers with self-funded plans, and providers with capitationor other risk-sharing reimbursement contracts all face a number of risks in the course of playingtheir roles in managed healthcare. As we mentioned in Risk Management in health plan1s, healthplans and provider organizations use various types of liability insurance to transfer a number ofrisks that are not unique to health plans. For example, a health plan may purchase fire insuranceto protect its home office building. Our focus in this lesson, however, is on stop-loss coverage,which is a widely used means of transferring risks specifically surrounding the liabilitiesgenerated in health plan by utilization rates.

Transfer Approaches

Health plans use two basic means of transferring utilization risk and the risk of higher-than-expected medical expense outcomes. The first, as we have discussed in previous assignments,involves reimbursement arrangements with providers, including capitation contracts and otherpayment systems that place providers “at risk” for utilization rates. These payment systems:

Require providers to share the risk of overutilization. Use financial rewards to motivate providers to manage the portion of that risk over which

they have control.

The focus of this lesson is a second means of transferring risk: the use of insurance to transfer therisk of higher-than-anticipated medical expenses. The insurance typically used in this type of risktransfer includes various forms of stop-loss insurance and stop-loss reinsurance. In the healthcareindustry, the terms stop-loss reinsurance and stop-loss insurance are often used interchangeably,and with respect to risk transfer, in many ways they function the same. Traditionally, however,the insurance industry has distinguished between reinsurance and insurance according to whattype of entity is purchasing the policy. According to this distinction, stop-loss reinsurance is atype of insurance that an insurer purchases to transfer the risk of loss on medical expenses abovea certain amount, either for individual catastrophic cases, or for the total medical expense liabilityincurred by a healthcare plan. Stop-loss insurance provides protection on the same kind of losses,but to entities that are not licensed insurers, such as physicians and hospitals with at-riskcontracts, employers with self-funded healthcare plans, and health plans that are not regulated bystate insurance departments.

Under a stop-loss reinsurance contract, a health plan that is regulated as an insurer is transferringrisk from itself to a reinsurer. The reinsurer accepts this risk in exchange for a premium that thehealth plan pays. An entity that is not licensed as an insurer, but that is at risk for medical expenselosses— for example, a physician group under capitation or an employer offering a self-fundedhealthcare plan to its employees—buys stop-loss insurance, but not reinsurance. In a fewjurisdictions, however, courts have held that the stop-loss protection purchased by employersoffering self-funded plans is reinsurance rather than insurance, even though such employers arenot licensed insurers. Because the core function of both stop-loss reinsurance and stop-lossinsurance is the same—the transfer of risk in exchange for a payment—we will use the term stop-loss coverage in cases that apply equally to insurance and reinsurance. In other words, stop-losscoverage can be either in the form of insurance or reinsurance and can be purchased by any of theparties who accept utilization risk in a health plan contract, including health plans, providers,provider groups, hospitals, and employers or other groups with self-funded plans. The entity thatprovides the stop-loss coverage is called the carrier. Carriers include health plans, other insurers,and reinsurers.

Types of Stop-Loss Coverage

There are two general types of stop-loss coverage: specific stop-loss coverage and aggregate stop-loss coverage. After describing these two types, we will examine some important features ofeach.

Specific Stop-Loss Coverage

Specific stop-loss coverage is insurance or reinsurance that provides protection against lossesarising from individual cases in which medical expenses are disproportionately large orcatastrophic. This stop-loss coverage is the more commonly written of the two stop-loss types.Specific stop-loss insurance can be used, for example, to assure that the costs of treating the acuteillnesses of one or two plan enrollees do not wipe out all or a significant percentage of aprovider’s capitation reimbursement or risk pool allocation. Specific stop-loss coverage normallyapplies to each and every member for whom the provider (or employer or health plan, as the casemay be) is at risk. Thus, specific stop-loss coverage is triggered on a case-by-case basis when anindividual member experiences serious illness or injury that requires expensive medicaltreatment. If, on the other hand, higher-than-expected medical costs occur exclusively because theplan experiences a large number of small claims, specific stop-loss coverage will not be triggered.

Aggregate Stop-Loss Coverage

Aggregate stop-loss coverage is insurance or reinsurance that protects against losses that occurwhen utilization rates among a covered population as a whole are significantly higher thananticipated at the time that either the reimbursement rates or the premium rates were established.For example, an employer offering a self-funded healthcare plan would be protected underaggregate stop-loss insurance against losses associated with an unexpectedly large number of itscovered employees seeking medical treatment during the same coverage period. In contrast tospecific stop-loss coverage, aggregate stop-loss is triggered when the total covered medicalexpenses generated by the plan reach an agreed-upon level, rather than by individual high-costcases.

Stop-Loss Attachment Points

An important feature of any stop-loss coverage is that coverage’s attachment point. Theattachment point is the loss amount that must occur before the stop-loss coverage begins to coverany expenses. The higher the attachment point, the greater the risk retained by the entitypurchasing the stop-loss coverage, and the lower the cost of that coverage, all other things beingequal. In other words, the attachment point of a stop-loss insurance or reinsurance agreementfunctions like a deductible.

The purchaser of the stop-loss coverage pays all expenses up to the attachment point. Forexpenses in excess of the attachment point, the carrier of the stop-loss coverage is at risk.However, a stop-loss agreement usually does not call for the carrier to reimburse the purchaserfor 100% of the costs above the attachment point. Instead, there is usually a corridor of expenseamounts for which the stop-loss coverage pays the purchaser a certain percentage of the expenses.

The exact percentage is negotiated by the carrier and the entity purchasing the stop-loss coverage,based on the purchaser’s risk tolerance in relation to the cost of the stop-loss coverage, the size ofthe corridor, the amount of the attachment point, and other coverage variables. Beyond thiscorridor, the stop-loss coverage may reimburse the purchaser at 100% of all additional expensesas a way of setting a maximum limit on the exposure to loss for the purchaser.

Figure 4B-1 provides an example of stop-loss coverage structured in this way.

To understand why the stop-loss coverage in Figure 4B-1 contains a corridor for amounts greaterthan the attachment point, notice that both the hospital and the health plan benefit from thestructure of this stop-loss coverage.

First, the hospital receives protection against the risk that one or two large-amount claims willwipe out the hospital’s entire withhold pool.

Second, because the hospital and the health plan share the exposure to risk for the first $75,000 ofa patient’s treatment costs, the health plan is assured that the hospital is motivated to expend

some effort in delivering cost-efficient care for the first $75,000 of the cost of any case, eventhough the hospital’s total exposure to loss is only $35,000.

Third, the hospital is motivated to notify the health plan of serious cases relatively early and towork with the health plan in developing the best treatment option for the patient, which enablesthe health plan to initiate case management techniques as quickly as possible.

Fourth, the possibility of stop-loss coverage facilitates the use of contracts that place the hospitalat risk for overutilization. Placing the provider at risk is a key cost-control element in many healthplan strategies. The availability of stop-loss coverage allows the hospital (or other providers) toshare risk and utilization management without placing the hospital in the position of assuming somuch risk that its own solvency is in danger.

Aggregate stop-loss also uses attachment points. These attachment points are set at somepercentage above the predicted costs faced by the purchaser. Beyond the attachment point, thepurchaser is usually responsible for only a small percentage of the actual costs.

For example, suppose a provider group enters a risk contract with a health plan, and the providergroup’s predicted healthcare costs are $1,000,000 for the year. The provider group could purchaseaggregate stop-loss with an attachment point of 115% of the projected $1,000,000 costs, andcopayments of 10% for any costs above the attachment point. In this case, then, the attachmentpoint is $1,150,000. If actual costs for the year were $1,350,000, then the provider group wouldbe responsible for a) all of the costs up to the attachment point ($1,150,000), plus b) 10% of thecosts above the attachment point. The actual costs in this case exceed

the attachment point by $200,000. Ten percent of $200,000 is $20,000. Thus, the providers areresponsible for $1,170,000 in costs, and the stop-loss carrier would be responsible for $180,000.

health plans purchase specific stop-loss coverage much more frequently than they purchaseaggregate stop-loss coverage because most stop-loss carriers require high attachment points inaggregate stop-loss. Aggregate stop-loss essentially transfers underwriting risk from thepurchaser to the carrier.

As we noted in Risk Management in Health Plans, underwriting risk is the largest risk healthplans face. Providing aggregate stop-loss with a low attachment point to a health plan wouldrequire that the stop-loss carrier accept most of the risk for the health plan’s core business. Thisdegree of risk would therefore require the carrier to charge a premium that would be nearly aslarge as the premium the health plan charges to provide the group healthcare coverage. Thus, inmost cases, aggregate stop-loss for health plans is either too expensive or has such a highattachment point that purchasing such stop-loss is not practical.

Incurred Claims and Paid Claims in Stop-Loss Settlement

In addition to the specific and aggregate categories of stop-loss coverage, another importantdistinction between stop-loss coverages is the manner in which claims are settled. The stop-losscontract may provide that claims are settled using a paid claims method, or on an incurred claimsmethod. Under the paid claims method, the stop-loss carrier is obligated to make stop-losspayments based on when the stop-loss policyholder—for example, a group employer—pays theclaim for the enrolled member’s medical expenses. Until the policyholder pays the claim, thestop-loss carrier is not liable to the policyholder for that claim.

Under the incurred claims method, the stop-loss carrier is obligated to make payments on theapplicable claims as of the date the medical expense was incurred. Figure 4B-2 providesexamples of both the paid claims and incurred claims methods of settlement.

The difference between paid claims and incurred claims administration is an important issue forrisk managers involved in stop-loss coverage to consider before the stop-loss contract is signed.This issue is important because stop-loss contracts are written for specific periods of time. Atboth the beginning and end of stop-loss contracts, some claims will have been incurred but notpaid. In the example described in Figure 4B-2, for instance, if the term of the stop-loss contractends on September 1, then in the absence of any other agreement, the stop-loss carrier will beobligated to pay its share of the expenses under the incurred claims method, but would not beobligated to pay under the paid claims method. The reverse would be true if the stop-losscoverage begins to take effect on September 1.

As much as 90% of all medical expenses are not paid in the same month in which they occur,however. The process of the treatment itself, the time it takes the provider to bill the plan and forthe plan to process the provider’s bill combine to cause most payment dates to follow treatmentsby more than 30 days.

For this reason, some expenses will be incurred before the stop-loss contract year begins but paidafter the contract year begins, and some expenses will be incurred before the contract year endsbut not paid until after the contract year ends. Thus, the parties involved in stop-loss coveragemust make certain that the coverage matches not only the level of risk that the entity seeking thecoverage can tolerate, but also that the timing of the coverage is appropriate to the needs of theparties.

Incurred Claims and Paid Claims in Stop-Loss SettlementA stop-loss contract can be written to cover any number of variables having to do with thecontract period, when claims are incurred, and when claims are paid. Variation in contracts caninclude the following types of clauses (the "claims" listed below are assumed to have met theappropriate aggregate or specific attachment points):

Claims paid- Claims will be covered if paid during the contract year, no matter when theexpenses were incurred.

Claims incurred and paid Claims that are both incurred and paid during the contract yearwill be covered.

Claims incurred and paid with run-in Claims that are paid within the contract year arecovered, as long as they were incurred either in the contract year or within the run-inperiod. A run-in period is a set number of months or days before the contract year of astop-loss contract begins. For example, suppose the contract year begins October 1, 1999,and has a 60-day run-in period. A claim that was incurred on August 10, 1999, and waspaid on October 10 would be covered, because August 10 falls within the 60-day run-inperiod.

Claims incurred in contract year and paid within contract year plus X days Claims arepaid if they both (1) occur within the contract year and (2) are paid within a specificnumber of days after the contract year ends. This form of agreement allows the purchaserof the stop-loss coverage time to process claims incurred in the last few months of thecontract year.

In stop-loss agreements, the carrier is seldom responsible for paying the purchaser before thepurchaser pays the medical expenses. One reason stop-loss contracts are structured this way isthat not all of the medical expenses are necessarily covered by the health plan; therefore thecarrier’s liability is based on the medical expense payments the stop-loss purchaser actuallymakes.

Claims will be covered if paid during the contract year, no matter when the expenseswere incurred.

Claims that are both incurred and paid during the contract year will be covered. Claims that are paid within the contract year are covered, as long as they were incurred

either in the contract year or within the run-in period. A run-in period is a set number ofmonths or days before the contract year of a stop-loss contract begins. For example,suppose the contract year begins October 1, 1999, and has a 60-day run-in period. Aclaim that was incurred on August 10, 1999, and was paid on October 10 would becovered, because August 10 falls within the 60-day run-in period.

Claims are paid if they both (1) occur within the contract year and (2) are paid within aspecific number of days after the contract year ends. This form of agreement allows thepurchaser of the stop-loss coverage time to process claims incurred in the last few monthsof the contract year.

Health Plans as Suppliers of Stop-Loss Coverage

Health plans are both suppliers and purchasers of stop-loss coverage. A health plan may purchasestop-loss coverage to limit its own exposure to large losses, but it may also supply stop-losscoverage to at-risk providers with whom it has reimbursement agreements or to groups with self-funded healthcare plans. For example, a health plan that capitates a provider group almost alwaysprovides or offers to provide stop-loss coverage to that provider group.

The reason that such protection is attractive to both health plans and providers has to do with thelaw of large numbers. Recall that the larger the number of enrollees a health plan has, the closerthe average medical expense of those enrollees will be to the average experience of the generalpopulation, assuming that the plan has attracted enrollees of average health.

This means, for example, that actuaries can predict with reasonable accuracy approximately howmany enrollees in a large group plan will experience illnesses or injuries that result in extremelylarge medical expense costs. Even if actuaries accurately predict the number of large cases thatwill occur over a period of time, however, it is impossible to tell in advance which specificenrollees will become ill, and therefore impossible to tell which of the capitated providers willhave to bear the expense of treating these seriously ill enrollees.

Suppose, for example, the expected experience of the employer group includes two cases of high-cost treatments. The premiums for that group can be designed so that the health plan iscompensated for the risk of assuming these expensive cases. If the plan signs full professionalcapitation contracts with 10 provider organizations, these capitation rates reflect the averagedegree of risk assumed by the provider organization for each enrolled member who signs up withthat organization. However, neither the providers nor the health plan knows which of the 10provider organizations will have to treat the two enrollees who will become seriously ill.

This element of chance is obviously a problem for the providers, because the treatment costs ofthese patients could be higher than the reimbursement any one individual provider group receivesunder the capitation contract. Assuming two provider groups treat these two high-cost patients,the contract would be financially disastrous for 2 out of the 10 provider groups unless thesegroups are able to secure some form of protection.

In the absence of stop-loss protection, such a capitation contract is much less desirable for theproviders, because none of the 10 provider groups can tell ahead of time whether it will beresponsible for a very expensive medical treatment.

If stop-loss coverage were not available to at-risk providers, health plans would also facedisadvantages. First, as we have just seen, convincing providers to sign a capitation contractwould be difficult. Second, if the risk for the large cases is factored into the capitation rate for allthe provider groups, then two of the groups are disastrously undercompensated, while eight areslightly overcompensated. In other words, the reimbursement for the risk is spread out, but therisk itself is concentrated, resulting in an inefficient reimbursement system.

Health plans use two means of providing stop-loss protection to at-risk providers. One method isto offer, in exchange for a premium, stop-loss coverage in the form of a separate insurancecontract along the lines we have already discussed.

The second method of supplying at-risk providers with protection against large losses is tostructure capitation and other risk agreements in such a way that providers share only a smallamount of the risk of catastrophically large losses. This second method, which is quite commonlyused, is not an insurance contract. With this type of stop-loss protection, each provider is at riskaccording to the capitation contract, but once a case or course of treatment reaches a specifiedlevel of expense, the reimbursement method limits the provider’s risk. For example, on a case thatreaches the specified expense level, the provider may be reimbursed for further treatmentaccording to a discounted FFS schedule. The discounted FFS payments cover the provider’sexpenses in treating the case, and thus eliminate much of the risk to the provider of large losseson individual catastrophic cases.

Technically, this type of contractual arrangement is neither insurance nor reinsurance, althoughits practical effect is to supply the providers with stop-loss protection. This protection is not

technically insurance because the health plan is retaining the risk of catastrophic cases. In otherwords, because the capitation contract does not transfer the catastrophic risk to the providers inthe first place, they do not have to seek insurance to transfer that risk back to the health plan or aninsurer.

Typically, the provider remains responsible for some share of the loss on large-amount cases.This share of the risk remains within the limit that the provider is willing and able to accept, butjust as coinsurance motivates an enrollee to avoid seeking unnecessary care, a share of the risk inlarge-amount cases motivates the provider to control costs in those cases.

In our discussion of provider reimbursement methods, we stressed the importance of capitation asa means of transferring some of the risk of overutilization from the health plan to the provider inorder to motivate the provider to supply cost-effective care. If a capitation contract transfers riskfrom a health plan to the provider, you may wonder why the health plan is willing to retain therisk of very expensive cases, or offer to transfer some of that risk back from the provider to thehealth plan.

The answer is that the risks being transferred by capitation and those being transferred by stop-loss coverage are different types of risk. The main goal for a health plan in seeking a capitationagreement from a provider is to motivate the provider to supply the most cost-effective care bymanaging the utilization variables over which the provider exercises at least some control.

Stop-loss insurance, however, transfers the risk that a given provider will have to treat anenrollee who suffers a serious illness or injury and whose treatment costs under the most efficientcare are still too high for that provider to absorb. The provider has no control over whether or notan enrollee contracts such an illness, no matter what reimbursement system the health plan uses.Thus, a provider without stop-loss coverage may provide excellent treatment while efficientlycontrolling costs and still suffer ruinous losses if one or two patients develop catastrophicillnesses.

As we mentioned earlier in this lesson, stop-loss agreements also can be structured to motivateproviders to inform the health plan soon after a serious illness is diagnosed, which allows thehealth plan to engage in large-case management as soon as possible.

Providers with capitation contracts do not always purchase stop-loss coverage from the healthplan offering the contract. Provider groups and hospitals in particular may shop for the leastexpensive stop-loss coverage. Large groups with self-funded healthcare plans also explore thestop-loss market, often with the help of a broker or agent. In doing so, both the providers and self-funded groups must have an accurate assessment of the liability that the healthcare plan exposesthem to, and their own ability to retain risk.

A health plan that retains a large-amount risk through stop-loss provisions in a providerreimbursement contract can expect to incur larger costs in the long run, either because the healthplan will have to pay large-amount claims itself or because the health plan will have to purchasestop-loss coverage to protect itself against the risk of those costs. Typically, capitation contractsin which the health plan offers a provider stop-loss coverage or non-insurance stop-lossprotection will offer capitation rates that are lower than those offered by contracts in which thehealth plan transfers to the provider the risk of large losses.

Health plans purchase stop-loss coverage as a means of adjusting the amount of risk theorganization retains. For a health plan, decisions concerning how to deal with risks associatedwith its core business involve an assessment of opportunity costs. Risk retention and risk transferboth have benefits and drawbacks. The health plan must assess the benefits and drawbacks ofthese choices given the specifics of the risk involved.

The central benefit of retaining utilization risk for a health plan is the possibility that thepayments, such as premiums, that the health plan receives for assuming the risk will be greaterthan the actual cost of the risk.

However, as we pointed out in our solvency discussion in Risk Management in Health Plans, byassuming risk a health plan assumes potential liabilities. The decision to retain risks carries with itthe cost of making assets available to cover losses. As long as these assets are held in liquidinvestments, they cannot be used for long-term investments in many kinds of businessopportunities, such as expanding into new markets or developing new products; nor, in the caseof for-profit health plans, can they be distributed to stockholders as earnings.

Transferring risk through stop-loss insurance or reinsurance reduces the health plan’s risk,particularly pricing or underwriting risk, and thereby reduces the health plan’s need for liquidassets in support of these risks. Typically, solvency requirements set by the RBC formula arehigher than those set by the HMO Model Act. Consequently, for health plans that find themselvessubject to new RBC requirements as a result of a state’s adoption of RBC solvency requirements,purchasing stop-loss coverage can reduce the need to raise money in order to increase the healthplan’s net worth. The influence of stop-loss coverage on a health plan’s underwriting risk islimited compared to the influence of the health plan’s provider reimbursement contracts.Nevertheless, stop-loss does marginally reduce the health plan’s underwriting risk.

An added benefit of stop-loss coverage as a means of reducing risk is that stop-loss contracts canoffer the health plan a more flexible means of dealing with risk than many alternatives. The stop-loss contract can adjust for the amount of risk transferred, the period of time that the risk istransferred, as well as the conditions under which it is transferred.

Stop-loss coverage itself carries costs, however. Like any insurer or reinsurer, a stop-loss carriermust not only set premiums at a rate high enough to cover the insured losses, but must alsoinclude in the premium an amount sufficient to administer the insurance and provide a return oninvestment. The health plan will also experience its own administrative costs in securing stop-losscoverage and making claims under that coverage. Furthermore, because stop-loss carriers are atrisk based on the health plan’s underwriting and actuarial practices, the carrier may wish toreview those practices before issuing stop-loss protection.

The cost of a stop-loss contract varies depending on a number of factors. Costs will varyaccording to the type of stop-loss (specific or aggregate), the number of persons covered by thestop-loss contract, the types of losses that are covered, the predicted rate at which the plan’spopulation of enrollees will experience catastrophic illnesses or injuries, and the stop-losscoverage’s attachment point, among other elements.

Finally, although purchasing stop-loss coverage reduces a health plan’s underwriting risk, thesame stop-loss coverage will increase the health plan’s affiliate risk. Recall that affiliate risk isthe risk that the financial condition of an affiliated entity (in this case, the stop-loss carrier) willcause an adverse change in capital (in this case, the health plan1’s capital). Although the decreasein underwriting risk is always greater than the increase in affiliate risk, the increasing affiliate risk

is part of the cost of securing stop-loss coverage. The greater the financial strength of the stop-loss carrier, the lower the health plan’s affiliate risk.

AHM Health Plan Finance and Risk Management: Health Plan Funding

Course Goals and Objectives

After completing this lesson you should be able to

Distinguish between fully funded and self funded health plans Identify and describe the two main types of self funded health plans

Fully Funded Plans

A fully funded plan, also called a fully insured plan, is a form of group insurance in which aninsurer or a specific type of health plan, rather than an employer or other group plan sponsor, islicensed to assume the financial responsibility for healthcare services rendered to or for healthplan members.2 In other words, in a fully funded plan, a group plan sponsor pays a premium to ahealth plan and the health plan assumes the risk that the premiums will not be enough to cover thecosts of services rendered to health plan members.

Recall from Healthcare Management: An Introduction that a premium is a payment or series ofpayments made to a health plan or insurance company by purchasers, and often plan members,for healthcare benefits. Premiums are required by a health plan to establish and maintain the planin force. Typically, fully funded health plans require group plan sponsors to prepay monthlypremiums for healthcare services. In Pricing and Rating lesson, it discusses how an insurer orhealth plan establishes premiums for its products.

Indemnity plans, Blue Cross and Blue Shield plans, HMOs, PPOs, and POS options may be fullyfunded health plans. Health plans either (1) bear all plan risks or (2) share these risks withemployers or other group plan sponsors. Figure 5A-1 provides a brief review of traditionalindemnity plans and Blue Cross and Blue Shield plans.

Under a fully funded health plan, upon acceptance of a premium, a commercial insurancecompany, Blue Cross or Blue Shield organization, or HMO, for example, bears the entirefinancial risk of paying for all claims for services provided as well as the administrative expensesassociated with health plan operations. Therefore, if the dollar amount of services rendered to

group plan members exceeds the dollar amount of premiums collected, the insurer must make upthe difference. On the other hand, if group plan members incur a lower dollar amount ofhealthcare services than the dollar amount of premiums collected, then the insurer may earn alarger profit on the health plan.

Most health plans, including indemnity plans, incorporate the use of some health plan techniquesin the financing and delivery of healthcare services. Indemnity carriers have offered variousalternate funding arrangements for a long time, although, in many states, HMOs are prohibitedfrom offering alternate funding arrangements. Even in those states that allow HMOs to offeralternate funding, most HMOs still enter into fully funded arrangements.

A fully funded plan is the traditional funding arrangement for a group health insurance plan. Theinsurer usually issues the group health policy on a 12-month, renewable basis. The monthlypremium is typically guaranteed for 12 months and provides coverage for that period. Withproper notification to the group plan sponsor, the insurer may increase the premium for the next12-month period. In recent years, multiyear premium rate guarantees have become morecommon.

To prevent insurers from setting inadequate premium rates, some states require that the stateinsurance department approve all first-year premiums charged by insurers.

States that have this requirement attempt to protect the insurer from insolvency and plan membersfrom losing coverage because of insurer insolvency.

Depending on the size of the group and the state laws that apply to the group, the insurer mayestablish new premium rates for the group at the end of the initial 12-month period. Newpremium rates may be determined in part by the sex and attained ages of group plan members, thelocation of the group, and the group’s industry classification, for example. For large groups, therates may also be determined on the basis of the group’s experience.

Insurers and employers have developed a variety of alternatives to this traditional arrangement ofpaying premiums in advance to fund a group health plan. These alternative funding arrangementsmodify the manner in which premiums are paid, thus enabling employers to reduce the total costof providing a health plan to their employees.8 We discuss these alternative funding methods inAlternative Funding Methods.

Self-Funded Plans9

A self funded plan, also called a self insured plan, is a form of group health coverage in which agroup plan sponsor—typically a large employer—rather than a health plan or insurer, isfinancially responsible for the costs of healthcare services rendered to or for plan members.10 Aself funded plan may be completely or partially self funded. For example, in a partially selffunded plan, an employer may purchase stop loss insurance to transfer part of the financial risksthat the employer has assumed.

Many employers take an active role in providing healthcare benefits by choosing to self fund,either partially or completely, the medical expense coverage they provide for their employees. Asa result, these employers bear some or all of the risk of paying for the costs of healthcare services,including the risk that these costs may exceed expectations.

Self funding may help employers and other group plan sponsors to manage increasing healthcarecosts. In a typical fully funded plan, the health plan or insurer sets premiums that are adequate to:

Pay the costs associated with healthcare services rendered to plan members Cover administrative and selling expenses, including administrator fees and broker or

agent commissions Provide some profit for the health plan or insurer

Under a self funded plan with separate stop loss insurance coverage or a partially self fundedhealth plan, the employer typically is financially responsible for paying a certain level ofhealthcare services. The risk for incurring costs above a specified level can be transferred to atraditional health insurance provider. For example, an employer could self fund the health plan’sfirst $50,000 of a plan member’s healthcare expenses and purchase supplemental medicalinsurance coverage from an insurer to cover healthcare expenses that exceed $50,000.

By self funding, an employer may avoid some of these costs, such as broker or agentcommissions, that are included in the premiums for fully funded plans. Another advantage to selffunding is improved cash flow for the employer, because the employer initially retains the moneyit would have paid in premiums. Instead, the employer pays for healthcare expenses as theyoccur. As a result, the employer can earn interest on that money. However, a potentialdisadvantage is that the employer may experience severe cash flow problems resulting fromunexpectedly high costs for healthcare services rendered to plan members.

Self funded plans are exempt from state laws and regulations that apply to health insurancepolicies. Therefore, employers that establish a self funded health plan may have more freedomwith respect to state-mandated coverage requirements and may avoid premium taxes.

However, most self funded plans are subject to the federal Employee Retirement Income SecurityAct (ERISA), because employee benefits that are subject to ERISA include medical, surgical, andhospital care benefits. Funding requirements under ERISA mandate that health plans developwritten policies regarding the plan’s funding sources, procedures for carrying out these policies,and specified funding methods used to support the plan’s goals. Further, self funded health plansmust comply with ERISA requirements concerning the limits on benefit discrimination for classesof employees.

When an employer self funds a health plan, the money that the employer and employees normallywould have paid in premiums to a health plan or insurer is deposited into an account until themoney is used to pay healthcare expenses. The account into which the employer deposits themoney is called the funding vehicle. The type of funding vehicle determines the type of selffunded health plan. Two common types of self funded plans are general asset plans and trusteedplans.

General Asset Plan

A general asset plan, also called a non-trusteed plan, is a type of self funded health plan underwhich the employer pays covered healthcare expenses from its current operating funds, ratherthan from a trust fund established for this specific purpose.11 In a general asset plan, the employerusually deposits money into a commercial checking account or similar account.

The premiums and other funds set aside for the health plan are not considered separate from theemployer’s current assets or operating funds, from which the employer pays all healthcareexpenses. Therefore, in the meantime, the employer has the use of this money until it is needed topay for healthcare services. One disadvantage of a general asset plan is that these funds aresubject to the claims of the employer’s creditors, so the funds may not be available when needed.

Trusteed Plans

Trusteed plans are another type of self funded group health plan. A trusteed plan is a type of selffunded plan under which covered healthcare expenses are paid from a trust established by theemployer or other group sponsor.12 Under a trusteed plan, the employer deposits into a trust fundsset aside for the health plan. The trustee, not the employer, has the duty of managing the trustproperty for the benefit of employees and their dependents who are covered by the health plan.Unlike funds deposited in a general asset plan, funds placed in a trusteed plan are not subject tothe claims of the employer’s creditors. Other advantages of establishing a trusteed plan includethe preferred tax treatment available to trusteed plans.

Figure 5A-2 lists three common trusts that an employer may establish to fund a health plan. Wediscuss the 501(c)(9) (VEBA) trust in detail in Alternative Funding Methods.

Endnotes

1. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMA’s Glossary of Insurance Terms,3rd ed. (Atlanta: LOMA, ©1997).

2. Ibid.3. Ibid.4. Ibid.5. Ibid.6. Ibid.

7. Ibid.8. Adapted from Harriett E. Jones and Dani L. Long, Principles of Insurance: Life, Health,

and Annuities (Atlanta: LOMA, ©1996), 369-370. Used with permission; all rightsreserved.

9. Adapted from Harriett E. Jones and Dani L. Long, Principles of Insurance: Life, Health,and Annuities (Atlanta: LOMA, ©1996), 305, 371-372. Used with permission; all rightsreserved.

10. Desoutter and Huggins11. Ibid.12. Ibid.13. Carlton Harker, Self-Funding of Health Care Benefits, 4th Edition (Brookfield, WI:

International Foundation of Employee Benefit Plans, Inc., ©1998), 137.14. Desoutter and Huggins15. Harker, 137-138.

AHM Health Plan Finance and Risk Management: Alternative Funding Methods

Course Goals and ObjectivesAfter completing this lesson you should be able to

Distinguish between a contributory plan and a noncontributory plan Describe the individual components of a premium, including the interest charge, the risk

charge, and the retention charge List the key characteristics of premium delay arrangements, reserve-reduction

arrangements, minimum-premium plans, retrospective-rating arrangements, andadministrative-services-only arrangements

The methods of alternative funding can be divided into two general categories: those thatprimarily modify traditional fully insured group insurance contracts and those that have some selffunding (either partial or total). The first category includes:

Premium-delay arrangements Reserve-reduction arrangements Minimum-premium plans Retrospective-rating arrangements

These alternative funding methods are regarded as modifications of traditional fully insured plansbecause the insurance company has the ultimate responsibility for paying all benefits promisedunder the contract. Most insurance companies will allow only large employers to use thesemodifications. Although practices differ among insurance companies, generally a group insuranceplan must generate between $150,000 and $250,000 in claims before these funding methods willbe available to the employer.

The second category of alternative funding methods includesTotal self-funding from current revenue and self-administrationSelf-funding with administrative-services-only arrangementsFunding through a 501(c)(9) trustIn contrast to the first category of alternative funding methods, some of these alternatives can beused by small employers.

Premium-Delay Arrangements

Premium-delay arrangements allow the employer to defer payment of monthly premiums forsome time beyond the usual 30-day grace period. In fact, these arrangements lengthen the graceperiod, most commonly to 60 or 90 days. The practical effect of premium-delay arrangements isthat they enable the employer to have continuous use of the portion of the annual premium forother purposes.

For example, a 90-day premium delay allows the employer to use three months (or 25%) of theannual premium for other purposes. This amount roughly corresponds to what is usually in theclaims reserve for medical expense coverage. Generally the larger this reserve is on a percentagebasis, the longer the premium payment can be delayed. Because the insurance company still has astatutory obligation to maintain the claims reserve, it must use other assets besides the employer’spremiums for this purpose. In most cases, these assets come from the insurance company’ssurplus.

A premium-delay arrangement has a financial advantage to the extent that an employer can earn ahigher return by investing the delayed premiums than by accruing interest on the claims reserve.In actual practice, interest is still credited to the reserve, but this credit is offset by either aninterest charge on the delayed premiums or an increase in the insurance company’s retentioncharge.

Upon termination of an insurance contract with a premium delay arrangement, the employer isresponsible for paying any deferred premiums. However, the insurance company is legallyresponsible for paying all claims incurred prior to termination, even if the employer fails to paythe deferred premiums. Consequently, most insurance companies are concerned about theemployer’s financial position and credit rating.

For many insurance companies, the final decision of whether to enter into a premium-delayarrangement, or any other alternative funding arrangement that leaves funds in the hands of theemployer, is made by the insurer’s financial experts after a thorough analysis of the employer. Insome cases, this may mean that the employer will be required to submit a letter of credit or someother form of security.

Reserve-Reduction ArrangementsA reserve-reduction arrangement is similar to a premium-delay arrangement. Under the usualreserve-reduction arrangement, the employer is allowed (at any given time) to retain an amount ofthe annual premium that is equal to the claims reserve. Generally such an arrangement is allowedonly after the contract’s first year, when the pattern of claims and the appropriate amount of theclaims reserve can be more accurately estimated.

In succeeding years, if the contract is renewed, the amount retained will be adjusted according tochanges in the size of the reserve. As with a premium-delay arrangement, the monies retained bythe employer must be paid to the insurance company upon termination of the contract. Again, theadvantage of this approach lies in the employer’s ability to earn more on these funds than itwould earn under the traditional insurance arrangement.

Minimum-Premium Plans

Minimum-premium plans were designed primarily to reduce state premium taxes. However,many minimum-premium plans also improve the employer’s cash flow. Under the typicalminimum-premium plan, the employer assumes the financial responsibility for paying claims upto a specified level, usually from 80% to 95% of estimated claims. The specified level may bedetermined on either a monthly or an annual basis. The funds necessary to pay these claims aredeposited into a bank account that belongs to the employer.

However, the actual payment of claims is made from this account by the insurance company,which acts as an agent of the employer. When claims exceed the specified level, the balance ispaid from the insurance company’s own funds. No premium tax is levied by the states on theamounts the employer deposits into such an account, as it would have been if these deposits hadbeen paid directly to the insurance company. In effect, for premium-tax purposes, the insurancecompany is only considered to be the administrator of these funds and not a provider ofinsurance.

Under a minimum-premium plan, the employer pays a substantially reduced premium, subject topremium taxation, to the insurance company for administering the entire plan and for bearing the

cost of claims above the specified level. Because such a plan may be slightly more burdensomefor an insurance company to administer than would a traditional group arrangement, the retentioncharge may also be slightly higher. Under a minimum-premium arrangement, the insurancecompany is ultimately responsible for seeing that all claims are paid, and it must maintain thesame reserves that would have been required if the plan had been funded under a traditional groupinsurance arrangement. Consequently, the premium will include a charge for the establishment ofthese reserves, unless some type of reserve-reduction arrangement has also been negotiated.

Some insurance regulatory officials view the minimum-premium plan primarily as a loopholeused by employers to avoid paying premium taxes. In several states, there have been attempts toseek court rulings or legislation that would require premium taxes to be paid either on the fundsdeposited in the bank account or on claims paid from these funds. Most of these attempts havebeen unsuccessful, but court rulings in California require the employer to pay premium taxes onthe funds deposited into the bank account. If similar attempts are successful in the future, themain advantage of minimum-premium plans will be lost.

Retrospective-Rating Arrangements

Under retrospective-rating arrangements, the insurance company charges the employer an initialpremium that is less than what would be justified by the expected claims for the year. In general,this reduction will be between 5% and 10% of the premium for a traditional group insurancearrangement. However, if claims plus the insurance company’s retention charge exceed the initialpremium, the employer will be called upon to pay an additional amount at the end of the policyyear. Because an employer will usually have to pay this additional premium, one advantage of aretrospective-rating arrangement is the employer’s ability to use these funds during the year.

This potential additional premium is subject to a maximum amount based on some percentage ofexpected claims. For example, assume that a retrospective-rating arrangement bases the initialpremium on the presumption that claims will be 93% of those actually expected for the year. Ifclaims in fact are below this level, the employer will receive an experience refund (discussed inRating and Underwriting). If they exceed 93%, the retrospective-rating arrangement will be“triggered,” and the employer will have to reimburse the insurance company for any additionalclaims paid, up to some percentage of those expected, such as 112%. The insurance companybears claims in excess of 112%, so some of the risk associated with claims fluctuations is passedon to the employer.

This will reduce both the insurance company’s risk charge and any reserve for claimsfluctuations. The amount of these reductions will depend on the actual percentage specified in thecontract, above which the insurance company will be responsible for claims. This percentage andthe one that triggers the retrospective-rating arrangement are subject to negotiations between theinsurance company and the employer. In general, the lower the percentage that triggers theretrospective arrangement is, the higher will be the percentage above which the insurancecompany is fully responsible for claims. In addition, the better the cash-flow advantage theemployer has, the greater will be the risk of claims fluctuations. In all other respects, aretrospective-rating arrangement is identical to the traditional group insurance contract.

Total Self-Funding and Self-Administration

The purest form of a self funded benefit plan is one in which the employer pays benefits fromcurrent revenue (rather than from a trust), administers all aspects of the plan, and bears the risk

that actual benefit payments will exceed expected benefit payments. In addition to eliminatingstate premium taxes, avoiding state-mandated benefits, and improving cash flow, the employerhas the potential to reduce its operating expenses to the extent that the plan can be administered ata lower cost than the insurance company’s retention charge (other than premium taxes). Adecision to use this kind of self-funding is generally considered most desirable when all thefollowing conditions are present:

Predictable claims. Budgeting is an integral part of the operation of any organization,and it is necessary to budget for benefit payments that will have to be paid in the future.This can best be done when a specific type of benefit plan has a claim pattern that iseither stable or shows a steady trend. Such a pattern is most likely to occur in those typesof benefit plans that have a relatively high frequency of low severity claims. Although aself-funded plan may still be appropriate when the level of future benefit payments isdifficult to predict, the plan will generally be designed to include stop loss coverage(discussed in Capitation and Plan Risk).

A noncontributory plan. Several difficulties arise if a self-funded benefit plan iscontributory. Some employees may resent paying “their” money to the employer forbenefits that are contingent on the firm’s future financial ability to pay claims. If claimsare denied, employees under a contributory plan are more likely to be bitter toward theemployer than they would be if the benefit plan were noncontributory. Finally, theEmployee Retirement Income Security Act (ERISA), which is discussed in Rating andUnderwriting, requires that a trust must be established to hold the employees’contributions until the plan uses the funds. Both the establishment and maintenance of thetrust will result in increased administrative costs to the employer.

A nonunion situation. Self-funding of benefits for union employees may not be feasibleif a firm is subject to collective bargaining. Self-funding (at least by the employer) clearlycannot be used if benefits are provided through a negotiated trusteeship. Even whencollective bargaining results in benefits being provided through an individual employerplan, unions often insist that benefits be insured in order to guarantee that union memberswill actually receive them. An employer’s decision about whether to use self-funding ismost likely motivated by the potential to save money. When unions approve of self-funding, they also frequently insist that some of these savings be passed on to unionmembers through additional or increased benefits.

The ability to effectively and efficiently handle claims. One reason that manyemployers do not use totally self-funded and self-administered benefit plans is thedifficulty in handling claims as efficiently and effectively as an insurance company orother benefit-plan administrator would handle them. Unless an employer is extremelylarge, only one person or a few persons will be needed to handle claims. Who in theorganization can properly train and supervise these people? Can they be replaced if theyshould leave? Will anyone have the expertise to properly handle the unusual or complexclaims that might occur? Many employers want some insulation from their employees inthe handling of claims. If employees are unhappy with claim payments under a self-administered plan, dissatisfaction (and possibly legal actions) will be directed toward theemployer rather than toward the insurance company. The employer’s inability to handleclaims, or its lack of interest in wanting to handle them, does not completely rule out theuse of self-funding. As will be discussed later, employers can have claims handled byanother party through an administrative-services-only contract.

The ability to provide other administrative services. In addition to claims, theemployer must determine whether the other administrative services normally included inan insured arrangement can be provided in a cost-effective manner. These services are

associated with plan design, actuarial calculations, statistical reports, communication withemployees, compliance with government regulations, and the preparation of governmentreports. Many of these costs are relatively fixed, regardless of the size of the employer;unless the employer can spread them out over a large number of employees, self-administration will not be economically feasible. As with claims administration, anemployer can purchase needed services from other sources.

The ability to obtain discounts from medical care providers if medical expensebenefits are self-funded. In order to obtain much of the cost savings associated withhealth plans, the employer must be able to secure discounts from the providers of medicalcare. Large employers whose employees live in a relatively concentrated geographicregion may be able to enter into contracts with local providers. Other employers may usethe services of third party administrators who have either established or entered intocontracts with preferred provider networks. Recall from Healthcare Management: AnIntroduction that a third party administrator (TPA) is a company that providesadministrative services to health plans or self-funded health plans.

The extent of total self-funding and self-administration differs significantly among the differenttypes of group benefit plans. The larger the employer is, the more likely that its medical expenseplan will be self funded. The major problem with a self funded medical expanse plan is not theprediction of claims frequency but rather the prediction of the average severity of claims.Although infrequent, claims of $300,000 to $500,000 or more do occasionally occur. Most smalland medium-size employers are unwilling to assume the risk that they might have to pay such alarge claim.

Only employers with several thousand employees are large enough to anticipate that such claimswill regularly occur and to have the resources that will be necessary to pay any unexpectedlylarge claims. This does not mean that smaller employers cannot self fund medical benefits. Toavoid the uncertainty of catastrophic claims, these employers often self fund basic medicalexpense benefits and insure major medical expense benefits or self fund their entire coverage butpurchase stop-loss protection.

It is not unusual to use self-funding and self-administration in other types of benefit plans, such asthose providing coverage for dental care, vision care, prescription drugs, or legal expenses.Initially, it may be difficult to predict the extent to which these plans will be utilized. However,once the plans have “matured,” the level of claims tends to be fairly stable. Furthermore, theseplans are commonly subject to maximums so that the employer has little or no risk of catastrophicclaims. Although larger employers may be able to economically administer the plans themselves,smaller employers commonly purchase administrative services

Two of the problems associated with self-funding and self-administration are the risk ofcatastrophic claims and the employer’s inability to provide administrative services in a cost-effective manner. For each of these problems, however, solutions have evolved—namely stop-loss coverage and administrative-services-only (ASO) contracts—that still allow an employer touse elements of self-funding. Although an ASO contract and stop-loss coverage can be providedseparately, they are commonly written together. In fact, most insurance companies require anemployer with stop-loss coverage to have a self funded plan administered under an ASOarrangement, either by the insurance company or by a third party administrator.

Until recently, stop-loss coverage and ASO contracts were generally provided by insurancecompanies and were available only to employers with at least several hundred employees.

However, these arrangements are increasingly becoming available to small employers, and inmany cases, the administrative services are now being purchased from third party administratorswho operate independently from insurance companies. We discussed stop-loss coverage inCapitation and Plan Risk. Following is a brief description of ASO arrangements.

Under an administrative-services-only (ASO) contract, the employer purchases specificadministrative services from an insurance company or from an independent third partyadministrator. These services will usually include the administration of claims, but they may alsoinclude a broad array of other services. In effect, the employer has the option to purchase servicesfor those administrative functions that can be handled more cost effectively by another party.Under ASO contracts, the administration of claims is performed in much the same way as it isunder a minimum-premium plan; that is, the administrator has the authority to pay claims from abank account that belongs to the employer or from segregated funds in the administrator’s hands.However, the administrator is not responsible for paying claims from its own assets if theemployer’s account is insufficient.

In addition to listing the services that will be provided, an ASO contract also stipulates theadministrator’s authority and responsibility, the length of the contract, the provisions forterminating and amending the contract, and the manner in which disputes between the employerand the administrator will be settled. The charges for the services provided under the contractmay be stated in one or some combination of the following ways:

Percentage of the amount of claims paid Flat amount per processed claim Flat charge per employee Flat charge for the employer

Payments for ASO contracts are regarded as fees for services performed, and they are thereforenot subject to state premium taxes. However, one similarity to a traditional insurance arrangementmay be present: The administrator may agree to continue paying any unsettled claims after thecontract’s termination but only with funds provided by the employer.

Funding through a 501(c)(9) Trust

Section 501(c)(9) of the Internal Revenue Code provides for the establishment of 501(c)(9) trusts,commonly referred to as voluntary employees’ beneficiary associations or VEBAs. Recall fromHealth Plan Funding that 501(c)(9) trusts are funding vehicles for the employee benefits that areoffered to members. The trusts have been allowed for many years, but until the passage of the1969 Tax Reform Act, they were primarily used by negotiated trusteeships and associationgroups. The liberalized tax treatment of the funds accumulated by these trusts resulted in theirincreased use by employers as a method of self-funding employee benefit plans. However, theTax Reform Act of 1984 imposed more restrictive provisions on 501(c)(9) trusts, and their usehas diminished somewhat, particularly by smaller employers who previously had overfundedtheir trusts primarily as a method to shelter income from taxation.

AdvantagesThe use of a 501(c)(9) trust offers the employer some advantages over a benefit plan that is self-funded from current revenue. Contributions can be made to the trust and can be deducted forfederal income tax purposes, just as if the trust were an insurance company. Appreciation in thevalue of the trust assets or investment income earned on the trust assets is also free or taxation.

The trust is best suited for an employer who wishes to establish either a fund for claims that havebeen incurred but not paid or a fund for possible claims fluctuations. If the employer does not usea 501(c)(9) trust in establishing these funds, contributions cannot be deducted until they are paidin the form of benefits to employees. In addition, earnings on the funds will be subject to taxation.

Although the Internal Revenue Code requires that certain fiduciary standards be maintainedregarding the investment of the trust assets, the employer does have some latitude and does havethe potential for earning a return on the trust assets that is higher than what is earned on thereserves held by insurance companies. A 501(c)(9) trust also lends itself to use by a contributoryself-funded plan, since ERISA requires that, under a self-funded benefit plan, a trust must beestablished to hold the contributions of employees until they are used to pay benefits.

There is also flexibility regarding contributions to the trust. Although the Internal RevenueService will not permit a tax deduction for “overfunding” a trust, there is no requirement that thetrust must maintain enough assets to pay claims that have been incurred but not yet paid.Consequently, an employer can “underfund” the trust in bad times and make up for thisunderfunding in good times with larger-than-normal contributions. However, any underfundingmust be shown as contingent liability on the employer’s balance sheet.

DisadvantagesThe use of a 501(c)(9) trust is not without its drawbacks. The cost of establishing and maintainingthe trust may be prohibitive, especially for small employers. In addition, the employer must beconcerned about the administrative aspects of the plan and the fact that claims might deplete thetrust’s assets. However, as long as the trust is properly funded, ASO contracts and stop-losscoverage can be purchased.

Requirements for EstablishmentIn order to qualify under Section 501(c)(9) of the Internal Revenue Code, a trust must meetcertain requirements, some of which may hinder its establishment. These requirements includethe following conditions:

Membership in the trust must be objectively restricted to those persons who share acommon employment-related bond. Internal Revenue Service (IRS) regulations interpretthis broadly to include active employees and their dependents, surviving dependents, andemployees who are retired, laid off, or disabled. Except for plans maintained pursuant tocollective-bargaining agreements, benefits must be provided under a classification ofemployees that the IRS does not find to be discriminatory in favor of highly compensatedindividuals.

It is permissible for life insurance, disability, severance pay, and supplementalunemployment compensation benefits to be based on a uniform percentage ofcompensation. In addition, the following persons may be excluded in determiningwhether the discrimination rule has been satisfied: (1) employees who have notcompleted three years of service, (2) employees under age 21, (3) seasonal or less-than-half-time employees, and (4) employees covered by a collective-bargaining agreement ifthe class of benefits was subject to good-faith bargaining.

With two exceptions, membership in the trust must be voluntary on the part ofemployees. Members can be required to participate (1) as a result of collective bargaining

or (2) when participation is not detrimental to them. In general, participation is notregarded as detrimental if the employee is not required to make any contributions.

The trust must provide only eligible benefits. The list of eligible coverages is broadenough that a trust can provide benefits because of death, medical expenses, disability,and unemployment. Retirement benefits, deferred compensation, and group property andliability insurance cannot be provided.

The sole purpose of the trust must be to provide benefits to its members or theirbeneficiaries. Trust assets can be used to pay the administrative expenses of the trust, butthey cannot revert to the employer. If the trust is terminated, any assets that remain afterall existing liabilities have been satisfied must either be used to provide other benefits orbe distributed to members of the trust.

The trust must be controlled by (1) its membership, (2) independent trustees (such as abank), or (3) trustees or other fiduciaries, at least some of whom are designated by or onbehalf of the members. Most 501(c)(9) trusts are controlled by independent trusteesselected by the employer.

Limitation on ContributionsThe contributions to a 501(c)(9) trust (except collectively bargained plans, for which U.S.Treasury regulations prescribe separate rules) are limited to the sum of (1) the qualified directcost of the benefits provided for the taxable year and (2) any permissible additions to a reserve(called a qualified asset account). The qualified direct cost of benefits is the amount that wouldhave been deductible for the year if the employer had paid benefits from current revenue.

The permissible additions may be made only for disability, medical supplemental unemployment,severance pay, and life insurance benefits. In general, the amount of the permissible additionsincludes (1) any sums that are reasonably and actuarially necessary to pay claims that have beenincurred but remain unpaid at the close of the tax year and (2) any administration costs withrespect to these claims.

There are several potential adverse tax consequences if a 501(c)(9) trust does not meet prescribedstandards. If reserves are above permitted levels, additional contributions to the reserves are notdeductible and earnings on the excess reserves are subject to tax as unrelated business income.(This effectively negates any possible advantage of using a 501(c)(9) trust to prefundpostretirement medical benefits.) In addition, an excise tax is imposed on employers maintaininga trust that provides disqualified benefits. The tax is equal to 100% of the disqualified benefits,which include (1) medical and life insurance benefits provided to key employees outside theseparate accounts that must be established, (2) discriminatory medical or life insurance benefitsfor retirees, and (3) any portion of the trust’s assets that revert to the employer.

Endnotes

1. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMA’s Glossary of Insurance Terms,3rd ed. (Atlanta: LOMA, ©1997).

2. Burton T. Beam, Jr., Group Benefits: Basic Concepts and Alternatives, 7th ed. (BrynMawr, PA: The American College, ©1997), 348-349.

3. Desoutter and Huggins.4. Adapted from Academy for Healthcare Management, Health Plan: An Introduction, 2nd

ed.(Washington, D.C.: Academy for Healthcare Management, © 1999), 9-29.5. Desoutter and Huggins.6. Ibid.

7. Ibid.

AHM Health Plan Finance and Risk Management: Financial Aspects of Medicare andMedicaid for Health Plans

Course Goals and ObjectivesAfter completing this lesson you should be able to

Describe the new payment methodology for Medicare Define the Medicare adjusted community rate (Medicare ACR) and its relationship to the

Medicare average payment rate (Medicare APR) List the two federal Medicaid law directives to states concerning payment methodology

for health plans and describe some methods used by states to comply with thesedirectives

Describe some of the financial risks for a health plan that provides healthcare services tothe Medicare or Medicaid populations versus the commercial population

List the key features of a state Medicaid program that will determine a Medicaidmanaged care plan's level of risk

Describe some of the aspects of a health plan’s regulatory environment that imposeadditional costs on health plans

Discuss provider reimbursement in Medicare and Medicaid markets

The Balanced Budget Act of 1997 (BBA), a federal law, contained provisions designed to furtherincrease enrollment in and availability of Medicare and Medicaid contracting health plans. TheBBA amended Medicaid law to facilitate states’ ability to mandate the enrollment of mostMedicaid beneficiaries into health plans.

In addition, the BBA expanded the range of health plan choices available to Medicarebeneficiaries and significantly revised the program under which health plans enter into risk-basedcontracts to provide services to Medicare beneficiaries. The revised Medicare risk-contractingprogram, known as Medicare+Choice, began on January 1, 1999.

In December, 2003, the Medicare Modernization Act of 2003 was signed into law. This Actchanged the name of the Medicare+Choice program to Medicare Advantage, and provided anumber of short term and long term reforms to the program to enhance benefits for enrollees andencourage access and shoice within the system. The final regulations are expected in spring 2005,and at that time the courses will be updated accordingly. See Insight 6A-1.

Insight 6A-1

The Medicare Modernization Act of 2003

On December 8, 2003, President George W. Bush signed into law the Medicare ModernizationAct of 2003 (MMA), taking steps to expand private sector health care choices for current andfuture generations of Medicare beneficiaries. The MMA proposes short-term and long-termreforms that build upon more than 30 years of private sector participation in Medicare.

The centerpiece of the legislation is the new voluntary prescription drug benefit that will be madeavailable to all Medicare beneficiaries in 2006. Additional changes to the M+C programinclude:

M+C program’s name is changed to Medicare Advantage (MA);

Increased funding is provided for MA plans in 2004 and 2005; MA regional plans are established effective 2006.

On January 16, 2004 CMS announced new county base payment rates for the MA program.Beginning March 1, 2004, all county MA base rates received an increase which plans arerequired to use for enhanced benefits. Plans may use the extra money in one of four ways:

Reduce enrollee cost sharing; Enhance benefits for enrollees; Increase access to providers; Utilize the stabilization fund.

The short-term reforms have already improved benefits and reduced out-of-pocket costs formillions of Medicare beneficiaries who are covered by health plans in the Medicare Advantageprogram, previously known as the Medicare+Choice program. These coverage improvementsbecame effective on March 1, 2004.

On June 1, 2004, beneficiaries saw additional improvements in Medicare under anotherimportant MMA initiative, the Medicare-Endorsed Prescription Drug Discount Card Program,which will remain in effect through the end of 2005. This program gives beneficiaries the optionof purchasing prescription drug discount cards—sponsored by private sector entities andendorsed by Medicare—which offer discounted prices on prescription drugs. Furthermore, thediscount card program is providing low-income Medicare beneficiaries with up to $600 annuallyin assistance, in both 2004 and 2005, to help cover their prescription drug costs.

Beginning in 2006, the MMA will provide beneficiaries with a broader range of private healthplan choices similar to those that are available to working-age Americans and federal employees.In addition to the locally-based health plans that currently cover more than 4.6 million Medicarebeneficiaries, regional PPO-style plans will be available as a permanent option under theMedicare Advantage program.

Beginning in 2006, all beneficiaries will have the option of choosing prescription drug coveragedelivered through private sector entities. This coverage will be available as a stand-alone drugbenefit or, in other cases, as part of a comprehensive benefits package offered by MedicareAdvantage health plans.

Other important provisions of the MMA address Medigap choices and specialized MedicareAdvantage plans for beneficiaries with special needs.

Public comments on the regulations are currently in review, and changes to the draft regulationsare anticipated. Final regulations are expected in the spring of 2005, and content updates will bemade after the release of the final regulations.

Contracting to provide services to Medicare and/or Medicaid beneficiaries presents a range offinancial issues for health plans. In this lesson, we discuss Medicare and Medicaid payment tohealth plans, the distinct financial risks and costs associated with providing services to Medicareand/or Medicaid beneficiaries, and issues related to paying providers for services rendered to ahealth plan’s Medicare and/or Medicaid enrollees.

This discussion focuses on health plans that have Medicare and/or Medicaid beneficiariesenrolled pursuant to a risk-based contract with the Centers for Medicare and Medicaid Services(CMS), the federal government agency responsible for administering the Medicare and Medicaidprograms. However, an important issue to keep in mind is that almost every health plan hasparticipating Medicare beneficiaries who are not enrolled under a Medicare contract but areenrolled under the health plan’s commercial lines of business.

Background: Medicare and Medicaid Payment to Health Plans

In the following sections, we discuss federal and state laws and regulations that set forth themethods for paying health plans for providing healthcare services to the Medicare and Medicaidpopulations.

Medicare

Prior to 1998, Medicare contracting plans were paid 95% of the estimated cost of providing theservices to a beneficiary under Medicare fee-for-service, known as the adjusted average percapita cost (AAPCC). The payment amounts were calculated on a county-by-county basis andwere beneficiary specific in that they adjusted for demographic factors including age, sex, andinstitutional status, as well as factors reflecting whether the beneficiary was Medicaid-eligible,had other insurance that was primary to Medicare, and was eligible for both Medicare Parts A andB.

Under AAPCC payment methodology, the payment rate for plans tended to vary significantly bygeographic region. In many areas, particularly rural areas, the rates of payment were so low thatMedicare risk-based contracts were not feasible. The payment rates for plans also tended to varysignificantly from year to year, making the program unreliable for many contractors.

In 1998, CMS implemented a new payment methodology authorized under the BBA. Under thenew methodology, Medicare-contracting health plans are paid the highest of the following threeamounts:

A rate reflecting a blend between national and local fee-for-service cost (unlike the oldmethodology which was based entirely on local costs) and subject to other adjustments such as aphased-in carve-out of graduate medical education payments and a budget neutrality factor

The health plan’s payment rate for the previous year, increased by 2 percent

A "floor" payment amount per enrollee covered, which was $367 per enrollee per month in 1998and is increased annually by a rate that reflects the national rate of growth in per capita Medicareexpenditures

Payments are adjusted by the same demographic and other factors applied under the previouspayment methodology.

The new payment methodology has significantly decreased the rate of growth in payments tohealth plans. As a result of basing payments on the new methodology, the payment rate in ruraland other low-payment counties was raised to the payment floor. The increased payment rate inthese counties, however, was financed by reducing the rate of increase in payments in othercounties where most Medicare contractors are located. Because of the constraint that these

Medicare changes be budget neutral, the blended rate methods was not used in payments for 1998or 1999. During 1998 and 1999, the vast majority of plans were paid an amount equal to theirprevious year’s payment increased by 2%. This trend is expected to continue for several years.Before the new methodology was implemented, growth in payment rates was typically greaterthan 5%.

Citing the decreasing growth in Medicare payments to health plans in conjunction with increasinggrowth in medical costs, in 1998 some plans with risk-based Medicare contracts announced theirintention to terminate their Medicare contracts or significantly decrease their service areas in1999.

Beginning in the year 2000, CMS will further revise the payment methodology by implementinga risk adjustment methodology known as the Principal Inpatient Diagnostic Cost Group (PIP-DCG) to account for variations in per capita costs based on health status. This risk adjustmentmethodology will be integrated with recalculated adjustment factors for age, gender, Medicaideligibility, and institutional status to adjust payments to health plans.

Because CMS currently only has inpatient data on which to base such a risk adjustmentmethodology, the agency is constrained initially to using a model that requires only inpatientdata.1

The application of the risk adjustment methodology could make payments to health plans varysignificantly from current payment levels and over time, therefore making participation in theMedicare program less attractive to health plans that have a healthier-than-average enrollment bysubstantially reducing their overall payments.

Under both the old and new payment methodologies, health plans with risk-based Medicarecontracts are required to calculate and submit to CMS a Medicare adjusted community rate(ACR). The Medicare adjusted community rate (Medicare ACR) is the plan’s estimate of thepremium it would charge Medicare enrollees in the absence of Medicare payments to the healthplan. To determine this estimated premium, the health plan uses the same rates it chargesenrollees in non-Medicare plans for a benefit package limited to covered Medicare services.2

The Medicare ACR includes amounts for administrative costs and profit. Each health plancompares its Medicare average payment rate (APR), which is the average amount the health planreceives or expects to receive from CMS per beneficiary covered, to its Medicare ACR. If theaverage rate of Medicare payment exceeds the health plan’s Medicare ACR, the plan is requiredto use the “excess” amount either to provide additional benefits or to reduce enrollee cost-sharingobligations.

Medicare-contracting health plans compete on premium amounts and benefits with otherMedicare-contracting health plans, Medigap insurers, and the Medicare fee-for-service programfor beneficiaries. The more benefits a health plan can provide and the lower the premium, thebetter the health plan will be able to compete by attracting beneficiaries to enroll in their healthplan. In the past, one of the key benefits health plans used to differentiate themselves fromcompetitors was pharmacy benefits, particularly in markets with relatively high Medicarepayments to health plans.

Pharmacy benefits have extremely limited coverage under the fee-for-service program and are anexpensive benefit for health plans to provide. Given that the beneficiaries have benefit choices, a

health plan that offers pharmacy benefits attracts beneficiaries who need pharmaceuticals to treatchronic or long-term conditions or diseases. These same beneficiaries tend to have higher-than-average needs for other healthcare services as well. One effect of the application of the newpayment methodology has been to cause a number of Medicare-contracting health plans to reducetheir costs through discontinuing or scaling back their pharmacy benefits.

Medicaid

Recall from Figure 6A-1 that Medicaid is a joint federal-state program. States administer theirown Medicaid programs after obtaining federal government approval of their programs. Thefederal government provides some funding for state Medicaid programs.

While Medicare law explicitly sets forth the methodology for payment of contracting plans,federal Medicaid law is relatively quiet on the question of payment to contracting plans. FederalMedicaid law does not contain any provisions regarding payment methodology but sets forth twodirectives for states. First, a state’s payment to health plans for providing Medicaid services cannot be more than it would have cost the state to provide the services under Medicaid fee-for-service (FFS), known as the upper payment limit.3

Second, states must pay Medicaid-contracting health plans that accept risk for comprehensiveservices on an "actuarially sound basis."4

One way that states comply with the requirement that payments not exceed FFS cost is to basetheir payment rates on the actuarial FFS equivalent, and then apply a factor of 95% or less todetermine the amount health plans will receive on a per member per month basis.5

These states then may apply any number of adjustments to the rates. Not all states base theirpayments on FFS equivalents. States use a variety of methodologies to determine payments tohealth plans, including competitive bidding. In states that base payments on competitive bids,plans providing services in the same geographic locations may receive different rates of paymentbecause the bid from one plan may differ from bids made by the other plans.

States vary not only in the methodology they use to pay health plans but also on the services forwhich health plans are paid and the mechanisms through which health plans are paid.

For example, states commonly carve out specific services from the capitation rate paid to healthplans. Such services may be provided through a separate health plan that is paid to provide onlythose carved-out services (mental health and substance abuse services are frequently provided inthis manner) or the state may reimburse the health plan separately for the carved-out services.Some states carve out the costs related to childbirth delivery from the health plan capitationpayment and make a separate, one-time payment to the health plan when an enrollee gives birth.States commonly carve out support services such as case management or transportation toprovider facilities and provide reimbursement for the services on a fee-for-service basis to thehealth plan and/or other providers eligible to deliver such services.

As illustrated in the preceding paragraph, there are many variations in the methods that each stateuses to pay its Medicaid-contracting health plans. However, across states there has been a generaltrend toward tightening payments to health plans while increasing contracting requirements andoversight. As we mentioned earlier, Medicaid is a joint federal-state program, which means thatsome of the funds for the Medicaid program are provided by the federal government and some bythe states. The trend toward tightening payments is likely to become more pronounced as federalMedicaid cuts (or decreases in the rate of growth of payments to health plans with Medicaidcontracts) are implemented over the next five years. Moreover, the federal Medicaid cuts arelikely to cause more states to manage costs by implementing mandatory health plan programs.

In addition to more stringent federal and state payment policies, several other factors have led toMedicaid health plan contracts becoming less attractive to health plans in some states. Medicaidprograms in some areas are unstable as states struggle with implementing and financing theprograms. A few states have solicited health plans to participate in proposed Medicaid managedcare programs that were never implemented. Other states have missed target dates, which hadbeen proposed to and approved by CMS, to move from voluntary to mandatory health planprograms, thereby delaying the potential benefits of health plans for this population.

Financial Risks of Providing Services to Medicare and/or Medicaid Benefits

Providing services under Medicare and/or Medicaid can impose financial risks and costs onhealth plans that are distinct from those related to providing services to the commercialpopulation. Differences in financial risks and costs include

Disenrollment provisions Intensive initial services, such as enrollee for education and outreach programs Utilization rates of the Medicare and Medicaid populations Marketing

Commercial enrollees are typically locked in to a plan for a twelve-month period. In contrast,currently all Medicare beneficiaries and most Medicaid beneficiaries can disenroll from a health

plan on a monthly basis. Therefore, Medicare- and Medicaid-contracting health plans are lessassured of recovering their initial enrollment and service provision costs through monthlypayments for ongoing enrollment.

However, the BBA may provide some relief to both Medicare- and Medicaid-contracting plansthrough its provisions. The BBA contains provisions that allow states greater flexibility in lockingin Medicaid beneficiaries. Medicare provisions allow for modified lock-in periods beginning inthe year 2002. Modified lock-in periods allow an enrollee to disenroll during a period of time—inthe case of Medicare after the year 2002, that period of time is three months--after making aninitial election to a plan. After the time period, the enrollee is locked in until the annual electionperiod.

Medicare and Medicaid enrollees tend to have a high level of costs in the first few months ofenrollment as the health plan educates them about the system and performs initial healthscreenings to evaluate their health. Health plans also tend to have high costs for providinghealthcare services during the initial months of enrollment as they address any healthcare issuesidentified in the initial screenings and initiate members into appropriate routines of care. Asignificant issue in Medicare contracting health plans, and one that differentiates the Medicaremarket from the commercial market, is the amount of time that it takes to recover these initialcosts.

In addition, the costs involved in providing care to the Medicare and Medicaid populations aresignificantly different than those involved in providing care to the commercial population.

For example, health plans are likely to incur greater expenses related to enrollee education forMedicare and Medicaid beneficiaries in order to ensure that the beneficiaries understand theirenrollment in a health plan system and the appropriate protocols and sites for accessing coveredcare. State and federal laws require that health plans follow certain procedures to ensure thatMedicaid enrollees understand their coverage. States with mandatory health plan programs assignMedicaid beneficiaries to a health plan in cases where the beneficiaries have not selected a healthplan themselves. These Medicaid managed care plans may incur significant costs in providingoutreach to inform the beneficiary that they have been enrolled in the health plan’s plan and toeducate the beneficiary about the implications of their enrollment.

Furthermore, Medicare and Medicaid plans have higher costs than the costs experienced by healthplans that contract for commercial business. These higher costs relate to coordinating care andcase management due to the higher incidences of chronic illness in both the Medicare andMedicaid populations.

An important area of difference between Medicare and Medicaid and commercial populations ishow each group utilizes medical services. The Medicare population tends to utilize a higherproportion of specialty care than do enrollees in commercial group plans do. In contrast, theMedicaid population tends to utilize a higher proportion of primary care services than do eitherthe Medicare or commercial populations.

A final area in which Medicare and Medicaid plans are likely to incur additional expense isassociated with individual marketing. With commercial products, health plans typically enrollmembers by groups. For example, when a health plan provides health plan options to a largeemployer, the employees sign up individually but all the individuals that sign up for each optioncan be treated as a group. Within an employer group, health plans may compete with other

healthcare options offered by the employer, but in general, the need to inform commercialmembers about product options requires less time and money per enrollee than that required topresent the same types of information to Medicare- and Medicaid-eligible beneficiaries.

Typically, under Medicare, a large portion of a plan’s enrollees will be enrolled individuallyrather than through groups, despite an increasing willingness by employers to contract withMedicare health plans to provide coverage to their Medicare-eligible employees and retirees.

Medicare-contracting health plans must market and appeal to individual beneficiaries bycommunicating the advantages of enrolling in a health plan to receive Medicare benefits.Medicaid-contracting health plans must also appeal to individual enrollees. However, underMedicaid, the ability of a health plan to market and the extent to which they need to market willdepend upon state law regulating Medicaid health plan marketing and whether the relevant stateuses a third-party enrollment broker to educate beneficiaries about their health plan choices.

Despite the increased costs of providing services to Medicare and Medicaid populations,Medicare- and Medicaid-contracting health plans with well-managed programs can still besuccessful because health plan techniques have the potential to significantly decrease the cost ofproviding services to beneficiaries from the amount it would have cost to provide the servicesunder FFS programs.

For Medicaid populations, the central challenge that health plans face is influencing the behaviorof enrollees. Medicaid-contracting health plans can decrease costs by ensuring that Medicaidbeneficiaries (1) access care at appropriate sites (and that they avoid inappropriate utilization ofexpensive emergency room services) and (2) receive appropriate care for chronic illnesses.Medicare-contracting health plans can decrease costs by influencing physician behavior to ensureappropriate utilization of specialty and inpatient services, to better coordinate care, and to managechronic illnesses.

Risk Related to the Structure of State Medicaid Programs

The risk involved in providing care to the Medicaid population depends largely on the structureof the relevant state’s Medicaid program. Key features of state programs that determine the levelof risk a Medicaid contractor will assume. These features include:

Which Medicaid groups are eligible to enroll in health plans Whether the state has a guaranteed eligibility provision Whether the state has a lock-in provision that mandates that each person who enrolls in a

health plan’s plan remain in that plan for a certain period of time Whether the state mandates participation in the health plan program.

Medicaid Eligibility Groups Eligible to Enroll in Health Plans

The Welfare Reform Act replaced a federal welfare program called Aid to Families withDependent Children (AFDC) with Temporary Assistance to Needy Families, but Medicaideligibility for women and children remains tied to state AFDC eligibility levels as they existed in1996 (although states have the flexibility to provide for more liberal eligibility standards).

The majority of persons receiving Medicaid are women and children who meet AFDC eligibilitystandards. Most of the remaining recipients are persons who are aged and disabled. Although the

AFDC population comprises 70% of recipients, it accounts for only 30% of costs. Aged anddisabled Medicaid beneficiaries account for the majority of Medicaid costs.

Historically, state Medicaid managed care programs have focused on enrollment of the AFDCpopulation. However, states are beginning to enroll their disabled populations into health plans aswell. Financial risk is particularly high with disabled enrollees, partly because states havestruggled to find an accurate payment methodology to account for their higher costs.

Aged Medicaid beneficiaries are both Medicare and Medicaid. This dual eligibility means thattechnically, they could participate in an Medicaid managed care program. Few states, however,have chosen to incorporate this population into their Medicaid health plan programs because ofthe difficulty in coordinating Medicare and Medicaid payments and services. Medicarerequirements allow Medicare beneficiaries to receive Medicare benefits from the Medicareparticipating provider of their choice, whether or not the provider is part of a health plan network.Therefore, a state could require that an aged beneficiary obtain Medicaid-covered services from aMedicaid-contracting health plan, but would not be able to require the same beneficiary to obtainMedicare-covered services from a health plan.

In addition, if a beneficiary is eligible for coverage under both Medicare and Medicaid, Medicareis the primary insurer. In effect, many of the Medicaid benefits would simply be coverage ofcopayments and deductibles for Medicare-covered services, and these Medicare services wouldbe delivered in a non-health plan environment.

Because Medicaid managed care enrollees are likely to be women and children, the Medicaidpopulation has a different spectrum of healthcare needs than do typical enrollees in commercialgroup plans. Medicaid-contracting health plans focus their resources on providing prenatal andobstetrical care and well child services. However, as previously noted, health plans must beprepared to manage the chronic care needs of this population. As government policy expandsMedicaid eligibility for children, chronic care issues, such as management of pediatric asthma,will become increasingly important to health plans

Guaranteed Eligibility Provision

One of the determining factors in a person’s eligibility for Medicaid is the amount of financialresources and income that person has. Thus, changes in financial status can cause a person to gainor lose eligibility. The temporary nature of Medicaid eligibility poses significant problems forMedicaid-contracting health plans.

Medicaid beneficiaries change eligibility status so frequently that it is often difficult to averagecosts over time or provide any continuity of care. Fluctuations in enrollee eligibility may make itdifficult for a health plan to recover its costs of providing initial services such as education, anyinitial outreach, or physical examinations. Moreover, fluctuations in eligibility decrease theincentive for health plans to provide additional non-Medicaid-covered preventive services as acost savings mechanism because a beneficiary’s enrollment may be of short duration.

Prior to the BBA, states had a limited ability to guarantee eligibility of Medicaid beneficiaries forperiods of longer than a month. The BBA amended Medicaid law to allow states to guaranteeeligibility for 6 months for any individual enrolled in a health plan entity and to allow states toguarantee eligibility to all beneficiaries under the age of 19 for up to 12 months.6

It is unclear whether states will take advantage of the ability to guarantee eligibility to allenrollees of health plan entities because of the potential cost of such a measure. However, a fewstates have already adopted and implemented guaranteed eligibility provisions for beneficiariesunder the age of 19 in connection with implementation of their State Children’s Health InsurancePrograms, which are federally funded and are designed to allow states to create programs toensure that needy children have healthcare coverage.

Lock-In Provisions

As noted earlier, lock-in provisions require that enrollees stay enrolled in the plan of their choicefor a certain period of time, such as a year. Lock-in provisions increase the financial stability ofthe Medicaid market for health plans because typically an enrollee must stay with a given plan forsome period of time before the health plan recovers the initial costs attributable to signing up thatenrollee. In the absence of a lock-in provision under state law, Medicaid beneficiaries candisenroll from a health plan on a monthly basis.

Prior to the BBA, states could only lock-in beneficiaries to a few limited categories of Medicaid-contracting health plans. Because it was unlikely that all Medicaid-contracting health plans in astate fit into these categories, this provision was of limited use. States were more likely to seek awaiver of the monthly disenrollment requirement, which was a requirement that Medicaidbeneficiaries be allowed to disenroll from a health plan on a monthly basis.

In 1997, the BBA amended Medicaid law to facilitate states’ ability to lock-in a beneficiary’shealth plan enrollment for up to a year. However, the provision requires that beneficiaries beallowed to disenroll without cause for 90 days after enrollment. Therefore, the law may notaddress health plan concerns regarding the ability to recover initial costs.

Cost of Compliance with Medicare and Medicaid Regulatory Requirements

A significant cost for Medicare and Medicaid contracting plans is the cost of compliance withfederal and/or state regulatory requirements. At the same time the rate of increase in Medicareand Medicaid payments to health plans is slowing, the regulatory requirements imposed onparticipating health plans are increasing.

Both Medicare- and Medicaid-contracting plans are required to comply with federal and staterequirements relating to the submission of data in order for the regulating entity to oversee thequality of care provided in the plan. Under Medicare, plans are required to report on the HealthPlan Employer Data and Information Set (HEDIS).

Many state Medicaid programs are also requiring reporting on HEDIS measures or on similarquality of care measures. Beginning in 1998, CMS required that all Medicare-contracting healthplans’ HEDIS data be audited. Although CMS covered the cost of the audit in 1998, it is likelythat Medicare-contracting health plans will be required to pay for the audits in subsequent years.

In 1997, the BBA made amendments that imposed additional costly requirements on Medicare-contracting plans that began in the 1998 contracting year. The BBA amended Medicare law toauthorize an assessment on Medicare-contracting health plans to fund CMS’ efforts to educateMedicare beneficiaries about their Medicare health plan choices. For 1998, the assessmentequaled 0.428% of health plans’ capitation payments. For many health plans, this was a

significant cost, because the majority of health plans only received a 2% increase in their previousyear’s rate for 1998.

Although the law sets forth guidelines regarding the amount of the annual assessment, thespecific amount of the assessment will be set each year through the legislative appropriationprocess. In addition, Medicare-contracting health plans were required to begin submittinginpatient encounter data to CMS to serve as a basis for CMS’ risk adjustment of health planpayments. The cost of collecting and submitting such data must be borne by the health plan.

Beginning in 1999, Medicare-contracting health plans will be required to comply with a numberof additional regulatory provisions that will impose additional costs on the health plans. Most ofthe requirements came from the provisions of the BBA that authorized the Medicare+Choiceprogram (see Figure 6A-1). The requirements include, but are not limited to, shorter timeframesfor making routine coverage determinations and new requirements regarding physicianparticipation in the Medicare health plan.

One of the most significant new requirements for Medicare-contracting health plans iscompliance with the Quality Assessment Performance Improvement (QAPI). TheMedicare+Choice regulations require that Medicare contracting plans comply with the qualitystandards and requirements beginning January 1, 1999. In addition, CMS will issue the QAPIstandards to states as guidance for the development of quality assurance and improvementstrategies in their Medicaid programs.

Although adoption of QAPI is voluntary for states, it is likely that states will adopt the QAPIstandards as a mechanism for compliance with new Medicaid requirements regarding qualityassurance standards. The BBA amended Medicaid law to require that states contracting withhealth plans develop and implement quality assessment and improvement strategies consistentwith the requirements set forth in QAPI. One of the requirements is that the state’s strategy beconsistent with standards established by the Secretary of Health and Human Services. TheSecretary will use QAPI as those standards.

Another new requirement that may result in additional health plan costs and are applicable to bothMedicare- and Medicaid-contracting health plans are requirements to cover emergency roomservices under a “prudent layperson” standard. This standard holds that if a prudent laypersonwould reasonably believe that an emergency medical condition existed, the health plan must payfor the cost of the emergency care, regardless of whether such an urgent medical conditionactually existed.

Finally, further new requirements regarding coverage of services provided in an emergency roomafter an enrollee is stabilized may also increase costs.

In early 1998, the President issued an executive order to all federal agencies responsible foradministering healthcare programs. The order required the agencies, to the extent possiblethrough administrative measures, to implement the provisions of the “Consumer Bill of Rightsand Responsibilities,” developed by the President’s Advisory Commission on ConsumerProtection and Quality in the Health Care Industry.

Many of the requirements of the Consumer Bill of Rights and Responsibilities were incorporatedin the Medicare+Choice implementing regulations. Those requirements include, but are notlimited to, allowing women direct access to a woman’s health specialist for routine and

preventive services, providing direct access to specialists for enrollees with complex or seriousmedical conditions, and taking specified actions to provide for continuity of care. It is likely thatCMS will require state Medicaid agencies to impose similar requirements on their Medicaid-contracting health plans.

Paying Providers to Provide Medicare and/or Medicaid Services

To remain financial viable, a health plan’s Medicare or Medicaid product must accuratelycalculate payments to providers and develop arrangements that encourage providers toappropriately control utilization. In this section, we discuss issues involved in developingeffective payment arrangements for the provision of services to Medicare and Medicaid enrollees.

Federal Law Regulating Health Plan Payments to Providers under Medicare and Medicaid

One of the most significant factors affecting payment of providers by Medicare- or Medicaid-contracting health plans is compliance with federal law regarding such payments. There are anumber of provisions under Medicare and Medicaid law that affect the structure of providerpayment arrangements and the relative amounts that certain providers must be paid or that theproviders must accept as payment.

The Physician Incentive Law 7

Under federal law, Medicare and Medicaid contracting health plans are prohibited from makingspecific payments to physicians or physician groups as an inducement to limit or reducemedically necessary services to specific individuals. The law further requires that if a Medicare orMedicaid contract places a provider at “substantial financial risk” for services that the providerdoes not directly provide (i.e. referrals), then the health plan must provide stop-loss protection tothe provider and must conduct beneficiary satisfaction surveys.

Under the regulations, a provider is at "substantial financial risk" if incentive arrangements placethe provider at risk for amounts in excess of 25% of the provider’s total potential reimbursement,where the risk is based on the use or cost of referral services and the size of the patient panel isnot greater than 25,000 patients. The patient panel may be determined by "pooling" physiciangroup enrollees from different product lines and even different Medicare- or Medicaid-contracting health plans if specified conditions are met.

Finally, the law requires that the health plans provide the HHS Secretary or state Medicaidagency with sufficient descriptive information to determine whether the health plan is incompliance with the law.8

The regulations also define the requirement that the health plan provide adequate stop-lossprotection where physicians or physician groups are at substantial financial risk. Under theregulation, health plans must meet this requirement by ensuring that the physicians or physiciangroups have adequate stop-loss coverage. The health plan may either pay for stop-loss insuranceitself or ensure that another organization pays for it. Either aggregate or individual stop-lossprotection may be used to meet the stop-loss requirement. If aggregate stop-loss protection isused, it must cover 90% of the cost of referrals that exceed 25% of total potential payments. Ifindividual stop-loss protection is used, the limit per individual must be decided based on thenumber of patients assigned to the patient panel, and the stop-loss protection must cover 90% ofthe cost of referral services that exceed the per-patient limit.

Finally, the regulations specify the information that health plans must disclose to CMS or thestate Medicaid agency regarding physician incentive arrangements.

Non-Discrimination in Provider Payments

The BBA amended Medicare and Medicaid law to provide that a contracting health plan may notdiscriminate with respect to participation, reimbursement, or indemnification against any providerwho is acting within the scope of the provider's license or certification under applicable state law,solely on the basis of such licensure or certification.

This provision would prohibit health plans from paying different amounts to providers for thesame service incases where the reimbursement differences are based solely on differences in howthe providers are licensed or certified. For example, a Medicare or Medicaid contracting healthplan would be obligated to pay a social worker and a psychiatrist the same amounts for providingthe same type of counseling. Similarly, a Medicare or Medicaid contracting health plan would berequired to pay an anesthesiologist and a nurse anesthetist the same amounts for providing thesame services.

Anti-Kickback Law

In general, the federal anti-kickback law prohibits any individual from offering or acceptinganything of value in exchange for making a referral for, or ordering, an item or service for whichpayment may be made in whole or part under a federal health program, including Medicare orMedicaid. For example, a primary care physician cannot accept a payment from a specialist forreferring a patient to the specialist.9

The anti-kickback law contains several exceptions for practices that are not considered to be inviolation of the law. These exceptions include

Discounts that are properly disclosed and reflected in the costs claimed or charges madeby the provider;

Payments by an employer to an employee for bona fide employment in the provision ofcovered items and services;

Remuneration between an organization and an individual or entity providing items andservices pursuant to a written agreement where the organization has a Medicare contractor the organization places the individual or entity at significant financial risk for theservices to be provided

Activities protected by the safe harbor regulations promulgated by the secretary of HHS.

The safe harbor regulations are regulations developed by the Secretary of HHS that make otherexceptions to the anti-kickback law for some types of arrangements that are unlikely to lead tofraud or abuse. In other words, the Secretary of HHS has identified activities that do not violate tothe anti-kickback law. There are two sets of final safe harbor regulations. The first set identifiessafe harbors in several broad areas. The second set of regulations offers three safe harborsdesigned specifically to address health plan arrangements. Of the three health plan safe harbors,the one most relevant to Medicare and Medicaid provider payment arrangements allows providersto negotiate price reductions or discounts with “health plans” in anticipation of increasedbusiness.

An activity does not have to meet one of the statutory or regulatory safe harbors to avoid anti-kickback prosecution. An arrangement that does not meet the requirements for safe harborprotection is not necessarily illegal. The safe harbors were provided to give health plansassurance that those arrangements are generally immune from potential criminal and civilsanctions.

An anti-kickback analysis of a provider payment arrangement may have three possible outcomes.First, the arrangement may not be implicated under the anti-kickback statute, in which case thereis no potential for anti-kickback liability. Second, the arrangement may be implicated by thestatute but fall under one of the anti-kickback safe harbors. In such a case, unless the arrangementis a sham transaction, there is no potential for anti-kickback liability. Finally, the arrangementmay be implicated by the statute and not fit within one of the anti-kickback safe harbors.

It is important to note that the anti-kickback law applies not only to services provided under ahealth plan’s Medicare and Medicaid contracts, but also to any services for which federal healthprogram payment may be made. This would include services to employer group enrollees whohave Medicare as primary or secondary payor because in some instances payment may be madeunder the Medicare program.

The Physician Self-Referral Law

The physician self-referral law prohibits physicians from making a referral to another providerentity for designated health services if the physician, or an immediate family member of thephysician, has a financial relationship with the entity.10

A "financial relationship" includes a direct or indirect relationship between a physician and anentity with which the physician has an ownership or investment interest or compensationarrangement. Therefore, if a physician has a payment arrangement with a health plan and makesreferrals to an entity owned by the health plan or in which the health plan has an investmentinterest, the self-referral law may be implicated.

To bill for a service that falls under the physician self-referral ban, any financial relationships thata physician has with an entity must meet one of the exceptions provided in the law. A generalexception for prepaid plans exempts from the self-referral ban services furnished by

Medicare-contracting HMOs Organizations with prepaid Medicare demonstrations Federally qualified HMOs to their enrollees

Medicaid-contracting health plans were more recently added by regulation to this list ofexceptions to the self-referral ban.

Structuring Provider Payment Arrangements

In addition to the Medicare and Medicaid laws set forth above, payment arrangements betweenMedicare- and Medicaid-contracting health plans and providers are subject to the same legalrequirements as those for providing services to the commercial population. In addition, Medicareand Medicaid physician payment arrangements are subject to the same informal influences ascommercial arrangements.

As under commercial contracts, geographic location and experience with health plans play a rolein the structure of physician payment arrangements. For example, if the health plan is located in ageographic region in which physicians are reluctant to take financial risk in connection with thecommercial population, the same or greater reluctance will apply to the Medicare and Medicaidpopulation.

Consequently, health plans with commercial lines of business are likely to use similar structuresin their provider payment arrangements under Medicare and Medicaid and their commercialpopulation. The payment amounts will be different, however, reflecting the different utilizationpatterns of these populations.

Typically, health plans enter into one contract with a provider that covers all the health plan’slines of business.

The mechanisms for payment (FFS, capitation, withholds, bonuses, and the formulas forcalculating withholds and bonuses) are typically the same across the health plan’s lines ofbusiness, unless the providers refuse to accept risk for a specific population, or state law preventscertain types of providers, such as PPOs, from accepting capitation.

However, the amount of payment will vary based on the line of business and, for Medicare and/orMedicaid, the health plan will either provide for stop-loss protection or limit any risk for referralto avoid delegation of “substantial financial risk” under the physician incentive law.

Most health plans also refine their provider reimbursement methodologies for their Medicare orMedicaid products to focus on areas of specific concern, such as specialty referrals for Medicarebeneficiaries, including ophthalmology (cataract treatment, etc.), cancer treatment, and cardiacservices.

In some instances, a health plan’s Medicare or Medicaid payment arrangements may also beaffected by its partnership with another healthcare organization that specializes in Medicare orMedicaid managed care. Such organizations focus on Medicare or Medicaid health plans andfrequently collaborate with an existing commercial health plan or develop a new health planproduct with a provider organization. Often these specialty Medicare/Medicaid health plans usetheir own proven Medicare or Medicaid provider payment methodologies.

Payment Amounts

In determining the amount to pay providers to supply services to individuals enrolled under theirMedicare or Medicaid contracts, health plans need to balance two objectives that may beconflicting. First, the health plan needs to pay providers at levels that ensure the health plan willhave an economically viable Medicare or Medicaid program. Second, the health plan needs to payproviders enough to make participation in their Medicare or Medicaid products attractive to theprovider.

In many markets, health plans pay providers an amount similar to the amount the provider wouldhave received under fee-for-service Medicare or Medicaid. This is true whether the provider ispaid on a fee-for-service basis or on a capitation basis where the capitation amount is calculatedby determining the actuarial equivalent of the value of services under the relevant FFS system.

However, this general rule does not apply in all geographic regions. Recall that Medicarepayments to health plans have been based on a percentage of the AAPCC, which often means thatthe health plans are paid less than the market FFS rate. To pay providers an amount similar to thatthey would receive under FFS, the health plan must achieve savings through utilizationmanagement. But in competitive markets where services such as inpatient days have already beenreduced, such savings are difficult.

Moreover, in Medicare, in some areas of the country there has been a trend in FFS providerpayments toward paying providers less than the Medicare fee schedule amount. This isparticularly true in urban settings that have a relative oversupply of competing specialists,hospitals or labs and where the beneficiaries in the area are willing to switch providers.

Figure 6A-2 discusses how payment is determined for providers who do not have contracts withMedicare health plans.

The way in which provider reimbursement is distributed differs under Medicare and Medicaid.Under Medicare, a smaller proportion of the total payment for services goes to primary careproviders and a greater proportion of the payment goes to hospitals and specialists.

This difference in utilization rates for PCPs and specialists must be reflected in any capitationarrangements made with providers rendering services to the Medicare and Medicaid planmembers. Therefore, if provider capitation payments for services provided to Medicarebeneficiaries are calculated by applying a multiplier to the commercial provider rates to accountfor higher utilization, the multiplier is smaller for primary care services than other services.

Under Medicaid, a greater proportion of the provider payments goes to primary care providers.For example, the multiplier for primary care physicians in a Medicaid capitation contract mightbe 3 to 4 times the multiplier used in a commercial capitation contract. For other services such asthose provided by skilled nursing facilities, the difference in multipliers will be even greater.

Providers and Financial Risk in Medicare and Medicaid

For health plans, the central financial risks in Medicare and Medicaid markets stem from twoconditions. First, the government sets the payments received by health plans, and therefore the

health plans cannot easily seek an increase these payments even in the face of rising costs.Second, regulations determine which services must be provided, and which persons are eligible toenroll in a plan.

Therefore, a health plan’s most important tool for achieving profit is the control of utilizationrates. A key method of controlling overutilization in health plan environments is, as we haveseen, provider reimbursement contracts that put providers at financial risk in cases ofoverutilization.

It is important to remember that there are two basic categories of services for which providersmay accept risk–services they provide directly and referral services. For physicians, referralservices include inpatient services and specialty physician services. A provider paymentarrangement may delegate risk for none, one, or both of these categories of services.

As noted earlier in this lesson, geographic region and experience with health plan play a similarrole in determining whether a provider will accept risk under Medicare or Medicaid as it doeswith the commercial population.

In addition, physicians and providers who have experience with the commercial population, butnot the Medicare or Medicaid population, may be reluctant to assume risk in connection with theMedicare or Medicaid population or may request significant utilization data from the health planbefore entering into a risk arrangement. There is typically more provider reluctance to accept riskin connection with providing services to the Medicaid population than with providing services tothe Medicare population.

For physicians or physician groups, the size of the patient panel is a key factor in whether thephysician or physician group will be willing to accept risk. Other factors being equal, the morepatients a physician or physician group has, the more attractive risk arrangements will be because,as we have seen in our discussion of the law of large numbers, the more patients a provider has,the more likely it is that the health utilization rate for that group of patients will fall within apredictable range.

Providers who are already accustomed to accepting capitation payments are most ideally suited toprovide services to a Medicare-contracting health plan, particularly if those providers have hadexperience treating large number of older patients, or have had experience with Medicarepopulations. These providers understand the need to manage the overall care of the member andestablish an ongoing relationship with members rather than providing episodic treatment fordisparate illness or injuries.11

As a practical matter, a key influence on the structure of payment arrangements betweenMedicare- and Medicaid-contracting health plans and their physicians is the federal physicianincentive law discussed earlier. Recall from our earlier discussion that the physician incentive lawregulates payment arrangements with physician and physician groups and only regulates financialrisk for services the physician or physician group does not directly provide. A health plantypically designs its risk-sharing arrangements to serve its business purposes, and then performsan analysis of the arrangement’s compliance with the physician incentive law.

In some cases, the risk imposed by an arrangement meets the definition of substantial financialrisk. If the health plan can make small adjustments to the arrangement to bring it under thesubstantial financial risk threshold without changing the basic structure of the arrangement, the

health plan will do so rather than comply with the additional regulatory requirements that areimposed when a health plan places a physician or physician group at substantial financial risk.

If bringing the compensation arrangement under the substantial financial risk thresholdundermines the basic structure of the arrangement, the health plan can choose instead to buy (orrequire providers to buy) stop-loss insurance. The health plan can also provide stop-loss insuranceto providers as a means of complying with the physician incentive regulations for its Medicare orMedicaid products.

Providers' Financial Risk and Medicaid

Under Medicaid, some providers that have traditionally provided services to low-income personsand served as a safety net have relatively little experience with accepting financial risk. However,it is important to include such providers in the health plan’s network, and health plans may berequired under state law or contracting conditions to include such providers in their networks.

Prior to implementation of Medicaid amendments made under the BBA, health plans wererequired to pay FQHCs 100% of reasonable costs unless the FQHC negotiated anotherarrangement with the health plan. As discussed earlier in this lesson, the BBA amended Medicaidlaw to require states to make supplemental payments to FQHCs and RHCs to guarantee that thelevel of payment from the health plan equals the guaranteed payment level set forth in federallaw.

Effective use of hospital utilization is the single most likely factor to contribute to the success of aMedicare-contracting health plan.12

Therefore, it is useful for Medicare contracting health plans to structure their physician paymentarrangements in a manner to provide incentive to avoid the risk of overutilization of hospitalservices. Such incentives can be provided through withholds, capitation contracts, or bonuses.The mechanism used by a particular health plan is likely to depend on the mechanisms used forthat health plan’s commercial population.

Managing the use of specialty services is also an important consideration for Medicare-contracting health plans. Because of the higher use of specialists required to provide care to theMedicare population, health plans should implement an incentive that addresses effectivereferrals from PCPs to appropriate specialists and from one specialist to another.

Special Risk Sharing Rules for Medicare-Contracting PSOs

If a Medicare-contracting health plan is a provider sponsored organization (PSO), it is subject torequirements to share risk with its providers. As defined under Medicare law, a PSO is a public orprivate entity that is established or organized and operated by a provider or group of affiliatedhealthcare providers and that provides a substantial portion of healthcare items and services underits Medicare contract directly through the provider or group of affiliated providers.

If the PSO is established or operated by a group of affiliated providers, the affiliated providersmust share financial risk with respect to the provision of items and services under the Medicarecontract and must have a majority financial interest in the PSO.

The implementing regulations to the law specify that each affiliated provider must share, directlyor indirectly, in substantial financial risk. The regulations indicate that the following mechanismsmay constitute risk-sharing arrangements and may have to be used in combination to demonstratesubstantial financial risk in the PSO:

Capitation payment for each Medicare enrollee Payment of a predetermined percentage of the PSO premium or the PSO’s revenue The PSO’s use of significant financial incentives for its affiliated providers, with the aim

of achieving utilization management and cost containment goals. For example, the use ofsignificant withholds or bonus arrangements would fall under this category

Other mechanisms that demonstrate significant shared financial risk.13

It is likely that a PSO would not have commercial lines of business and therefore would not haveagreements to provide services to commercial enrollees on which to base its Medicare providerpayment arrangements.

Key Health Plan Issues in Medicare and Medicaid Markets

As we have seen, in deciding whether to enter into a Medicare or Medicaid contract or evaluatingthe Medicare or Medicaid markets, health plans should be mindful of the payment amounts theorganization will receive, the regulatory environment, and the special needs of the populations tobe served.

Finally, a health plan’s relationships with providers are an important factor in its success. Tomake a Medicare or Medicaid product financially viable, a health plan must

Structure its payment arrangements to attract providers who will work well in a healthplan environment

Provide incentives to appropriately control utilization and manage care, and to beconsistent with the health plan’s financial goals given the payment rate that the healthplan receives from the state or federal government.

Endnotes

1. PREAMBLE TO COMMENT SOLICITATION ON RISK ADJUSTMENTMETHODOLOGY, 63 FR 47507 (SEPTEMBER 8, 1998).

2. 42 CFR 417.410.3. 42 CFR 477.361.4. Section 1903(m)(2)(A)(iii) of the Social Security Act.5. Robert Hurley, Leonard Kirschner, and Thomas Bone, “Medicaid Health Plan” in The

Managed Health Care Handbook, ed. Peter R. Kongstvedt, 3d. (Gaithersburg, Maryland:Aspen Publishers, 1996) 770.

6. SECTION 1902(E) OF THE SOCIAL SECURITY ACT.7. Adapted from Kelli Back, Group Practices: Meeting Obligations under the Physician

Incentive Requirements,” Group Practice Journal (May/June 1997): 16,19. Used withpermission.

8. SECTIONS 1852(j)(4) (relating to Medicare) AND 1903(m)(2)(A)(x) (relating toMedicaid) OF THE SOCIAL SECURITY ACT.

9. SECTION 1128B(b) OF THE SOCIAL SECURITY ACT.10. SECTION 1877 OF THE SOCIAL SECURITY ACT.

11. Roger Taylor and Craig Schub, Medicare Risk Plans: The Health Plan’s View,”in TheManaged Health Care Handbook, 3rd ed., ed. Peter R. Kongstvedt (Gaitsburg, MD:Aspen Publishers, Inc., 1996), 749.

12. Ibid., 750.13. 42 CFR 422.356.

AHM Health Plan Finance and Risk Management: The Relationship Between Rating andUnderwriting

Course Goals and ObjectivesAfter completing this lesson you should be able to

Explain the relationship between rating and underwriting Describe the actuarial function and the underwriting function in a health plan Discuss the common tiers used in rating methods Define community rating, manual rating, experience rating, and blended rating, and

describe circumstances under which a health plan would use each method

Health plans use underwriting and rating to achieve some of the central goals of their corebusiness: pricing health plan benefits and other products in such a way that the rates for the healthplan’s products, including health plans, are adequate, reasonable, equitable, and competitive.Each of these is described in Figure 7A-1.

The process by which a health plan achieves these goals is complex. A health plan regularlymonitors how well its assumptions about expenses and risk match the costs that the health planincurs. Demographic factors, medical treatments, technology, and health plan techniques changeover time. As a result, a health plan’s expenses change, so the health plan analyzes andincorporates the effect of these and other changes into its underwriting and rating assumptions.

Rating and Underwriting

Rating, also called pricing, is the process of calculating the appropriate premium to chargepurchasers, given the degree of risk represented by an individual or group, the expected costs todeliver healthcare services, and the expected marketability and competitiveness of the healthcareservices.1 Underwriting is the process used to assess the risks associated with providinghealthcare services for an individual or group and to determine the conditions under which thoserisks are acceptable.2

The process of rating is usually accomplished by using a mathematical formula that considers thespecific costs that affect the delivery and financing of healthcare services to a particular group orindividual. The rating formula represents each cost by a specific, measurable, cost-generatingvariable. This formula is sometimes called the book rate formula or the manual rating structure.We discuss manual rating later in this lesson.

A health plan’s underwriting process may modify the book rates and/or establish certainconditions that must be satisfied by the group or individual before the health plan accepts therisks associated with providing healthcare services. The rating structure that a health plan usesmust

Consider the costs of providing healthcare services Calculate premium rates for those services Anticipate future increases in utilization and claims costs Comply with applicable laws and regulations that govern premium rates

The results of the rating formula are typically expressed on the basis of per member per month(PMPM) cost. The PMPM cost must in turn be transformed into premium rates for each employeecategory through the use of an appropriate tier rating structure, which we discuss later in thislesson and in Pricing and Rating lesson.

The rating formula and its components have other important applications to a health plan. Theseapplications include establishing budgets or cost objectives by medical service category ordepartment; establishing funding for provider-based risk pools; and identifying, quantifying, andranking opportunities for healthcare services within the health plan. A health plan can use thesedata to establish provider-based education and incentives necessary to realize businessopportunities. A health plan’s actuarial and underwriting functions are involved in thedevelopment of premium rates and risk selection.

The Actuarial Function

Generally, the actuarial function is the work group and/or processes that a health plan establishesto be responsible to see that the health plan’s operations are conducted on a mathematically soundbasis.3 Recall from the Health Plan Financial Information lesson that an actuary developspremium rates and evaluates claims experience with respect to the risk associated with healthcarebenefits for product pricing, provider contracting, and other purposes. Ultimately, thedetermination of the appropriate rate (price) to charge for a given level of healthcare benefits andadministrative services (cost) in a particular market (competition) is a critical component ofmanaging the profitability of a health plan.

Employees in a health plan’s actuarial function typically:

Calculate premium rates Identify the type and amount of the health plan’s liabilities Conduct research to establish underwriting guidelines Determine the health plan’s overall profitability Play a key role in managing the health plan’s risk-based capital (RBC) requirements, if

applicable Design and revise healthcare products and services (with employees in the health plan’s

marketing function)

The Underwriting Function

Recall from the Health Plan Financial Information lesson that an underwriter assesses andclassifies the degree of risk represented by a proposed group or individual. The underwritingfunction is the work group and/or set of processes that a health plan establishes to assess the risksassociated with a group or individual and which determines the conditions under which thoserisks are acceptable to the health plan.4 Through a process of risk assessment, risk classification,and risk selection, the underwriting function seeks to ensure that the actual costs of providinghealthcare benefits for each purchaser do not exceed the costs that were assumed when the priceof those benefits was calculated.

A health plan’s underwriters and other employees who perform the underwriting function usepurchaser-specific quantitative or qualitative considerations to modify the results obtained fromthe rating formula to reflect accurately the health plan’s risks in underwriting the purchaser orgroup. For large employer groups, underwriters may include minimum penetration requirements,which we discuss in the next lesson. For small employer groups, underwriters also may considerthe result of medical underwriting, which we discuss in the Small Group Underwriting andIndividual Underwriting lesson.

Either the actuarial function or the underwriting function in a health plan also negotiates andmanages stop-loss insurance contracts and reinsurance contracts that the health plan uses totransfer some or all of its risk. Underwriters and other employees who perform the underwritingfunction in a health plan rely on the premium rate structure developed by the actuarial functionand consider which assumptions should be accepted as is or modified through additional generalor specific procedures.

Underwriting, Rating, and Risk Management

In Risk Management in Health Plans, we discussed how a health plan uses risk managementtechniques to avoid, assume, share, or transfer the risks associated with the financing and deliveryof healthcare services. In the following sections, we review risk assessment, risk classification,and risk selection in the context of underwriting and rating.

Risk Assessment

As part of its decision process to provide healthcare benefits to a group or individual, a healthplan reviews the risk assessment factors associated with that group or individual. Risk assessmentfactors associated with group healthcare benefits may include the size, stability, experience,geographic area, industry, level of participation, and demographics associated with a group andthe type of health plan and the level of healthcare benefits being sought by the group.

Risk assessment factors associated with individual healthcare benefits may include theindividual’s age, gender, health status, occupation, hobbies, and the existence of other healthcarebenefits. Although some of the same factors apply to both group and individual underwriting, ananalysis of these factors is typically less detailed for large groups because group members withhigh utilization rates are expected to offset those with low utilization rates. We discuss key riskassessment factors in group underwriting in the next lesson. Key risk assessment factors in smallgroup and individual underwriting are discussed in the Small Group Underwriting and IndividualUnderwriting lesson.

Risk Classification

To assist in the development of appropriate premium rates, a health plan classifies the risksassociated with groups and individuals. In the context of establishing premium rates, riskclassification involves sorting group members into classes or tiers. The actuarial functiondevelops premium rates for each class or tier.

Typically, the amount of risk associated with each tier determines the premium rate for that tier.Two-tier, three-tier, or four-tier classes are typically used for employer groups. In some cases, upto seven tiers may be used. Premium rates vary among tiers.

For example, in a two-tier structure, an employer is billed one amount for each employee whoenrolls for employee-only coverage (Tier 1), and another amount for each employee who enrollsfor family coverage (Tier 2). In other words, the premium is determined by multiplying the Tier 1rate by the number of employees who enroll for employee-only coverage and the Tier 2 rate bythe number of employees who enroll for family coverage, then combining these two amounts.

Figure 7A-2 depicts common tiers used in rating methods. We continues our discussion of thedevelopment of premium rates by tier in the Pricing and Rating lesson.A health plan usually develops premium rates on the basis of a group’s risk profile. The degree towhich a group’s rates are based on its own risk profile depends on the size of the group andapplicable state regulations regarding rating practices. For example, some states do not allowhealth plans to use a rating differential based on the health status of small groups. Riskclassifications for group underwriting include those based on utilization patterns and/or averageclaims costs. Risk classifications for individual underwriting include preferred risk, standard risk,substandard risk, and uninsurable risk.

A health plan may have one risk classification that consists of groups whose members have thelowest utilization patterns and/or average claims costs, compared to those of other similar groups.Similarly, the health plan may have another risk classification for those groups whose membershave the highest utilization patterns and/or average claims costs.

Between these two ranges are groups whose members exhibit less extreme levels of utilizationpatterns and/or average claims costs. As you may have expected, health plans usually chargegroups or individuals with lower utilization patterns and/or average claims costs a lower premiumrate for a given level of healthcare coverage.

After classifying the risk, a health plan decides to accept or to decline the risk, based largely onthe health plan’s tolerance for risk and the cost of providing a given level of healthcare benefits.Note that federal law and some state laws may limit a health plan’s ability to decline coverage forsome individuals and groups.

Suppose an employer group offers its employees a double option: an HMO and a traditionalindemnity plan. Assume that the premiums are lower for the HMO than for the indemnity plan. Inthis case, individual low utilizers are more likely to enroll in the HMO because they are lesslikely to be concerned about the limits imposed by the HMO.

In this context, individual low utilizers of healthcare services are those group members who,because they tend to be healthier, have lower levels of utilization and lower average claims costs.Similarly, given a triple option (an HMO, an HMO with a POS option, and an indemnity plan),individual low utilizers are most likely to enroll in the HMO and least likely to enroll in theindemnity plan, for the same reason. In contrast, individual high utilizers of healthcare servicesare more likely to enroll in a health plan with a POS option or an indemnity plan because theywant broad access to healthcare services in anticipation of using such services.5

Note that the premium and the presumed level of quality for each product also influence choice ina double-option or triple-option environment. For example, if the employer offers several HMOs

as options, employees will select an HMO on the basis of premium and access. Most likely, theHMO that charges the lowest premium would be selected by both high and low utilizers ofhealthcare services, if access is similar across the HMO options.

In many cases, to remain competitive or to comply with regulatory requirements, a health planthat ordinarily would decline to accept the risk represented by a specified group may opt tocontract with that group for the provision of healthcare benefits. For example, in some states,health plans that compete in the small group market—those with fewer than 50 employees—mustcomply with regulations concerning both mandated benefits and premium rates.

Also, a health plan may choose to adjust its premium or the level of healthcare benefits offered toa group in order to obtain or retain business in a particular market. Although health plans mayreduce benefits to maintain or to lower premiums, health plans that do so accept the risks that theplan will not be competitively priced or will not meet the needs of purchasers or plan members.

Underwriting Guidelines6

Underwriting guidelines are general rules that the underwriting function uses in assessing,classifying, and selecting risks that an insurer or health plan assumes. An health plan’sunderwriting guidelines address the level of overall risk and the risk classifications that the healthplan is willing to accept when offering a given level of healthcare benefits to individual or groupplan members.

The underwriting function determines what degree of risk is so high that a health plan cannotunderwrite the business at all, thereby declining the risk. These determinations are establishedaccording to the health plan’s strategic goals, its attitude (conservative or aggressive) toward risk,and its pricing decisions.

Underwriting guidelines influence a health plan’s cash flows—money coming into the plan in theform of premiums and money going out of the health plan in the form of healthcare expenses.

Managing the underwriting cycle effectively is a means of influencing the health plan’s cashflows positively. The underwriting cycle is the historical occurrence of a period during whichhealth insurers generated underwriting profits on their business, followed by a period duringwhich the health insurers generated underwriting losses on their business. For the past threedecades, the underwriting cycle has followed a pattern of three years of underwriting profits,followed by three years of underwriting losses.

Historically, the underwriting cycle occurred when health insurers and health plans adopted morestrict underwriting guidelines after three unprofitable years of underwriting healthcare coverage.Strict underwriting guidelines typically result in premium rate increases for a health plan. As aresult of higher premiums, the health insurers and health plans experienced three highly profitableyears, which provided them a financial cushion from which they could relax their underwritingguidelines.

The establishment of lenient underwriting guidelines usually resulted in lower premium rates forthe health plan. Charging lower premium rates improved the health insurer’s or health plan’sability to respond to market competition. However, lower premium rates could result in severalunprofitable years for the health plan, the health insurer, or the health plan. During years in whichhealth insurers and health plans experienced underwriting losses on specific products, investment

income and revenues from other sources were critical for the health insurers and health plans togenerate company-wide net income (profit).

Following several years of losses, the health insurer or health plan was likely to tighten itsunderwriting guidelines once again. Strict underwriting guidelines usually resulted in higherpremium rates, thereby improving the plan’s profitability for the next few years.

Finding the appropriate balance between competitive premium rates and actuarially soundpremium rates is therefore critical to managing the underwriting cycle and predicting healthcarecash flows. By the late 1990s, conventional wisdom is that the effect of the underwriting cyclehas been alleviated by the evolution of health plan techniques, which have improved a healthplan’s ability to predict costs.

Rating Components 7

To develop an effective rate formula, health plans pay close attention to two major components insetting premium rates: (1)the cost of incurred claims and (2) the retention charge. The cost ofincurred claims, also called incurred claims expense, is the portion of the premium that a healthplan determines will be needed to pay claims. For large group plans, a health plan projects thecost of incurred claims by collecting claims experience data.

The period of time during which a health plan collects this data is called the experience period.Typically, the experience period ends three or more months before the rating period (contractrenewal date) to give the health plan enough time to review the data, develop the new rate, andgive the purchaser advance notice of a rate change, if any. The new rate then becomes applicableat renewal; in other words, during the next contract (or rating) period.

Recall from the Fully Funded and Self-Funded Health Plans lesson that, in the context ofhealthcare benefits, the retention charge is the portion of the premium that is not paid out to coverthe cost of incurred claims. In other words, it is the portion of premium that a health plan retainsto cover administrative expenses such as processing claims, staff salaries, taxes, conversioncharges, and to allow a margin for profit. Retention charges also include risk charges and othercharges.

A health plan’s retention charge differs on the basis of the health plan’s structure. For example, acapitated health plan includes most of the costs incurred by the plan’s medical managementfunction—including utilization management and quality management—in its cost of incurredclaims rather than its retention charge. On the other hand, costs incurred by the medicalmanagement function in health plans that are not capitated typically are included in the retentioncharge component of the plan’s premium. Figure 7A-3 presents an example of how a health plancomputes the cost of incurred claims, using various retention rates.

Underwriting, Market Competition, and Group Size

Generally, the amount of underwriting that a health plan performs varies according to marketcompetition and group size. For example, health plans that operate in very competitive marketsmay choose to accept greater risks than they would be willing to take on otherwise in order toobtain market share. They then use risk management techniques to transfer some or all of theseadditional risks.

Government mandates influence the degree of underwriting that a health plan undertakes in orderto obtain group business. Legal and regulatory requirements often mandate that all members of agroup, particularly small groups of 2 to 50 members, be accepted regardless of the risk posed byany individual group member.

In assessing, classifying, and selecting the risks for a group, a health plan may use medicalunderwriting. Medical underwriting is the use of health questionnaires, medical histories,paramedical examinations, or physical examinations to assess, classify, and select or decline therisk.

There is an inverse relationship between the degree of medical underwriting a health planundertakes and group size. In other words, health plans use medical underwriting regularly inunderwriting individuals and small groups, unless prohibited by law or regulation, but seldom useit in the case of large groups. We discuss medical underwriting in more detail in Small GroupUnderwriting and Individual Underwriting. The following sections discuss common ratingmethods used by health plans to price their products.

Rating Methods 8

As noted in the preceding section, the actual premium rate charged by a health plan is a directresult of the actuarial function (calculating the appropriate premium rate for a given level ofhealthcare benefits) and the underwriting function (assessing, classifying, and selecting the risks

to be assumed). Also, as we have seen, the financial success of a health plan depends a great dealupon its ability to appropriately price its products.

Recall from Risk Management in Health Plans that antiselection is the tendency of people whohave a greater-than-average likelihood of loss to seek healthcare coverage to a greater extent thanpeople who have an average or lower-than-average likelihood of loss. Antiselection, also calledadverse selection, can also occur when the highest utilizing groups or individuals enroll in aparticular health plan, rather than choose no option or another healthcare benefit option. This typeof antiselection typically occurs within groups that have a dual option or triple option available tothem or within highly competitive markets.

Although health plans that attract the healthiest (lowest utilizing) groups experience favorableselection, competition for these groups’ business is so keen that a health plan may be tempted toundercharge a group in order to obtain or retain the group’s business. In this case, the groupwould most likely retain their current health plan because the group would not be able to obtainthe same level of healthcare benefits at a lower cost in the marketplace. We discuss the issue ofpricing in a multiple-choice environment in more detail in Pricing a New Health Plan.

Undercharging may be an appropriate short-term solution in certain circumstances—for example,to enter a new market or to increase market share in an existing market. However, undercharginga group is not a viable long-term strategy because a health plan must charge premium rates thatare adequate to cover at least the health plan’s costs.

Further, competing on the basis of price alone may encourage employer groups to viewhealthcare benefits as a commodity to be purchased from the health plan that charges the lowestprice with no consideration of service levels and other important healthcare delivery factors.Health plans differentiate themselves in the marketplace by the benefits they provide, and theymust set premium rates that are adequate to cover their expenses and generate a fair profit. Avariety of rating methods is available to health plans to achieve their strategic business goals.Below is a review of several common rating methods.

Community Rating

Community rating is a rating method that sets premiums for financing healthcare benefitsaccording to the expected costs for healthcare in a market or segment, known as a block ofbusiness, rather than to a subgroup within that block of business. In other words, a health plancalculates the premium rate according to the costs for the block as a whole, rather than as afunction of each risk class within the block of business. Because both low-risk and high-riskclasses are factored into community rating, the expected costs are spread across the entirecommunity.

Community rates may vary by type of health plan or group size, although all groups pay similarpremiums for the same level of benefits. If actual costs exceed expected costs, then the healthplan is financially responsible for the difference. Community rating is seldom used for largegroups, except where specified by state law, because other rating methods are more specific, and,therefore, more competitive. However, health plans often first calculate a large group’s premiumusing community rating as a point of reference for calculating the premium rate under anotherrating method.

The use of modified community rating methods has increased for small groups, spurred byseveral federal and state initiatives that have mandated such community rating methods for smallgroups. Some small groups benefit from modified community rating methods because thesegroups incur less fluctuation in premium rates and have more stable contract relationships withhealth plans than they are likely to have under other rating methods. However, typically 70% to80% of small groups have actual healthcare costs that are below the average, or community, rate,so these groups pay higher premiums to achieve that stability.

From the perspective of both the health plan and the group, premium rates established usingcommunity rating are generally more stable than those established under other rating methods.Consequently, the group can more accurately estimate its total premium costs and the health plancan receive a steady flow of premium income. Community rating is also compatible with healthplan provider reimbursement techniques such as capitation.

The use of community rating enables a health plan to spread the risks it assumes for both high-risk and low-risk groups throughout the market or segment it serves. Community rating is arelatively straightforward process—typically only a few factors are considered in determiningpremium rates—so a complex information system is not required in most circumstances.

Although community rating tends toward stable premium rates, the advantages of such stabilitymay be undercut by a competitor that uses another rating method or is willing to charge a lowerpremium. In the latter case, a competing health plan may be willing to assume greaterunderwriting risk in order to obtain or retain market share. Artificially low premium rates mayattract a group initially, but a health plan most likely would have to increase premiumssignificantly after it determines the community’s actual utilization rates and actual costs.

In 1991, the National Association of Insurance Commissioners (NAIC) promulgated a smallgroup model act that allows health plans to use a modified form of community rating tounderwrite small groups. This modification, referred to as community rating by class (CRC), alsocalled factored rating, allows a health plan to use tiers on the basis of experience or duration. Wediscuss experience rating and durational rating later in this lesson. Rating classes, such as age,sex, industry, and so on, are overlayed on these tiers. The premium rate developed using CRCresults from calculating the weighted average of these factors.

In this context, the term experience means a specific group’s historical healthcare costs andutilization rates. All members of the same class or group pay the same premium, which is basedon the experience of the class or group. The average premium in each class may not be more than120% of the average premium for any other class.

A 1995 amendment to this model act eliminated the class rating rules and promulgated the use ofadjusted community rating. Adjusted community rating (ACR), also called modified communityrating, is a rating method under which a health plan calculates the ratio of a group’s experience toits historical manual rate—which is based on age, sex, industry, and so on—then multiplies thisratio by the group’s future manual rate. We discuss manual rating in the next section.

Under ACR, a health plan cannot consider the experience of a class, group, or tier in developingpremium rates. Note that, because NAIC model acts and their amendments do not carry the forceof law, laws based on the 1991 small group model act still exist in many states. Also, anothermodified community rating method allows a health plan to establish an average or index rate,

which may or may not be adjusted for demographics. The health plan may charge premium ratesthat are plus or minus 25% of the index rate.

The Centers for Medicare and Medicaid Services (CMS) requires health plans that assumeMedicare risk to use ACR so that premium rates reflect expected utilization levels, rather than theactual costs of healthcare benefits. The Health Maintenance Organization Act of 1973 (the HMOAct) required federally qualified HMOs to use only community rating to establish premium rates.Subsequent amendments to the HMO Act allow the use of CRC and ACR methods.

Manual Rating

Manual rating is a rating method under which a health plan uses its average experience—andsometimes the experience of other health plans—rather than the purchaser’s actual experience, toestimate the group’s expected experience. Manual rating is similar to community rating in thatboth rating methods use demographics to determine the rate for a block of business. Manual ratesare typically developed with the use of proprietary data or published morbidity tables, which wediscuss in the next lesson.

In developing manual rates, a health plan assesses primarily its own experience. For example, ahealth plan may derive its own average manual rate, perhaps adjusted by a group’s characteristics,industry, or geographic area. Manual rates are sometimes called book rates because a health planoften lists them in a rate book, underwriting manual, or rate manual.

Before rating and underwriting a proposed group, a health plan typically checks the rate book tosee what the manual rate is for a given level of healthcare benefits. Manual rates are often used toestablish premiums for small groups and other groups that have had no previous plan experience.

Experience Rating

Experience rating is a rating method under which a health plan considers a group’s actualexperience, including its healthcare costs and utilization rates, to determine premium rates. Inother words, the health plan analyzes a group’s healthcare costs by type and calculates thegroup’s premium in part or in full according to that experience.

Under experience rating, health plans charge lower premiums to groups that have experiencedlow utilization rates and higher premiums to groups that have experienced high utilization rates.Unlike community rating methods or methods that combine the experience of a number ofdifferent groups to determine a manual rate, experience rating is specific to a particular group.

Because a group’s experience changes over time, a health plan frequently uses at least two yearsof the group’s experience to calculate experience rates. In most cases, the size of the group isimportant in determining the degree to which experience rating applies. Generally, health plansexperience rate groups that have more than 250 employees, although many health plans havestarted to use experience rating for groups of 50 or more employees. Experience rating methodsmay be either prospective or retrospective.

Prospective Experience Rating

Prospective experience rating is an experience rating method that uses a group’s experience toestablish the premium for the next contract period. Often the premium rate is based on a weighted

average of a group’s own experience and the experience of many small groups. A health planmay pool (combine) the experience of many small groups to obtain a large enough group toexperience rate. Pooling enables small groups to obtain lower premium rates than wouldotherwise be possible.

Twelve-month periods are typically used for prospective experience rating for an employergroup. Because prospective experience rating does not carry over gains or losses from one ratingperiod to the next, health plans that use prospective experience rating absorb the gains or lossesgenerated by a group’s experience.

Adjusted community rating, discussed earlier in this lesson, is a type of prospective experiencerating. Another type of prospective experience rating is durational rating. Under durationalrating, premium rates increase automatically with group tenure in a health plan for a specifiedperiod, such as six months or a year. For example, a health plan may charge a large employergroup a $120 premium PMPM in the first year, $130 in the second year, and $135 in the thirdyear for a three-year contract for the same level of healthcare benefits, before inflation. Medicalunderwriting is often used along with durational rating for small groups.

Retrospective Experience Rating

Retrospective experience rating is a type of experience rating method under which a health planconsiders both the gains and the losses experienced by a group during each rating period. Thehealth plan refunds part of a group’s premium, called an experience rating dividend orexperience refund (also called an experience rating refund) after the rating period is over if thegroup’s experience has been better than expected during the rating period. A health plandetermines a premium rate, in part, on the basis of its assumptions about a group’s expectedutilization rate or claims costs. At the end of the covered period, the health plan compares thegroup’s actual experience with its expected experience.

On the other hand, if the group’s experience has been worse than expected during the ratingperiod, the health plan charges the group extra premiums for the excess costs, either in a lumpsum or in future premium increases. Often, when a health plan notifies a group of a premium rateincrease because the group’s experience was worse than expected, the group will drop its healthplan with the health plan and move to another plan. Therefore, the health plan must include a riskcharge in its premium rate to cover for such losses. We defined risk charge in the Fully Fundedand Self-Funded Health Plans lessons.

Because the excess costs will be paid by the purchaser after the covered period, the purchasermust have a good credit rating to qualify for retrospective experience rating. In some cases, if agroup’s experience is significantly worse than expected, the health plan may choose not to renewthe group’s coverage. In effect, under retrospective experience rating, a group assumes some ofthe financial risk associated with its experience.

Many large groups that have low healthcare costs and low utilization rates expect to obtain eithera rate decrease in the next contract period or an experience rating dividend. The opportunity toobtain an experience rating dividend or to sustain the same premium or a lower-than-averageincreased premium in the next rating period is an incentive to the group to control healthcarecosts and utilization. However, many states prohibit HMOs from using retrospective experiencerating.

Note also that the premium determined under retrospective experience rating usually is higherthan the premium under prospective experience rating, because some of the premium will bereturned to the purchaser in the form of a refund. Whether a health plan uses prospective orretrospective experience rating, the health plan can expect similar profit levels from either type ofexperience rating method.

Blended Rating

Blended rating is a rating method that combines experience rating and manual rating. Underblended rating, a health plan develops a premium rate using a group’s own experience, weightedby the health plan’s manual rate and the group’s credibility. Credibility is a measure of thestatistical predictability of a group’s experience, which is expressed as a percentage or in decimalform as a credibility factor. The calculation of the statistical probability of a group’s credibility isbeyond the scope of this course. Generally, the experience of a large group is generally morecredible than that of a small group.

The values of credibility factors typically fall between 0 and 1.00. The closer a group’s credibilityfactor is to 1.00, the more reliable the group’s experience, and the more likely that a health planwill weight the group’s experience more heavily than it weights the manual rate in calculating thegroup’s overall premium rate.

A credibility factor of 1.00 means that a group’s premium rate is based entirely on the group’sexperience. Most experience rating is a blended rating, unless the group is large enough to have100% credibility (that is, a credibility factor of 1.00) assigned to its experience.

The blended rate is found by (1) multiplying theexperience rate by the credibility factor, (2)multiplying the manual rate by the difference between1.0 and the credibility factor, then (3) adding theretention to these amounts, as follows:

Using a group’s experience may not necessarily be predictive of its future utilization rate orclaims costs, however. A health plan addresses the risk that a group’s experience may not beindependent from one year to the next by lowering (discounting) the group’s credibility factor bya specified amount or otherwise incorporating this risk into its blended rate formula.

Other ways that a health plan can incorporate the risks that it assumes into calculating a group’scredibility factor include:

Using two or more years of the group’s experience Removing the group’s large, unusual claims from the calculation of the credibility factor Excluding a portion of claims beyond a particular amount Pooling large claims from many groups to smooth out experience fluctuations and

assessing a pooling charge to cover the cost of these large claims

Figure 7A-4 illustrates how a health plan incorporates a group’s experience into determining ablended rate.

In this case, Legrand would charge Holcomb a $144 premium (based on claims costs) permember per month (PMPM), plus retention. Note that Holcomb’s blended rate is greater than itsexperience rate, but less than its manual rate. The higher a group’s credibility factor, the closer itsblended rate would approach its experience rate.

Renewal Underwriting and Rating

The processes of renewal underwriting and renewal rating, which are sometimes combined, serveto determine whether a health plan should continue to underwrite the risk, and, if so, at whatpremium rate. Renewal underwriting and rating consume a significant amount of time and efforton the part of both the underwriting function and the actuarial function.

Renewal underwriting is the process by which a health plan reviews all the selection factors thatwere considered when the health plan contract was first issued, then compares the actual andexpected dollar amounts and utilization rates to determine if the health plan should continue tounderwrite the risk.9 Renewal rating is the process by which a health plan, through reviewingutilization rates, claim costs, and other factors, determines the dollar amount of premium to becharged to a group or individual in a renewal contract.

All rating methods, including prospective experience rating, that we described in the previoussections may be used to determine the initial premium rate for an initial contract. Often, a healthplan can use prospective experience rating when the health plan obtains a proposed group’sexperience from the group’s previous health plan.

Experience information of this type is generally not available for HMOs or groups with fewerthan 100 employees. Note also that prospective experience rating can only be used in renewalrating and underwriting if a group has some credible experience from its previous health plan.

Earlier we discussed some typical underwriting guidelines and rating methods that health plansuse to determine initial premium rates for a group. A health plan also considers several otherfactors, two of which are summarized in the following sections, to determine renewal rates.Although we separately discuss these factors, keep in mind that health plans typically combineseveral factors in determining renewal premium rates.

Exposure Period

In the context of renewal rating and underwriting, the exposure period is the amount of timeduring which a health plan is financially responsible for any or all risks that it assumed under agroup healthcare contract. A one-year contract period between a health plan and a group mayenable the health plan to more closely correlate the premium rates it established for that groupwith the group’s actual utilization rates and overall experience.

Sometimes, to remain competitive and to minimize disenrollment, health plans contract withgroups for two-year or three-year periods. However, the longer the contract period, the higher therisk that the assumptions, under which the initial premium rate was established, will not correlateclosely with the group's actual and healthcare costs.

Use of Catastrophic Claims Pools

Suppose a group that typically has low utilization rates experiences a catastrophic claim in onecontract period. In this case, a health plan has a number of options with respect to considerationof that catastrophic claim in the renewal rating process. The health plan can include all of thecatastrophic claim cost in the group’s experience and adjust the group’s premium rateaccordingly. Conversely, the health plan can choose to exclude the total catastrophic claim fromthe group’s experience. In either case, the health plan may consider the probability that a similarclaim will occur in the future and adjust the group’s premium rate to reflect that probability.

Another option available to a health plan is to exclude a percentage of the catastrophic claim costsfrom the group’s experience. Although the premium rate might increase for that group, thisincrease may be lower than it would have otherwise been, if the total cost of the catastrophicclaim had been included.

The preceding example depicts the impact of a catastrophic claim on one group. Suppose that, ina given block of business, several groups had catastrophic claims. In this case, a health plan maydeduct the catastrophic claims from the renewal rate calculation, then incorporate a catastrophicclaims pool to spread the cost over all groups in that block of business.

Endnotes

1. from Academy for Healthcare Management, Healthcare Management: An Introduction,3rd ed. (Washington, D.C.: Academy for Healthcare Management, 2001), 9-24.

2. Ibid., 9-20.3. Nicholas L. Desoutter and Kenneth Huggins, eds. LOMA’s Glossary of Insurance Terms,

3rd ed. (Atlanta: LOMA, ©1997).4. Ibid.5. Adapted from Blue Cross and Blue Shield Association, Rating and Underwriting Trining

Session: Strategic Consulting Services (Chicago: Blue Cross and Blue ShieldAssociation, ©April 1996), 10. Used with permission; all rights reserved.

6. Adapted from Susan Conant, Nicholas L. Desoutter, Dani L. Long, and RobertMacGrogan, Managing for Solvency and Profitability in Life and Health InsuranceCompanies (Atlanta: LOMA, ©1997), 109. Used with permission; all rights reserved.

7. Adapted from Blue Cross and Blue Shield Association, Pricing and Financing theProduct (Chicago: Blue Cross and Blue Shield Association, ©1992), 6–7. Used withpermission; all rights reserved.

8. Adapted from Academy for Healthcare Management, Managed Healthcare: AnIntroduction, 2nd ed. (Washington, D.C.: Academy for Healthcare Management, ©1999), 9-24-9-27. Used with permission; all rights reserved.

9. Academy for Healthcare Management, Managed Healthcare: An Introduction, 9-23

Portions of this section were adapted from Stephen M. Cigich, "Rating and Underwriting," inEssentials of Managed Health Care, ed. Peter R. Kongstvedt, MD: Aspen Publishers, Inc.,©1997), 367. Used with permission.

AHM Health Plan Finance and Risk Management: Group Underwriting

Course Goals and ObjectivesAfter completing this lesson you should be able to

Identify the key federal and state laws and regulations that apply to group underwriting Discuss how a health plan adjusts for morbidity factors and other underwriting risk

factors in group underwriting Identify and describe the key aspects associated with underwriting the proposed group

and the proposed group coverage

In the previous lesson, we discussed the role of rating and underwriting in a health plan. Thislesson focuses on the underwriting of a key market for health plans: large and medium groups,particularly employer groups. First, we discuss the federal and state laws and regulations thataffect group underwriting (other than small group underwriting, which we discuss in Small GroupUnderwriting and Individual Underwriting). Then we discuss key aspects of group underwritingand group underwriting procedures.

If a health plan is incorporated, then it is subject to all federal and state laws and regulations thatapply to corporations. In addition, health plans that serve the group market must comply withother laws that concern employee benefit plans, such as laws that pertain to medical records. Inthe course of assessing, classifying, and selecting risk, health plans gather a great deal of personalinformation about individuals. General laws and court cases relating to confidentiality of medicalinformation apply to the handling of this information. Some states also specifically addressprocedures, including specific methods for filing and retrieving information and a specifiedperiod of time for retaining files for maintaining medical records.

Federal Laws and Regulations 1

Below is a summary of several key federal laws and regulations that may affect health plans thatoffer products, particularly employee benefit plans, and services to the employer group market.Note that other federal laws and regulations, particularly those concerning Medicare, Medicaid,and healthcare benefits for federal employees and the military, have a significant impact on healthplans that cater to these markets.

The Health Maintenance Organization Act

The Health Maintenance Organization Act of 1973 (HMO Act), which applies only to federallyqualified HMOs, originally required HMOs to use community rating to determine premiums. Atthe time of its enactment, the HMO Act prohibited HMOs from using experience rating. A 1981amendment to the HMO Act expanded the allowable rating options to include community ratingby class, which enabled HMOs to consider certain characteristics of each group—such as thegroup’s industry and the age, gender, and marital status of its members—when determining thegroup’s premium rates.

In 1988, the HMO Act was amended to expand the allowable rating options to includeprospective experience rating (also called adjusted community rating in the context of federallyqualified HMOs). These 1988 changes enabled HMOs to consider specific characteristics and the

utilization and claims cost experience of each group when determining rates for a future rating(contract) period.

However, the HMO Act continued to prohibit retrospective experience rating, which would haveallowed an HMO to adjust a group’s prior premiums on the basis of the group’s experienceduring the prior rating (contract) period. Note that, although federal qualification is no longer ofcritical importance to HMOs, federally qualified HMOs must comply with the HMO Act and itsamendments.

Employee Retirement Income Security Act

Employer-sponsored benefit plans that provide healthcare benefits must comply with theEmployee Retirement Income Security Act (ERISA) of 1974, a broad-reaching law thatestablished, among other things, requirements for the disclosure of plan provisions and fundinginformation to plan participants. Also contained in ERISA are strict reporting requirements,including requirements for the preparation and submission of reports to the Department of Laborand the Internal Revenue Service.

Underwriters appraising the risk of a group that previously had a self-funded plan may use thedocuments files under ERISA reporting requirements to assess the risk. However, when a grouppreviously has been insured by another health plan, underwriters typically do not rely uponERISA reports. Instead, the underwriters use reports provided by the group’s previous health planto address the group’s claims experience and to establish premium rates.

Consolidated Omnibus Budget Reconciliation Act

The Consolidated Omnibus Budget Reconciliation Act (COBRA) of 1986 requires plan sponsorsto allow qualified beneficiaries (employees and their dependents) to continue their grouphealthcare coverage for a specified period of time following a qualifying event that causes theloss of group healthcare coverage. Because this continuation requirement applies to plansponsors, not health plans and insurers, it has important implications for group underwriting.

Suppose a plan sponsor elects to terminate its group coverage with a health plan. In this case, thehealth plan is not required to continue coverage for the COBRA- qualified beneficiaries, becauseCOBRA places this responsibility with the plan sponsor. The successor health plan, indetermining whether to accept or decline the risks associated with this group, would also considerthe risks associated with the group’s COBRA-qualified beneficiaries. Under COBRA, a healthplan is not required to cover these individuals. However, the successor plan must decide whetherto cover the COBRA beneficiaries “outside the policy” as a condition for doing business with thepurchaser.

Americans with Disabilities Act

The Americans with Disabilities Act (ADA) of 1990 is a federal law that protects disabledindividuals from various types of discrimination. Because of its scope, the ADA applies to thefacilities and activities of all types of health plans. For example, the ADA requires that a healthplan facility must be accessible to wheelchairs. Also, a health plan must not discriminate againstdisabled providers.

In addition, underwriting guidelines that exclude or reduce benefits that apply to a specificdisease have been challenged in court as violations of the ADA. However, a health plan thatreduces benefits for a particular service, for example, that does not discriminate against aparticular group of individuals would generally not be in violation of the ADA.

Suppose a health plan eliminates coverage for allergy shots for asthmatics. In this case, the healthplan may be found in violation of ADA. On the other hand, if the health plan reduces prescriptiondrug benefits for all employee classes, the health plan is less likely to be found in violation of theADA. Further, if a health plan has a sound underwriting reason for eliminating or reducingbenefits that impact only individuals with a particular disease or disability, the plan may not be inviolation of ADA.

Health Insurance Portability and Accountability Act

The Health Insurance Portability and Accountability Act (HIPAA) of 1996 contains provisionsto ensure that prospective or current enrollees in a group health plan are not discriminated againstbased on health status (for example, there are rules and limits on the use of pre-existing conditionexclusions). This law also requires guaranteed access to health insurance for small employers andcertain other eligible individuals.

Similarly, HIPAA generally requires the guaranteed renewal of healthcare coverage for certainindividuals and for both small and large groups, regardless of the health status of any member.These and other requirements restrict a health plan’s ability to accept or decline certain risks andthey may directly impact a health plan’s rate-setting process.

Amendments to HIPAA created the Newborns’ and Mothers’ Health Protection Act (NMHPA)of 1996 and the Mental Health Parity Act. Recall that the NMHPA, which we discussed inProvider Reimbursement Arrangements, requires that a health plan cover hospital stays forchildbirth for both the mother and the newborn for at least 48 hours for normal deliveries and 96hours for Caesarean births.

The Mental Health Parity Act (MHPA) of 1996 prohibits a health plan, under certaincircumstances, from imposing annual or lifetime dollar benefit limits for mental illness on agroup if there are no such limits for physical illness. The MHPA does not require that a healthplan offer benefits for mental healthcare. However, if a health plan does offer mental healthbenefits, then the MHPA mandates that the annual or lifetime limit on such benefits cannot beless than the benefit limit that the health plan's plan sets for physical illness.

The MHPA also allows an exemption for employers that can demonstrate (after six months) thatproviding mental health parity would increase health plan costs by at least 1%. This exemptionmeans that few health plans offer mental health parity.

Benefit mandates such as the federal NMHPA and MHPA and numerous state laws andregulations (briefly discussed in the following sections) have a major impact on a health plan’sunderwriting and rating process. Mandated benefits directly increase the cost of incurred claims,and, to a lesser extent, the associated administrative charges that are applied to retention incalculating premium rates.

State Laws and Regulations 2

Most state insurance laws contain provisions that in some way affect the underwriting and ratingpractices of health plans. Often the purpose of state underwriting laws and regulations is toprotect consumers from unfair discrimination in terms of eligibility. For example, most statesrequire that any differences in healthcare benefits for members of an employer group must bebased on conditions pertaining to employment.

This means that an employer group would not be permitted to have separate benefit levels forcertain employees listed in a memorandum sent by the company’s human resources manager to ahealth plan. However, the employer group would be permitted to provide separate benefit levelsbased on conditions pertaining to employment, such as hourly or salaried status, job class, orsalary range.

In deciding whether or not to accept risk for an employer group, a health plan’s underwriters mustbe aware of state group insurance laws that specify the individuals who can or must be coveredunder a group policy. For example, some state laws specify whether or not dependent coveragemust be provided. Also, most state laws define certain types of dependents that must be covered ifdependent coverage is provided under a health plan.

As we mentioned in The Relationship Between Rating and Underwriting lesson, states sometimesplace limits on how much a health plan may charge for healthcare benefits. Generally, thepurpose of these limits is to ensure reasonableness and adequacy in rating. For instance, in a statethat requires rate filings for a particular product, an insurance department might reject a rateincrease because of concerns about the reasonableness of the proposed rates. Alternatively, astate insurance department might reject a rate decrease submitted in a rate filing on the groundsthat the rates are not adequate to meet the health plan’s operational costs.

In addition to eligibility and rating requirements, many states have enacted benefit mandates thathave a significant impact on underwriting and rating decisions. Recall from the ProviderReimbursement Arrangements lesson that mandated benefit laws require a health plan to covercertain conditions or treatments or to pay a specified level of benefits for certain conditions ortreatments.

Similar to benefit mandates are provider mandates, which, among other things, may require ahealth plan to cover the services of certain types of providers or healthcare facilities. In effect,state mandates help shape the overall plan design developed by an health plan’s actuaries andunderwriters because —for certain portions of the health plan, at least—these mandates determinewhat the plan covers and the cost of providing certain types of benefits.

Benefit mandates add to the cost of healthcare benefits. Benefit mandates also increase a healthplan’s risk because the health plan may have to delay premium rate decreases or, in some cases,may be prevented from increasing premium rates. Self-funded groups can avoid such mandatesbecause their self-funded status exempts them from state insurance regulations.

In the next lesson, we discuss state laws and regulations that govern small group rates. Other statelaws and regulations govern guaranteed issue, guaranteed renewal, reinsurance pools, and ratecertification requirements. Discussion of these additional laws and regulations is beyond thescope of this course.

Major Risk Factors in Group Underwriting 3

Underwriters may use many information sources to assess and classify the risk represented by agroup seeking healthcare benefits. In this section, we discuss published morbidity tables, whichare available from various sources, including actuarial associations and actuarial consulting firms.

The term morbidity means sickness, injury, or failure of health. A morbidity rate is the rate atwhich sickness and injury occur within a defined group of people. Factors that may limit thedirect application of published morbidity data include such variables as geographical costvariances, group composition, benefit level, and the timeliness of reporting cost data. Because ofthese factors, many health plans develop their own sources of morbidity statistics.

A group’s morbidity rate is of particular concern to a health plan. Generally, in pricing a healthplan, a group’s own morbidity data is the most preferred source. Recall from The RelationshipBetween Rating and Underwriting that the use of experience rating usually results in theestablishment of equitable, reasonable, and adequate rates for a large group.

However, sometimes a health plan may not have sufficient information to effectively forecast agroup’s morbidity, or a health plan may be prohibited by law from using experience rating. Inthese situations, a health plan may use the manual rates that it developed from its aggregateexperience, published morbidity data to fill in the gaps, data from similar groups, or acombination of these approaches. Figure 7B-1 depicts an example of how a health plan woulddevelop a reasonable morbidity rate for 25-year-old females.

A health plan may also have to adjust published or proprietary morbidity rates to account for non-sex-related differences. For example, an HMO with half its plan members from a steel companythat has a significant number of retirees would have to adjust published morbidity rates to reflectthe actual population it serves. Figure 7B-2 summarizes the key risk factors associated with groupunderwriting.

Key Aspects of Group Underwriting 4

To evaluate a group prospect, an underwriter considers the characteristics of both the group andthe requested coverage. While each health plan has its own specific guidelines for assessinggroup risk, most underwriters adhere to certain general underwriting principles.

Group underwriting usually does not involve evaluating individual members, but it does requirecareful assessment of a group. After considering the major underwriting risk factors, a healthplan’s underwriters evaluate the risk assessment factors associated with that group.

If the requested coverage falls within a health plan’s underwriting guidelines, then the health planfigures the cost of the coverage and of the services that will be provided to the group. The costincludes the health plan’s expected claims expenses and claims reserves, risk charges,administrative expenses, selling expenses, and the health plan’s expected surplus or profit. Thehealth plan’s underwriters use these costs to determine the appropriate price to charge. The healthplan may increase or decrease the premium rate at policy renewal.

If the requested coverage does not fall within the health plan’s guidelines, where state law allows,the underwriter adjusts the coverage—and the premium—so that the health plan more closelymeets the health plan’s guidelines. If the underwriter cannot structure the coverage to thesatisfaction of the purchaser, then coverage for that group is denied.

Typically, the underwriter assesses each group according to two primary risk assessment factors:(1) characteristics of the proposed group and (2) characteristics of the proposed coverage. Thenthe underwriter decides whether to approve coverage for the group. We discuss the riskassessment factors in the following sections.

Characteristics of the Proposed Group

A health plan’s underwriters gather and evaluate several types of information about the proposedgroup. The risk of one factor may vary independently of other risks—that is, a given group maypresent a greater-than-average risk associated with geographic factors, but at the same time alower-than-average risk in terms of age. For this reason, underwriters are likely to analyze manyof a group’s risk assessment factors simultaneously, then analyze the total risk presented by thegroup. The following sections summarize risk assessment factors associated with a group.

Reason for Existence

Generally, health plans decline to cover a group that has been formed for the sole purpose ofobtaining healthcare coverage. In addition, some state laws prohibit insurers from issuingcoverage to such a group. This precaution protects health plans from antiselection that may occurwhen several people—all of whom present poor underwriting risks—join together to purchasehealthcare coverage. Where permitted by state law, some health plans underwrite groups—suchas professional organizations and trade associations—that were formed in part to obtainhealthcare coverage.

Type of Group

Most organizations that obtain group healthcare coverage can be classified as one of three typesof groups:

Employer-Employee Groups Employer-employee groups (private employers and publicemployers). Large private employer-employee groups tend to present the fewest underwritingrisks because they typically present a balance of ages and health conditions, which helps toprevent antiselection. Further, the opportunity for individual antiselection is minimized becausean employee is limited to the coverage offered through his or her employer.

Generally, full-time employees are healthy and some may have even received a medicalexamination before being hired. Because large employers typically coordinate the record keepingassociated with group healthcare benefits, administrative expenses are lower for the health plan.However, some large groups—such as employers involved primarily in contracting orsubcontracting arrangements, professional sports, or seasonal industries, for example—typicallyrepresent a greater risk than other employer-employee groups.

Public employers—that is, federal, state, and local government employers—present slightlydifferent concerns to a health plan’s underwriters. Because of budgetary constraints and changesin elected personnel, many public employers switch health plans annually to obtain lower

premiums. As a result, public employers present a somewhat higher underwriting risk than doprivate employers.

Multiple-Employer Groups Multiple-employer groups (trade associations, negotiated trusteeships,and Multiple- Employer Welfare Arrangements). When two or more employers in the sameindustry provide coverage for their employees through one group plan, the employers haveformed a multiple-employer group.

Individual members of a multiple-employer group or a professional association are not requiredto obtain coverage through the group or association. Therefore, the risk of antiselection is higherfor both multiple-employer groups and professional associations than it is for employer-employeegroups. To avoid antiselection in multiple-employer groups, a health plan follows clearly definedunderwriting guidelines, focusing especially on the size of the group. The health plan also checksthe group’s prior coverage and claims experience.

Professional Associations As noted above, antiselection risk is higher in a professionalassociation than it is in an employer-employee group. One way that an health plan evaluates therisks represented by a professional association is to consider the industry experience of the agentor broker that sells a group plan to the association.

If the agent or broker has submitted sound business in the past, the health plan can better assessthe risk represented by this new business. If the health plan is uncertain about approving coveragefor a professional association, then the health plan can require each association member to submitevidence of insurability.

Group Size

Compared to small groups, large groups present lower overall risks to a health plan. Historically,many health plans limited group coverage to groups that contained at least 50 or 100 members toavoid the risks associated with underwriting small groups.

Currently, some health plans underwrite groups with as few as two members. Increasinglyreliable information about the morbidity experience of small groups, increased marketcompetition, and expanded legislation concerning small group healthcare benefits havecontributed to this trend of underwriting small groups. Small groups still present uniquechallenges to underwriters. We discuss small group underwriting in the next lesson.

Age

Although a health plan’s underwriters do not consider the insurability of each member of aproposed group (except for some small groups), they do examine the age spread of the entiregroup. Specifically, underwriters watch for groups with a majority of older members becausethese groups tend to experience higher morbidity rates.

A group’s turnover rate usually has a significant effect on the group’s average age. A group withlow turnover tends to increase in average age because fewer new, usually younger, individualsjoin the group. Underwriters look more favorably upon a group that has a steady flow of new—particularly young—enrollees, because such flow helps maintain the desired age spread in agroup.

Sex

A health plan’s underwriters also consider the ratio of females to males in a group. Actuarialstudies show that, as a group, women tend to experience higher morbidity rates, at ages below 55,than do men as a group. Therefore, a group with a large proportion of young females is likely tohave higher healthcare costs than does a group with a large proportion of young males.

Stability

In the context of underwriting, group stability means that a group maintains a steady flow ofyounger, new members to replace or balance the gradual aging of older members. A group whosecomposition either changes too frequently or remains static for a long period of time presentshigher risks to the health plan.

If a group’s members change too frequently, the health plan’s administrative expenses increase.Sometimes a high turnover rate of group members indicates that members are joining the groupfor the purpose of receiving healthcare benefits for a short period of time. This situation wouldresult in high claims costs and high utilization rates for the period.

On the other hand, a group whose membership remains relatively stable over time generally hasmembers that are older than average, compared to the average age of groups that have greaterturnover. Because morbidity increases with age, a group with low turnover and a high averageage of members is likely to produce high claims costs. A sound rating methodology willaccommodate this demographic profile.

If a health plan identifies an imbalance in a group, the health plan may adjust the premium ratesupward to cover the risks associated with higher utilization, higher claims costs, and higheradministrative expenses. Also, health plans can encourage group stability by specifying whichgroup members are eligible for coverage. For instance, some health plans set a servicerequirement for groups. Under a service requirement, also called an employment waiting period ,a person must be employed for a certain length of time—usually three to six months—beforebeing covered under the plan.

Geographic Location

Many employers and other groups maintain offices or facilities in multiple locations. Whenevaluating groups in which group members are geographically dispersed, a health plan’sunderwriters consider each location’s applicable laws and regulations, morbidity rates, andmedical services costs.

Some laws regulating group coverage vary from state to state. Many states have group coveragerequirements relating to required policy provisions, group size, group eligibility, and mandatedbenefits. Underwriters consider the laws applicable in each location where coverage is providedfor members of a group.

Nature of Business

The type of work that a group performs affects the degree of risk the group represents to a healthplan. To develop appropriate group underwriting guidelines, health plans use information on

claims experience data showing the likelihood of people in certain jobs to experience highutilization rates.

Some health plans use pricing factors to reflect theeffect of a group’s specific industry on the premiumscharged to the group. A health plan develops a pricingfactor by using experience-based statistics. A pricingfactor is a number that illustrates the risk representedby group members working in a particular industry. Thehealth plan’s underwriters multiply the pricing factor bythe premium it has calculated for standard risks tocalculate a premium appropriate for the risk representedby a certain group, as shown:

Nature of Business

Instead of using a pricing factor, some health plans issue certain types of coverage to groups withhigh-risk characteristics if the group pays a flat extra premium. The extra premium is chargedbecause the group has one or more characteristics that increase the risk of illness or injury for itsmembers.

When evaluating risk, a health plan’s underwriters also consider the economic strength orweakness of an industry. Suppose market trends cause companies in certain industries to slowproduction or to lay off workers. In this case, a company’s employees are more likely to utilizehealthcare benefits if they are likely to lose them as the result of a layoff, for example. Also, thecompany’s ability to pay premiums may be compromised.

Employee Classes

Group members can be classified in several different and objective ways. Generally, an employeeclass is a group of employees categorized by position, earnings, or rank. To comply withregulatory requirements, health plans generally must establish employee classes on anondiscriminatory basis according to conditions pertaining to employment. Figure 7B-3illustrates typical, nondiscriminatory classes established for group coverage.

In calculating premium rates, a health plan’s underwriters carefully consider the mix of higher-income and lower-income employee classes. Actuarial experience has shown that higher-incomeemployees are statistically more likely to seek expensive healthcare or to seek healthcare moreoften than lower-income employees. Also, lower-income employees sometimes choose not toenroll in a contributory plan, which may adversely affect the plan’s level of participation,discussed next. A low participation level, in turn, can lead to antiselection.

Participation Level

Employer group coverage can be categorized as either noncontributory or contributory. Recallfrom the Fully Finded and Self-Funded Health Plans lesson that, in a noncontributory plan, theenrolled employees pay no portion of the premium for coverage. Instead, the employer pays theentire premium and coverage is automatic for all eligible members of the group. Typically, healthplans require a high participation level of eligible employees in noncontributory plans.

In a contributory plan, enrolled employees pay a portion of the premium for their coverage.Participation in a contributory plan is optional for eligible employees. A health plan prefers thatgroups come as close as possible to a 100% participation level because a high participation levelreduces the effects of antiselection.

Most health plans require that contributory plans have a participation level of between 75% and100% of eligible employees, depending on the group’s size. As group size increases, a healthplan’s risk decreases, so the health plan may lower the minimum participation level requirement.

Contribution Level

Most health plans also require employers to pay a specified percentage, such as 50%, of the totalpremium in contributory plans. This requirement enables a health plan to obtain a sufficientnumber of eligible employees to meet the minimum participation requirement, which in turnlowers the risk to the health plan. Traditionally, many families were eligible for just one grouphealthcare plan. Now, families often find themselves in the position to choose from among two ormore health plans.

Sometimes this choice is available because both spouses work for employers that offer grouphealth plans to eligible employees. In other cases, a spouse’s employer may offer two or morehealth plans. Whenever several health plans are competing for individual enrollees within agroup, the health plan’s underwriters must find ways to adjust minimum participationrequirements without increasing the risk of antiselection.

Dependents

Most health plans define a dependent as either (1) a spouse or (2) an unmarried child—includingan adopted child, stepchild, or foster child—who is under age 19, or under age 23 or 25 if a full-time student, and who relies on the employee for support and maintenance. In addition, mosthealth plans expand their definition of a dependent to include incapacitated dependent children toage 25.

The following list presents some of the questions that underwriters ask regarding dependentcoverage:

Is the employee eligible to participate in the group plan? Usually an employee’sdependent can be covered under a group plan only if the member is eligible and enrolledin the plan.

How many employees want to cover their spouses? If only a few eligible employeeschoose to cover their spouses, antiselection may become a factor, because the coveredspouses might have existing health impairments.

Is an eligible dependent confined to a hospital or under the care of a healthcare provideron the date that coverage begins for the employee? Under these circumstances, healthplans usually delay the effective date of group coverage for a dependent until thedependent is discharged from the hospital. This contractual provision is known as thenonconfinement requirement.

Did the employee enroll dependents when he or she became eligible or when thedependent became eligible (for example, within 30 days for a newborn or newly adoptedchild)? If not, antiselection may occur.

Prior Coverage and Claims Experience

Suppose an employer group requests that its existing coverage be transferred to a different healthplan. In this case, the succeeding health plan’s underwriters would thoroughly assess the group’scase. This assessment typically includes a review of the

Reasons for the transfer request Amount of premiums paid to the previous health plan Group’s claims experience and utilization rates Previous health plan’s underwriting guidelines, medical policies, and provider network

arrangements Changes in premium rates for the group’s coverage since the coverage began

The successor health plan also considers the people who currently have claims on file with theprevious health plan. These people must be protected from loss of benefits when the groupswitches to the successor health plan. If some employees are not actively at work, but are notdisabled on the effective date of the new coverage, the successor health plan determines thereason for these members’ absence. They could be on vacation or taking a leave of absence, orcould be sick or injured.

Typically, health plans require eligible employees to be actively at work on the effective date ofcoverage. Coverage for eligible employees who are not actively at work on that date is usuallydeferred until they return to work. Also, most health plans do not collect premiums on absentgroup members until those employees have returned to work on a full-time basis.

However, if an employee or dependent was covered under the previous health plan’s health planand would otherwise lose coverage as a result of the employer’s changing to a new health plan,the successor health plan usually would provide coverage for these individuals outside the plancontract. This extra contractual provision is sometimes called continuity of coverage or no-loss,no gain.

Generally, health plans require three years’ documentation of the group’s

Previous benefit changes and their effective dates Rates billed, premiums paid, claims incurred, and claims paid Large or catastrophic claims, including the amount claimed and the current status of each

claim Billing statements Employee plan description material Information about disabled employees and dependents

Note, however, that it may be difficult for health plans to obtain even one year’s documentation,depending on the employer and its previous coverage.

Characteristics of the Coverage

Although plan purchasers often choose a plan design that is the same as or close to a standardplan design offered by a health plan, many purchasers choose to customize their plan designs. Animportant part of the underwriting function is to ensure that the proposed coverage falls withinthe health plan’s parameters and is appropriately priced to reflect any variations from theseparameters. Plan administration and plan changes must also fit the health plan’s underwritingguidelines.

Plan Design

When evaluating a proposed plan design from a potential purchaser, a health plan’s underwritersconsider two key elements: (1) Eligibility requirements, and (2) Covered services/supplies andbenefit levels.

Eligibility requirements.

Generally, health plans require that only full-time, permanent employees and their dependents canenroll in a group plan. Therefore, a health plan’s underwriters verify the eligibility of each groupmember.

Under a contributory plan, members who choose to participate usually can enroll in the plan anytime during the 31 days following the date they become eligible for coverage. Most health plansrequire employees who do not enroll during the 31-day enrollment period to provide evidence ofinsurability before they can subsequently enroll. This requirement prevents the antiselection thatmight occur among employees who originally declined coverage, but later learned that they had aserious health problem.

Some group plans do, however, allow a previously nonparticipating employee who has a “lifeevent”—for example, an employee acquires a dependent spouse through marriage, acquires adependent child, or loses coverage under his or her spouse’s plan—to enroll in the plan without

providing evidence of insurability. In such cases, the nonparticipating employee must enrollwithin 31 days of the “life event.”

Covered services/supplies and benefit levels.

The healthcare services and supplies that are covered and the applicable benefit levels can largelydetermine a health plan’s financial success. For example, if a health plan provides anoverabundance of benefits, plan members tend to have higher utilization rates and higher-than-average claims costs.

On the other hand, a health plan that provides minimal benefits or unevenly distributes benefitsamong employee classes probably will not appeal to many employees. As a result, the health planprobably won’t achieve the desired participation level. The health plan’s underwriters strive toapprove plans that reach a balance between these two extremes.

Some plan purchasers establish benefit plans that avoid unequal distribution of benefits amongmembers by offering the same benefit for all employees, regardless of job class, salary, or lengthof service, for example. Other plan purchasers vary benefit levels according to specified,objective criteria related to employment.

Plan Administration

Group health plans often require active involvement of the employer or other plan sponsor tomanage and administer benefits. Because the employer often serves as a link between the groupmembers and the health plan, the employer plays a vital role in the successful administration ofthe plan. Effective plan administration is crucial to keeping plan costs low and helping ensure thelong-term satisfaction of both the employer and the plan members. Therefore, a health plan’sunderwriters evaluate the willingness and ability of a prospective purchaser to cooperate in planadministration.

Specifically, an employer should be able to promote the health plan and encourage all eligibleemployees to enroll in the plan. The employer should also be able to maintain accurate andcomplete records of plan enrollments and changes in employee eligibility, as well as the status ofeach employee’s plan contributions. In addition, the employer should be able to assist employeeswith eligibility changes, claims submissions (if applicable), and routine questions about the plan.

Plan Changes

When an employer group requests an increase in the type or extent of benefits offered under itshealth plan, the health plan’s underwriters first consider the group’s claims experience. As notedearlier, where state laws allow, if the group has had higher-than-expected claims experience, thegroup’s request may be denied. Alternatively, the group’s premium rate may be increased tocover the cost of additional healthcare benefits.

Conversely, if a group has had lower-than-expected claims experience, the health plan’sunderwriters might determine that additional benefits can be provided without an increase inpremium. Likewise, a group that requests a reduction in its healthcare benefits might receive alower premium rate, or a lower premium rate increase, provided that its claims experience has notbeen unfavorable.

When an employer wants to offer coverage to employee classes that were previously excludedfrom the health plan, the health plan’s underwriters evaluate the proposed employee classes.Factors considered in this process include:

Whether the proposed employee classes constitute a minor addition to the whole group,in which case the underwriter usually approves coverage

Whether the proposed employee classes comprise a considerable proportion of the wholegroup, in which case the underwriter evaluates the age, sex, and salary of the individualsin each class

The geographic location of the employees in the proposed employee class—for example,in situations when one company purchases another company or establishes a branchoffice in another location

Information about previous coverage of the employees in the proposed employee classes Type of industry in which the employees in the proposed employee classes work,

especially if that industry involves hazards that do not exist for the original group that iscovered

Conversions from Group Coverage to Individual Coverage

Group healthcare contracts often contain a conversion privilege, which, under certain conditions,allows covered plan members who lose coverage under their current group plan to obtaincoverage under an individual healthcare policy. Many states require health plans to include aconversion privilege. Under the terms of a conversion privilege, the health plan must issue anindividual healthcare policy to all eligible individuals who request one, regardless of theirmedical condition.

Because the health plan cannot decline coverage for an eligible individual, the bulk of theunderwriting for conversion policies is accomplished through health plan design. Often, healthplans provide the minimum covered services and benefit levels that are required under applicablefederal and state laws and regulations. Dental and vision benefits are rarely provided underconversion policies.

Because healthy employees typically move to another employer group, rather than apply forindividual coverage, the cost of the conversion privilege is high. Often a group plan’s premium ishigher to cover these costs. Premium rates for conversion policies are subject to the health plan’srating guidelines for individual coverage, which we discuss in the next lesson. Note that theintroduction of COBRA benefits and the guaranteed issue requirements for qualified individualsunder HIPAA have greatly reduced the need for conversion policies.

Endnotes

1. Portions adapted from Academy for Healthcare Management, Managed Healthcare: AnIntroduction, 2nd ed. (Washington, D.C.: Academy for Healthcare Management, ©1999),11-1–11-9 and from Academy for Healthcare Management, Health Plans: Governanceand Regulation (Washington, D.C.: Academy for Healthcare Management, ©1999), 7-1–7-53. Used with permission; all rights reserved.

2. Portions adapted from Academy for Healthcare Management, Managed Healthcare: AnIntroduction, 2nd ed. (Washington, D.C.: Academy for Healthcare Management, ©1999),11-10–11-33 and Academy for Healthcare Management, Health Plans: Governance and

Regulation (Washington, D.C.: Academy for Healthcare Management, ©1999), 5-1–5-36. Used with permission; all rights reserved.

3. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life andHealth Insurance Companies (Atlanta: LOMA, ©1997), 267-272. Used with permission;all rights reserved.

4. Adapted from Barbara Foxenberger Brown and Jane Lightcap Brown, Life and HealthInsurance Underwriting (Atlanta: LOMA, ©1998), 311-334. Used with permission; allrights reserved.

AHM Health Plan Finance and Risk Management: Small Group and IndividualUnderwriting

Course Goals and ObjectivesAfter completing this lesson you should be able to

List the common characteristics of small group reform laws Explain the effect of the guaranteed issue provision on the small group markets in which

they apply Define risk pooling as it relates to small group markets Discuss state reinsurance programs for small group carriers Identify and describe some characteristics of small groups and individuals that

underwriters consider, where state law permits

Although a large segment of the population typically obtains healthcare through employee benefitplans, historically, few small employers have offered healthcare benefits to their employees.During the 1990s, to increase small employer access to affordable healthcare, many states enactedsmall group reform laws. The definition of small group varies from state to state but typicallyspecifies employee groups that range from 1 to 50 or more employees. Not all small groups areemployee-employer groups—for example, some professional associations fall into small groupcategories—but this assignment focuses on private sector employer-employee small groups,because they represent the largest part of the small group market.

Small Group Reform Laws and Underwriting 1

Small group reform laws vary by state, but most small group statutes include language that

Stipulate a uniform benefit design for use with small groups Place restrictions on the small group underwriting practices of health plans Set requirements with respect to premium rates that health plans can charge small groups Require health plans to disclose plan and rating information to plan purchasers

Uniform Benefit Design

To make healthcare more affordable and accessible to small employer groups, most states havedeveloped uniform benefit designs for HMOs and PPOs as well as indemnity healthcare products.These plans, called low option plans, also called basic plans, essential plans, or bare bone plans,typically include features such as high annual deductibles, high copayments, limits on lifetimeand annual benefits, and a limited list of covered services and supplies.

Many states have also developed standard plans. Standard plans are health plans that requirehealth plans to offer small employers and their employees a choice of a more comprehensivehealthcare benefit plan than the low option plan. Standard plans approximate the healthcarebenefits available to large employers. Usually states require that health plans offer at least twohealth plans. Typically a health plan will offer more than two plans, however.

Restrictions on Underwriting Practices

Small group laws seek to improve access and affordability by restricting the underwritingpractices that health plans can use to reduce overall risk. Health plans that must accept largerrisks ultimately incur higher costs. Consequently, although the intent of mandated restrictions onunderwriting practices is to improve access to healthcare, one result of these restrictions is anincrease in the cost of providing that healthcare. Several of these restrictions have beenincorporated into the federal Health Insurance Portability and Accountability Act (HIPAA) of1996. These restrictions may be divided into two types: (1) those that apply to employer groupsand (2) those that apply to individual group members.

Underwriting Employer Groups

Most small group laws contain a guaranteed issue provision, and HIPAA now mandatesguaranteed issue in the small group market. A guaranteed issue provision requires each healthplan that participates in a small group market to issue a contract to any employer who requestshealthcare benefits, as long as the employer meets the statutory definition of a small group.

Typically, in the large group market, a health plan can elect not to issue a contract to a particulargroup if the group has had poor claims experience or has a member who is suffering from acatastrophic illness or injury that would result in substantial healthcare expenses. Laws pertainingto small groups prohibit this underwriting practice. State and federal small group laws alsocontain a guaranteed renewal provision, which prohibits health plans from canceling a smallgroup’s healthcare coverage because of poor claims experience or other factors that relate togroup underwriting, such as a change in health status of group members.

Underwriting Individual Members of Employer Groups

Before the enactment of small group reform laws, group insurance laws often set the minimumnumber of employees in an eligible employer group at 10 or more. This meant that employerswith fewer than 10 employees were not considered employer groups for the purpose of groupinsurance laws. Therefore, insurers and health plans used medical underwriting for the individualemployees of a small employer. In other words, an employer group could be accepted forhealthcare benefits, but specified employees within that group could be excluded because ofhealth conditions. The small group reform laws typically changed the definition of an employergroup to include employers with as few as two employees, thereby subjecting small groups togroup underwriting requirements, rather than to individual underwriting requirements.

In the past, one way that health plans could limit risk was to apply waiting periods and pre-existing conditions exclusions to individuals in certain high-risk categories who might haveotherwise been eligible for group healthcare benefits. Small group reform laws seek to improveaccess to healthcare by limiting these restrictions.

Requirements on Premium Rating

To reduce healthcare costs for small groups, small group market reform laws place restrictions onthe rates that health plans can charge small employers. Typically, these laws prohibit health plansfrom using experience rating and prescribe a method that limits the rate spread that health planscan use for all small employer groups. We discussed experience rating in the Rating and

Underwriting lessons. A rate spread limit is a law that places limits on the spread, or difference,between the highest and lowest premium rates that a health plan can charge any two small groups.

Many state laws require health plans to use a rating method that is either a pure community ratingor an adjusted community rating. Other state laws are based on the rating method contained in theunamended 1991 NAIC model small group laws and regulations. This rating method, which isreferred to as community rating by class (CRC), allows health plans to use up to nine ratingclasses with prescribed minimums and maximums in each class. Also, the rate spread cannot bemore than 120% from the highest to the lowest block of business, which is usually defined bymarket approaches.

Requirements for Disclosure of Plan and Rating Information

Small group laws typically include disclosure requirements that specify the types of informationthat health plans must share with plan purchasers to educate them and to help them makeinformed choices. Some states require that health plans obtain approval for all marketing piecesand that they file a copy of the approved pieces with the state insurance department before thesematerials are distributed for use. From a financial standpoint, these requirements increase a healthplan’s costs to the extent they mandate activities the health plans would not otherwise perform.

The Small Group Market

The small group market has at least three characteristics that make it attractive to health plans.First, the small group market contains a large number of potential plan members. Second, thismarket is growing, because the number of small businesses in the United States is growing. Third,compared to large groups, small groups are much less likely to have healthcare coverage.

We have already mentioned regulatory costs and underwriting limitations as disadvantages tohealth plans that are entering into or already operating in the small group market. The market alsopresents financial risk to health plans for at least three other reasons.

First, besides the costs of regulatory restrictions, the variation in these regulations from state tostate add costs to the operations of health plans that seek to enter markets in more than one state.

Second, in many segments of the small group market, employee turnover is high, and highturnover adds to the administrative costs of serving small groups.

Third, the owners of small businesses often have much more information concerning their healthand the health of their families and their employees than the health plan has, which means thatthis market is subject to a greater risk of antiselection than is the large group market.Antiselection occurs in small groups because business owners are more likely to seek healthcarecoverage if they believe that they, their family members, or their employees are likely to havehigh healthcare costs.

Over time, health plans and their underwriters have gathered increasingly reliable informationabout the morbidity experience of small groups.2 Generally, in comparison to large groups, smallgroups tend to

Less closely follow actuarial predictions regarding morbidity rates Have more frequent and larger claims fluctuations

Generate more administrative expenses as a percentage of the total premium amount thegroup pays

As a result of these market characteristics, an underwriter can have difficulty determining anappropriate premium for a small group.

Although small group laws have made healthcare coverage more accessible to groups thatpreviously would have been declined, these same laws have actually reduced access to healthcarebenefits for others. By limiting the ability of a health plan to reject individual employees withinan accepted group and by restricting premium rate methodology, these laws have causedpremiums to increase for many small groups.

High premium rates are typically the most important barrier to coverage for any group or groupmembers. Thus, for example, a small group with a heavy composition of young males who are ingood health might, because of small group laws, experience premium rate increases that make thecost of healthcare coverage prohibitive to some members of the group, thereby limiting theiraccess to healthcare benefits.

Where state laws allow, health plans sometimes use an underwriting method called pooling tohelp more accurately estimate a small group’s probable claims costs and to calculate an equitablepremium. Pooling is a method of determining a group’s premium in which underwriters treatseveral small groups as one large group for assessment purposes. The more plan enrollees (orproposed enrollees) that are grouped in a pool, the better the underwriter’s chances of accuratelyestimating the whole group’s claims costs.

Underwriting the Small Group 3

Underwriting small groups traditionally takes place on two levels: (1) evaluating the businessentity, and (2) examining the health status and other characteristics of each individual to becovered. Unlike underwriting large groups, variation in coverage is not a major factor for smallgroups. Small group plan designs are typically kept standard.

With the passage of small group reform laws, the approach health plans take to underwritingsmall groups has become much more important than in the past. These laws impose limitations ona health plan’s ability to reject or rate-up (increase rates to reflect worse-than-average risks)specific individuals within a group.

In underwriting small groups, both the characteristics of the members and of the employer itselfare considered. Examples of these characteristics include the nature of the employer’s business,the expected level of plan participation on the part of the employees, and prior claims experience.The small group underwriter examines many of the same member and employer characteristicsthat the large and medium group underwriter examines. The rating structure used by the healthplan, which is more and more often dictated by small group law, has an important bearing on thesignificance placed upon certain of these characteristics.

Financial Viability

A health plan incurs substantial costs in selling, underwriting, and issuing coverage to a group.These costs are proportionally greater for small group purchasers. To retain a small grouppurchaser as a client long enough to recoup these acquisition expenses, the business must be

financially viable. Such concern cannot be taken lightly; a significant number of small businessesfail each year.

Nature of Employer’s Business

As we saw in our discussion of large groups, the type of business and the duties performed by agroup’s employees are also related to expected future claims costs. Certain types of businessesare exposed to higher health risks. Some of these risks are clearly work-related, such as a job thatrequires handling hazardous chemicals. Other risks are related to lifestyle issues. For example,employees of a motorcycle dealership are more likely to ride motorcycles and might present agreater risk than employees of an accounting firm.

Traditionally, some small group carriers would not cover certain industries or occupations; otherswould charge a premium surcharge for coverage. The list of ineligible industries and industryrate-ups varies by health plan. Today, however, many states no longer allow industry rating;others limit the size of the surcharge. However, except in states that require guaranteed issue,health plans generally still retain the right to reject groups due to the nature of the business inwhich they are engaged.

Group Size

Group size is another important group characteristic, affecting both expected claims levels andper member acquisition and maintenance expenses. The larger the group, the more lives overwhich the morbidity risk can be spread. For a group of 25 as opposed to a group of 5, anindividual employee’s health status will be a smaller factor in the employer’s decision to purchasecoverage and the level of benefits chosen. Also, the administrative expenses incurred in coveringthe larger group are lower on a per member basis than those for the smaller group.

Historically, health plans offered coverage at lower rates and used less stringent underwriting asemployer group size increased. However, one typical objective of small group reform laws is tomandate that small group health plans pool the group-size risk over their entire small groupportfolios, by either disallowing or limiting variations on premium rates by group size. Forexample, states that require health plans to use adjusted community rating generally do not allowadjustment for group size. This can create additional risk for a health plan that provideshealthcare coverage in small group markets.

Participation Level

To qualify for medical coverage, a small group is expected to meet certain participationrequirements set by the health plan. As we saw in the previous lessons, these requirementsprovide the health plan some protection against antiselection at the point of sale by prohibiting asignificant number of employees (presumably the most healthy) from declining the coverage.Participation requirements also help protect the health plan from case stripping, a process inwhich a few employees and/or dependents with expected high medical costs remain under theplan, but over time, the healthier plan members drop coverage or purchase less expensive groupcoverage elsewhere.

The majority of states continue to allow health plans to set participation levels as a requirementfor coverage, even where coverage is otherwise guaranteed issue. Often, however, theparticipation requirements are limited by law. For example, a health plan may not be allowed to

require that more than 70% of eligible employees sign up for benefits as a condition of offeringthe group coverage. Some states, however, require that, in cases where employees have coveragefrom other sources such as a spouse’s plan, the health plan cannot consider these employees whendetermining participation levels.

Contribution Level

Another underwriting consideration that is particularly important for small groups is theemployer’s contribution to the cost of healthcare coverage. As we saw in Rating andUnderwriting lessons, the higher the percentage of the total cost the employer pays, the higher theemployee participation tends to be. Generally, health plans require that the employer make somecontribution to the cost. Although large employers frequently contribute 80% or more of the costof coverage, small employers typically cannot afford such high contributions. It is not uncommonfor small employers to pay a portion of the employee’s premium (50% for instance), but requirethe employee to pay the full cost of dependent coverage.

Employer concern over the cost of these employer contributions often results in a decision by theemployer not to sponsor a plan. The lower the employer contribution rate (and therefore theparticipation rate), the more likely it is that the employees who enroll in the health plan will beless healthy than the entire group as a whole. Some states will not allow a small group to becovered unless the employer contributes a minimum level of the premium and the group meetsminimum participation levels.

Health Status and Prior Coverage

In underwriting a group as a whole, a health plan’s underwriters gather and review informationregarding the health status and prior coverage of the group. If the group is obtaining healthcarecoverage for the first time, discovering the reasons for seeking coverage at this time can point toother areas that should be investigated more fully. For example, the spouse of a valued executivemay have contracted what is likely to be a costly medical condition.

If the group is changing health plans, information regarding the prior coverage is an importantunderwriting consideration, particularly today because most states require portability of coverage(usually without regard to the differences in healthcare benefits). Such portability does not allowa health plan to apply a pre-existing conditions provision to those enrollees who were previouslycovered, which consequently increases the health plan’s risk.

Health Status and Prior Coverage

To the extent possible, underwriters investigate the motives of the group for changing carriers,seeking answers to questions such as these:

Is the group increasing healthcare benefits or just seeking more competitive premiumrates?

Is the group seeking to add employees who were not covered under the prior healthplan’s health plan and would have been considered late entrants under that plan?

Are certain dependents being added who were not covered by the prior plan?

Individual Underwriting Considerations 4

The key to successfully underwriting a block of small employer healthcare programs is to assurea reasonable mix of healthy and unhealthy members. If a health plan’s underwriting guidelinesare too liberal compared to those of the competition, the health plan’s block of business couldattract a disproportionate share of unhealthy enrollees and be exposed to antiselection.

Many small group laws restricting underwriting and rating practices put limits on the ability ofhealth plans to single out individuals within an employee group by rejecting them or by ratingthem up. Although individual risk evaluation techniques continue to be used, they are nowemployed by underwriters in making a decision about the group’s rates, rather than about whetherto offer coverage to particular individuals.

Enforcement of Eligibility

The underwriter, using information in the application for coverage, checks for the eligibility ofeach employee and the employee’s dependents. Eligibility checks tend to be more critical forunderwriting the smallest groups because of the number of family businesses that seek healthcarecoverage and the temptation of a family business to present unhealthy relatives for coverage. Insuch cases, investigating each employee’s and dependent’s eligibility at the time of issue may beless cost-effective than conducting underwriting after a claim has been submitted.

Pre-Existing Condition Limitations

Portability requirements enacted under HIPAA and by most state small group reform laws camein response to employees’ reluctance to change employers for fear of loss of health coverage.Portability requirements increased the risks faced by health plans and introduced newunderwriting considerations. Where previously an underwriter might have accepted a groupknowing that the pre-existing condition exclusion period would provide adequate short-termprotection to make the case profitable, with portability such a group would need to be reassessed,since the health plan would essentially be buying claims at the outset of issuance.

Portability laws vary in their treatment of new and late entrants to a health plan. For example,HIPAA allows a pre-existing exclusion period of 12 months for new entrants and 18 months forlate entrants (each of which is reduced by qualified prior coverage). Therefore, underwritersdistinguish between new and late entrants to avoid the extra antiselection risk introduced by laterentrants.

Individual Medical Assessment

Both the employees of a small group and their dependents are usually individually medicallyunderwritten, even though small group reform prohibits health plans from singling out individualsfor rejection or substandard rate-ups.

In the absence of laws mandating otherwise, underwriting standards grow stricter as group sizegets smaller. Some medical conditions that may not be acceptable in a two-member group,because of the high expected claim cost, could be acceptable when compared against thepremiums generated by a 20-member group. Even in a 25-member group, however, oneespecially expensive ongoing medical condition can assure that the group will be unprofitable atany reasonable premium level.

While such an underwriting approach had been relatively straightforward in the past, small groupreform laws passed in the last decade require objective and nondiscriminatory application ofunderwriting criteria, regardless of group size. As such, the underwriting criteria must assureobjectivity and yet recognize the risk implications inherent in small groups.

Health plans use various underwriting approaches. Some enrollment applications use a short-formquestionnaire that asks a few broad questions; others ask a long list of detailed questions.Examples of these supplemental sources are attending physicians' statements (APS) andclearinghouses of medical and insurance information.

Gathering underwriting information, however, increases costs for the health plan. These costsmust be compared to the gains the health plan expects to achieve by using this information toreduce claims costs.

Small Group Rating Approaches

Small group reform laws have, as we have noted earlier, caused a health plan’s small groupunderwriting to become more like large group underwriting. State laws have also increasinglylimited the range between the highest and lowest rates among small groups.

Many of the factors used in determining small group rates are consequently the same as thoseused to rate large groups, as we discussed in Group Underwriting lesson. These factors are thetype of group, the age of the group members, the ratio of males to females in the group, thegeographical location of the group, the size of the group, and the nature of the group’s business.

Rating Structures

In the past, as a result of the underwriting and pre-existing condition exclusions used in the smallgroup market, initial claim costs per member started out very low, but increased rapidly as theselection and pre-existing condition exclusions wore off, eventually leveling off after the thirdyear.

This phenomenon, coupled with competitive pressures for sales, led to the practices of durationaland tiered rating, in which low entry rates were offered to groups at issue followed by fairlysignificant rate increases in the subsequent renewal periods, especially for groups with prioradverse claims experience. These practices caused healthier groups with good experience to shopfor a health plan that offered cheaper premium rates or that would place the group on the lowestrating tier. Less healthy groups had to either accept the hefty rate increases or cancel theircoverage, and face a new pre-existing conditions period from a new carrier, or risk the possibilityof not being accepted for new coverage.

The legislative and regulatory response was the adoption of the limits we have referred tothroughout this lesson. These new rules limited durational and tiered rating to a specifiedmaximum range, and in some states disallowed durational rating while still permitting limitedtiered rating. More recently, states have been compressing the allowable rate ranges or moving toadjusted community rates. Many states have established specific risk pooling programs for smallgroup business. These can be categorized into (1) reinsurance programs and (2) risk-adjustmentformula programs.

Reinsurance Programs

Many states that require guaranteed issue of at least two mandated plans (sometimes referred toas Standard Plans and Basic Plans) have established health coverage reinsurance programs forsmall employer groups. These programs develop reinsurance pools into which a carrier can placeentire groups or individuals enrolled in a group plan. In contrast to the commercial reinsurancewe discussed in Capitation and Plan Risk, the reinsurance offered through these programs isadministered by not-for-profit entities whose board members are appointed by the state insurancecommissioner for each state. The purpose of these programs is to reinsure health plans and othercarriers who offer guaranteed healthcare plans to small employers. These carriers are sometimesreferred to as small employer carriers.

Under these programs, a small employer carrier can reinsure either an entire small group, orspecific individuals within a group. The programs pool the risks of several small employercarriers and enable these carriers to offer guaranteed issue plans to small employers withouttaking on the entire risk of catastrophic loss often present in guaranteed issue plans. As we haveseen, this risk is higher than usual in small group, guaranteed issue plans because they areparticularly vulnerable to antiselection.

Typically, the reinsurance board sets a “base” reinsurance premium for the coverage on a plan.This base reinsurance premium is derived from the typical premiums for small employerhealthcare plans that have benefits similar to benefits of the plan being reinsured. This basereinsurance premium is then multiplied by a factor of 1.5 in the case of reinsurance on entiregroups, or a factor of 5 for reinsurance on individuals. The result of the base reinsurance premiummultiplied by the appropriate factor is the reinsurance premium.

To obtain reimbursement under the program, a small employer health plan may have to meetcertain cost-sharing requirements. For example, the small employer health plan seeking thereinsurance might have to pay a $5,000 deductible and 10% of the next $50,000 on a claimcovered by reinsurance. Any shortfalls in the pool are funded through assessments of theparticipating health plans.

Risk-Adjustment Programs

Some states have developed risk-adjustment formulas to be applied to the premium that the statereinsurance program charges to participating small employer carriers. These formulas attempt toproduce an equitable reallocation of premiums reflecting differences in risk among participatinghealth plans. However, establishing effective risk adjustment systems such as this has proven tobe difficult due to the complexity of the process and a lack of experience and technology in thisarea.7

Underwriting Individual Healthcare

Healthcare coverage is provided to millions of Americans as an employee benefit, but millionsmore people are covered under individual (sometimes called nongroup) health policies that theyhave purchased. Indemnity carriers rather tha health plans write most individual coverage, but insome markets health plans will underwrite individual healthcare coverage. In this section, weexamine the underwriting considerations for this coverage. We begin by briefly discussingapplicable laws and regulations.

Laws That Apply to Individual Underwriting

Many state laws that apply to the individual healthcare market are similar to small group laws inthat both sets of laws seek to improve healthcare access and affordability. For example, manystate laws on individual healthcare benefits require guaranteed issue provisions and placerestrictions on pre-existing conditions provisions. Also, some small group laws, which define aself-employed individual as a “small group,” are actually applying their small group laws toindividual healthcare benefits. States that do not address individual healthcare benefits defer tothe HIPAA for specific requirements.

Underwriting Substandard Risks

Health plans use an underwriting manual that contains information needed to underwriteindividual coverage. The manual usually describes and evaluates a number of impairments. Theunderwriter can accept, rate, or (if state law allows) decline an application according to the degreeof risk the applicant presents to the health plan. If an applicant represents a risk greater thanstandard, and if the risk is not so great that the underwriter must decline the application, theunderwriter can rate the application and accept the risk with a rated policy.

A rated policy is a policy issued to a person considered to have a greater-than-average risk ofloss. To ensure that the risk accepted is within the health plan’s guidelines, a rated policy may beissued with

A premium rate higher than the rate for a policy issued to a person with an average orless-than-average risk of loss

Modifications and exclusions Any combination of a higher premium rate, modifications, and exclusions

To evaluate the risk represented by an applicant, underwriters use a numerical rating systembased on standard morbidity. The standard premium is based on 100% of standard morbidity. Theunderwriter indicates degrees of extra risk as debits, which are converted to rating percentage.After assigning debits to an applicant, the underwriter next uses a rating schedule, which is atable that enables an underwriter to convert the total of the debits to a rating percentage. Eachhealth plan develops its own rating schedule. The rating percentage from the rating schedule isadded to the percentage (100) that represents the standard risk for which a standard premium ischarged.

Where state laws allow, a health plan might include an impairment rider on an individual policy.For underwriting purposes, an impairment is any aspect of an applicant’s present health, medicalhistory, health habits, family history, occupation, or activities that could increase that person’sexpected morbidity risk. An impairment rider, also known as an impairment waiver or anexclusion rider, is a policy attachment that excludes from coverage any loss that (1) arises from aspecified disease or physical impairment or (2) concerns a specific part of the body. Animpairment rider might be used with a health policy if the applicant has a chronic condition forwhich future treatment seems likely.

An impairment rider excludes from coverage a medical condition, a disease or disorder of aspecified body part, or both. To help an applicant to understand clearly what condition is beingexcluded from coverage, each impairment rider is worded in simple, straightforward terms. Ahealth plan’s medical director and legal department can help an underwriter draft a rider to suit

the circumstances of a specific case, assuming that the laws that apply to the health plan allowimpairment riders. To save the underwriter time in producing an impairment rider, mostunderwriting manuals suggest wording for a large number of conditions that generally warrant theuse of such riders.

Key Elements of Individual Underwriting

In underwriting individual coverage, several key elements are critical. The following sectionsdiscuss these elements.

Insurable interest

Insurable interest is the condition in which a person would suffer a genuine loss if the coveredevent were to occur. Under individual healthcare, the requirement for insurable interest is metwhen the applicant can demonstrate a risk of economic loss if he or she requires medical care.

Antiselection and Moral Hazard

A health plan’s underwriters are aware that antiselection and moral hazard can be factors in someapplications if the individuals seeking coverage have certain types of impairments such asnervous conditions and chronic depression or chronic pain. In general terms, moral hazard is acharacteristic that exists when the reputation, financial position, or other circumstances of anapplicant indicates that the person is more likely than most people to misrepresent a condition,cause a loss intentionally, or fail to limit a loss once it has occurred.

Impairments such as nervous conditions and chronic depression or chronic pain do notnecessarily result in undue numbers and amounts of claims, but some of them do, and healthplans often face difficulties in determining the validity of such claims. Some health plans excludecoverage for conditions like these by using riders; other health plans do not issue policies toapplicants with these or other serious impairments.

In contrast, health plans do not usually exclude benefits for impairments that are consideredtemporary, because such impairments are not statistically indicative of possible antiselection ormoral hazard. For instance, if an individual seeking coverage has a sprained shoulder or hasundergone successful shoulder surgery a month before applying for coverage, but has no previoushistory of shoulder problems, most health plans would issue a policy without excluding shoulderor joint problems.

Health History

The individual underwriter pays particularly close attention to the applicant’s health history andseeks complete information about certain impairments that warrant in-depth scrutiny. Theunderwriter focuses especially on impairments associated with two types of concerns: (1) futuremedical treatment and (2) probability of accidents.

Certain impairments are of considerable significance in underwriting individual coverage becausethese impairments have been shown statistically to result in higher-than-average claims resultingfrom future medical treatments. Such conditions as arthritis, back injuries, spinal curvature,recurring bronchitis, gallstones or kidney stones, and mild neuroses are examples.

Individual underwriters also give consideration to medical conditions that may result in a higher-than-average probability of accidents. Some impairments, such as epilepsy, vertigo, narcolepsy,numbness in hands and feet (neuropathy), paralysis, and impaired eyesight and hearing are oftenassociated with accidents and are examined thoroughly.

In addition to looking at the probable effects of impairments, the underwriter examinesinformation relating to health conditions that have been diagnosed or treated recently. Someconditions, especially certain types of cancer, are considered more serious when they have beenrecently discovered or treated.

Some conditions that have been stable for a number of years as specified in a health plan’sunderwriting manual may not negatively affect an applicant’s rating because the condition is notconsidered to have a significant potential effect on the future health of the applicant. Even ahistory of acute illness, such as pneumonia, may not be significant if the applicant has recoveredfully.

An underwriter can accept some applicants for coverage after a period of time followingtreatment for an impairment. Moreover, an underwriter does not consider each impairment inisolation, but tries to obtain a clear understanding of the possible connections between variousimpairments and their combined effect on the applicant’s health.

Finally, the health underwriter pays special attention to factors in the life of an applicant that candecrease or increase the probable effect of an impairment on the person’s health. Suppose that anindividual who is seeking coverage has been diagnosed with mild to moderate asthma and alsosmokes. Such a person is underwritten more conservatively than is a person who has asthma butdoes not smoke.

Existing Healthcare Coverage

Individual underwriters check the application to determine the amount and type of healthcarecoverage that the applicant already has in force. Health plans attempt to ensure that an individualhas adequate coverage, but that such coverage does not result in excessive benefits or profit forthe individual. Experience shows that people with excessive amounts of healthcare coverage tendto overutilize their coverage.

Lifestyle

If an applicant participates more frequently than average in some avocations—as examples, roadracing, mountain climbing, hang gliding, or horse racing—the underwriter usually adds animpairment rider to the policy. Underwriters also thoroughly investigate applicants who have arecord of substance abuse, including drugs and alcohol. If an applicant has a poor driving record,as shown by numerous citations, arrests, or accidents on the applicant’s motor vehicle record,most health plans severely limit benefits or decline coverage if state law allows. The underwriterpays special attention to any indication that an applicant has a record of driving under theinfluence of alcohol or other substances (DUI). Some health plans do not approve coverage forapplicants who have had a DUI conviction during the past three years.

Endnotes

1. Adapted from Academy for Healthcare Management, Health Plans: Governance andRegulation (Washington, D.C.: Academy for Healthcare Management, © 1999), 6-14–6-16. Used with permission; all rights reserved.

2. Barbara Foxenberger Brown and Jane Lightcap Brown, Life and Health InsuranceUnderwriting (Atlanta: LOMA, 1998),320, 322.

3. Portions of this section excerpted and adapted from William F. Bluhm, ed., GroupInsurance, 2nd ed. (Winsted, CT: ACTEX Publications, Inc., 1996), 298–301. Used withpermission.

4. Portions of this section excerpted and adapted from William F. Bluhm, ed., GroupInsurance, 2nd ed. (Winsted, CT: ACTEX Publications, Inc., 1996), 302–305, 310–312.Used with permission.

5. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMA’s Glossary of Insurance Terms,3rd ed. (Atlanta: LOMA, 1997).

6. Ibid.7. William F. Bluhm, ed., Group Insurance, 2nd ed. (Winsted, CT: ACTEX Publications,

Inc., 1996), 45–46.

AHM Health Plan Finance and Risk Management: Pricing a Health Plan

Course Goals and ObjectivesAfter completing this lesson you should be able to

Describe the relationships among health plan risk, rate-setting, and providerreimbursement

Describe how demand and costs combine to establish the upper and lower limit onpricing a health plan

Explain how a health plan uses underwriting margins, expense margins, and investmentmargins in its pricing strategy

Identify and describe rating factors that a health plan uses in developing premium rates

When managed health plans were first introduced, their premiums were significantly lower thanthe premiums on traditional indemnity plans. As a result, health plans obtained significantamounts of business that normally would have been placed with traditional indemnity insurers.

In the past decade, however, traditional indemnity insurers have adopted health plan principles.As a result, the difference between premium rates for managed healthcare plans and indemnityplans (now better known as managed indemnity plans) has decreased. This decrease has furtherincreased price competition among health plans. Therefore, to enter a new market or to build orretain current market share, health plans must offer competitive prices on their healthcareproducts.

Price sensitivity in the marketplace is a key factor in how a health plan determines a health plan’spremium rate. Although it is important for health plans to competitively price their products,health plans must be able to do so while effectively assessing the risk. In other words, a healthplan must first determine whether to accept the risk that a prospective group represents. If thehealth plan decides to assume the risk, then the health plan must establish a premium rate thatcovers the risk and provides the health plan with a profit on the plan.

Increased market competition has underscored the need for proactive rating and underwriting in ahealth plan. The ability to effectively perform these functions has become critical for health plans,which have to address in their pricing strategy ongoing market trends and factors, some of whichare listed in Figure 9A-1.

Margins1

A health plan that assumes risks incurs the costs of those risks. To ensure their solvency andprofitability, health plans use margins in calculating the costs associated with the risks that theyassume. The amount by which a product’s price exceeds its costs is called the product’s margin,also called the spread or profit margin. The following sections discuss the use of margins inpricing a health plan. Note that the same pricing principles also apply to a health plan’s otherhealthcare products.

Once a health plan’s actuaries have analyzed and forecasted a health plan’s costs, the health plangenerally determines a premium that exceeds the plan’s expected costs to provide the plan withan appropriate profit. To analyze product costs and margins, a health plan generally divides ahealth plan’s costs into two categories: (1) the costs of the benefit payments associated with theplan and (2) all other plan expenses.

A health plan also generally considers that a health plan’s costs are offset, or reduced, by a thirdfactor: the investment income that is earned on plan premiums. Investment income may benegligible on some healthcare products, however. Generally, a product’s overall margin, which isadded to the product’s price, can be thought of as having three components: an underwritingmargin, an expense margin, and an investment margin.

Some health plans combine or net the expense margin and the investment margin into onemargin. Other health plans may use other margins in pricing a product. Regardless of theapproach a health plan uses to develop margins, the health plan’s purpose is the same: to provideenough income to meet current and future claims obligations and to provide a profit. Before wediscuss the underwriting, expense, and investment margins, we first discuss a health plan’sexpected, assumed, and actual margins with respect to pricing a health plan.

The underwriting margin is the difference between a health plan’s actual benefit costsand the benefit costs (medical expenses) that a health plan assumes in its pricing.

The expense margin is the difference between the amount actually needed to cover ahealth plan’s nonmedical expenses and the assumed expense level that a health plan usesto price the plan

The investment margin is the difference between the amount of investment income that ahealth plan earns and the amount of investment expenses that a health plan incurs.

Expected Margins, Assumed Margins, and Actual Margins

At the pricing stage, a health plan has either an expected value or an assumed value. An expectedvalue is a value that a health plan’s actuaries believe is most likely to occur. In contrast, anassumed value is the value a health plan’s actuaries use in calculating the premium on a healthplan. An actual value is the value that actually occurs after the plan has been in force. Unlikeexpected values and assumed values, which are estimates developed before the pricing decision ismade, actual values are only available after a health plan has been in force—in other words, afterthe pricing decision has been made.

In calculating a plan’s premium, actuaries frequently assume different values from those theyexpect to occur. For example, if a health plan’s actuaries have observed a 50% utilization rate formammography screening, then the actuaries may assume a 75% utilization rate in pricing a healthplan. In another example, a health plan’s actuaries may use 200 inpatient days per 1,000(expected value) rather than 180 inpatient days per 1,000 (actual value) in pricing a health plan.

An expected margin is the profit margin that a health plan intends to produce and believes ismost likely to occur. An assumed margin is the difference between a health plan’s assumed valueand its expected value for the premium that the health plan charges for a health plan. A healthplan’s actual margin, which emerges after the health plan has been in force, is the differencebetween the assumed values and the actual values for the plan’s benefit costs, expenses, orinvestment income. Keep in mind that assumed margins and expected margins are built into theprice of a product. Actual margins are not known during the pricing process; they are known onlyafter the product has been in force.

The actual margin may be higher or lower than the assumed margin. In addition, one of thecomponents of total margin—the underwriting margin, the expense margin, or the investmentmargin—may be higher than expected and another component may be lower than expected.

Suppose a health plan observes that a health plan’s actual morbidity is lower than its assumedmorbidity and that the plan’s actual administrative expenses are higher than its assumedadministrative expenses. In this case, the plan’s actual underwriting margin would be larger thanits assumed underwriting margin. However, the plan’s actual expense margin would be lowerthan its assumed expense margin.

A product’s total margin—whether actual, expected, or assumed—can be composed of anycombination of the three margin components (underwriting, expense, and investment). Forexample, a health plan may base a health plan’s price on a large underwriting margin, a moderateexpense margin, and a very small investment margin. The health plan may base the price ofanother product on relatively large underwriting and expense margins and a moderate investmentmargin.

A health plan can analyze margins and profitability at several different levels, including the:

Product level (for example: HMO, POS, and PPO) Market level (for example: large group, small group, and individual purchasers Company level (for example: all products and markets combined)

Thin Margins and Wide Margins

A product is often described as having a thin margin or a wide margin. With respect to aproduct’s underwriting margin, expense margin, and investment margin, a thin margin is anarrow or small margin and a wide margin is a relatively large margin, expressed in monetary orpercentage terms. Specific products tend to have relatively thin margins; other products tend tohave wider margins. For example, administrative-services-only (ASO) contracts usually have thinmargins. Often, margin width is a function of group size in that large group business typically hasa thinner margin than small group business. Figure 9A-2 lists several factors that help determinethe size of a product’s margin.

Actuaries typically conduct several iterations of premium rates and margins before arriving at theprice and margins that will be used for a particular product such as a health plan. After the planhas been on the market, actuaries monitor its performance. Where possible, actuaries adjust themargins and price to improve plan performance.

Note that, even after a health plan has been in force, determining the plan’s actual underwriting,expense, and investment margins may be difficult. Some medical expenses may be known, butactual costs for incurred but not reported (IBNR) claims are more difficult to determine.

Actual administrative expenses may also be difficult to determine. For example, a health planmust decide what portion of the salaries paid to employees in the claims function should beallocated to the administrative expenses of a particular health plan. Consequently, thedetermination of an existing plan’s actual margin is as much a result of the allocation method that

a health plan uses as it is of the plan’s true profitability. We discuss the underwriting margin, theexpense margin, and the investment margin in more detail in the following sections.

Underwriting Margins2

Generally, both the level of underwriting risk that a health plan assumes in providing benefits andthe market competition it encounters directly affect the size of the assumed underwriting marginin a health plan. For example, a smaller assumed underwriting margin reduces a health plan’sprice, thus making the plan more competitive. Therefore, the more competition a health planfaces in the marketplace, the smaller the plan’s assumed underwriting margin.

A health plan can take steps to reduce its exposure to underwriting risk and thereby adjust itsunderwriting margin. One way that a health plan can reduce underwriting risk is to use stop lossinsurance, which we discussed in Capitation and Plan Risk. Because a health plan’s underwritingrisk can arise from a number of sources, the plan can also look at the sources of those risks andfind ways to control or manage them. Common sources of underwriting risk include (1) lack of ahealth plan’s experience in forecasting underwriting results, (2) the number and length of rateguarantees, and (3) antiselection. We briefly look at two of these sources and how they might becontrolled in order to improve a health plan’s underwriting margin.

A health plan takes on a greater underwriting risk when it has no direct experience on which tobase its morbidity forecasts. For example, a just-introduced health plan may have no crediblemorbidity experience, so it may include a proportionally greater underwriting margin than that ofan established health plan. In this case, effective utilization controls and provider reimbursementarrangements help to minimize the impact that the lack of credible experience has on a healthplan’s underwriting margin.

A health plan may also use a shorter or longer price or premium rate guarantee for specificgroups. Suppose a health plan offers a particular health plan to two groups, Group ABC andGroup XYZ, which are similar in size. The health plan offers a two-year premium rate guaranteeto Group ABC and a one-year guarantee to Group XYZ. In this case, the health plan may offerthe longer price guarantee to retain Group ABC’s business in a competitive environment becauseGroup ABC has lower utilization rates than does Group XYZ.

Expense Margins3

Earlier in this lesson, we defined a product’s expense margin as the difference between theproduct’s actual expenses and the expenses that a health plan assumed in pricing the product. Theexpense margin, therefore, is the part of the retention charge that is intended to contribute to thehealth plan’s profit (or surplus, for those health plans that must company with state insurancerequirements).

Recall from Assignment 5 that a product’s retention charge, also called expense charge or simplyretention, is composed of (1) the expected operating expenses necessary to support the product,(2) a risk charge that is designed to cover contingencies, and (3) the product’s expected expensemargin. In traditional individual insurance products, the retention charge is frequently calledloading. Note that the retention charge does not include medical expenses or investmentexpenses.

Recall also from Assignment 5 that a product’s risk charge helps to ensure that a health plan willbe able to fulfill its contractual obligations even under difficult circumstances. Contingencies areunexpected events that cause expenses, investment earnings, morbidity rates, or other factors tovary significantly from a company’s forecasts.

Keep in mind that the actual expense margin on a health plan is not known until after that planhas accumulated experience. When any of the expense factors in the retention charge varies froma health plan’s expectations—causing the health plan’s revenues to decrease or its expenses toincrease—the negative result is called an adverse deviation. Note that a favorable deviation—asituation in which a health plan’s revenues increase or its expenses decrease—can also occur.

Investment Margins4

For many health plans, investment income is insignificant because their cash inflows (premiums)and cash outflows (provider reimbursement payments) occur at the same time. As a result, thesehealth plans have little cash to invest to earn investment income. In such cases, the developmentof assumed investment margins and comparisons of assumed and actual investment margins maybe irrelevant. Other health plans develop investment margins on their products becauseinvestment income is a large dollar amount, even if not a significant percentage, of their totalrevenues.

One factor—the interest margin—determines the size ofa product’s investment margin. A product’s interestmargin is the difference between the product’s assumedinterest rate or assumed crediting rate and the actualinterest rate earned by a company on the assetssupporting that product:

The assumed interest rate is the interest rate that a company assumes when pricing a product. Acrediting interest rate is the interest rate that a company uses to credit investment return to aproduct. A health plan builds an assumed interest margin into the price of a health plan byassuming an interest rate that is lower than the interest rate that the health plan actually expects toearn on its investments. A crediting interest rate is not built into a product’s investment margin,however. A health plan determines the actual interest margin by calculating the actual interestrate that was earned on a product’s investments.

Purchasers are generally unaware of the interest rates a health plan assumes when pricingproducts. A health plan establishes a premium rate, based on a specific assumed interest rate, thatwill generate enough revenues to pay the benefits promised by a health plan. The funds that ahealth plan uses to pay plan benefits generally come from two sources: (1) premium income fromplan premiums that are paid by purchasers and (2) investment income from interest and dividendincome earned by the health plan from investing those plan premiums.

Again, investment income is a less significant factor than healthcare benefit expenses andadministrative expenses in pricing a health plan because benefit expenses are typically 82% to90%, and administrative expenses are typically 10% to 18%, of a plan’s premium. In many cases,a health plan’s investments must be short-term; because short-term investments earn lowerinterest income than long-term investments, the interest income may be negligible. Also, manyhealth plans must comply with statutory requirements concerning the type of investment and theamount of risk that they are able to assume.

Pricing Factors

We have seen how a health plan considers the risks associated with healthcare benefit expensesand administrative expenses in pricing a health plan. Other factors also limit the range withinwhich a specific health plan’s premium must fall. For example, market forces determine themaximum price that a health plan can charge for a health plan. If a plan’s premium is too high,compared to the premiums of other plans, then, given a choice between two plans, mostemployers will contract with the health plan that offers lower-priced plans.

On the other hand, the minimum price that a health plan can establish for a health plan isdetermined by the costs that the health plan expects that the plan will incur. The plan premiummust be high enough to cover the plan’s costs of paying for both the delivery of healthcarebenefits and the costs of selling and administering the plan.

Statutory requirements are another factor that may influence a plan’s minimum or maximumprice. Also, the existence of a number of plan options, which occurs when employers offeremployees two or more health plans, affects the premium of each health plan.

Market Forces Set the Upper Limit on Price

Although price is not the only point of competition among products, price is certainly a primaryconcern. Generally, as the price of a particular product increases, compared to the prices ofcompeting products, the quantity sold of that product decreases. Suppose a health plan establishestoo high a premium for a health plan, relative to the premiums on competing plans. In this case,the number of employers and other purchasers who contract with the health plan for this plan willbe so low that premium income will be insufficient to meet plan costs and contribute to the healthplan’s profit or surplus.

Therefore, market competition imposes an upper limit on a plan’s price, although the exact levelof this upper limit on price can change over time. When making decisions among competingplans, purchasers also consider other plan characteristics. Keep in mind that competitive forcesare dynamic—not static—and the demand for a specific product or category of products canchange.

In this context, demand refers to the quantity of a product that purchasers will buy at differentprice levels. Generally, the greater the demand for a product, the more of the product thatpurchasers will want at a given price. Also, the greater the demand for a health plan’s product, thehigher the product’s maximum price. Figure 9A-3 lists some factors that influence the demand forhealthcare products.

Costs Set the Lower Limit on Price

Just as the demand for a product creates an upper limit for a product’s price, the costs associatedwith developing and supporting the product usually set a lower limit on the product’s price. If ahealth plan prices a health plan in such a way that the plan’s benefits and expenses are greaterthan its revenues, then the health plan cannot make a profit (or add to surplus) on the plan.

Market forces and product costs provide the limits of the dollar range within which a product canprofitably be priced. If a health plan prices a health plan above the level indicated by the demandfor the plan, then the plan will not achieve adequate sales. As a result, the plan will not provideenough revenues to fulfill the health plan’s profit goals for the plan. If a health plan is pricedbelow cost, however, its revenues will be lower than its costs, so the health plan will incur a losson the plan.

In some situations, a healthcare product’s price, as indicated by the market, could be lower thanthe price necessary for a health plan to cover its costs on the product. As a result, no market pricewill allow the product to be profitable to the health plan. If a health plan finds one of its productsin such a situation, the health plan can take one of the following courses of action:

Reduce the costs associated with providing the product Stimulate an increase in demand for the product—for example, by redesigning the

product to make it more attractive to purchasers—but without significantly increasing theproduct’s costs

Sell the product at or slightly below cost in an effort to enter a new market or to increasemarket share in an existing market

Withdraw the product from the market, because the product is not attractive enough topurchasers to be sold at a profit.

Despite the possibility that, in a particular situation, a health plan might offer one or moreproducts at a price below cost, the costs of the health plan’s entire portfolio of products cannotexceed the revenues earned from all products. Otherwise, the health plan will be unable to operateprofitably and eventually will face insolvency.

Regulatory Impact on Health Plan Prices

Costs and competitive forces impose limits on the prices of all products. However, laws andregulations may place additional constraints on product prices. For example, some statutoryrequirements dictate the range of prices that a health plan can charge for a product by requiringthat the health plan develop plan premiums on the basis of community rating. Regulations canalso have an indirect impact on the prices that a health plan may charge for its healthcareproducts. Often, federal and state laws concerning benefit mandates increase the cost of providingand administering healthcare products, which in turn places upward pressure on plan premiums.

Rating in a Multiple-Choice Environment 5

A multiple-choice environment is any situation where purchasers or individuals have a choicebetween several of a health plan’s products. Individuals might be independent and have a widerange of choice, or might be part of an employer group and have more limited choice of productoptions. Healthcare products or services can include any and all items in an employee benefit planor, for individuals, any item that can be chosen on an optional basis.

The development of premium rates for healthcare coverage in a multiple-choice environmentpresents a challenge to a health plan’s standard rating formulas, which normally just focus on aproduct’s expected benefit costs. The existence of choice may also encourage antiselection, whichcan result in greater costs for healthcare products that attract a significant number of high utilizersof healthcare services.

When a health plan offers more than one type of health plan, the basic pricing strategy is for thehealth plan to determine the aggregate premium necessary to cover the aggregate cost of claimsfor all plans. Although the health plan should price each plan on a somewhat independent basis,the aggregate premium is the most important consideration. Other factors that health plansconsider in pricing several health plans—such as an HMO, a PPO, and an HMO with a POSoption—in a multiple-choice environment include the

Actuarial value of each plan option’s benefits, provider reimbursement arrangements,utilization management differences, retention charges, and expense margins

HMO/non-HMO enrollment mix In-network and out-of-network provider utilization under the non-HMO option Relative cost of benefits for those plan members who enroll in a non-HMO option,

compared to the costs for those plan members who enroll in the HMO

Note that this discussion focused on a specific scenario: one health plan that offers several planoptions. Issues concerning rating in a multiple-choice environment also exist in a scenario underwhich two or more health plans offer several plan options to an employer group. A detaileddiscussion of pricing strategies under various scenarios is beyond the scope of this course.

Trend Analysis6

A trend represents the change in dollar amount or ratio of an index over a period of time.Examples of trends in health plan products include the direction and/or magnitude of cost perservice or of per member per month (PMPM) costs. Health plans identify and monitor several keytrends in order to establish premium rates for health plans. Because of the potentially significant

impact that trends can have on a health plan’s financial performance, it is critical that the healthplan devise a system of long-term trend analysis.

Trend analysis, also called trend percentages or index-number trend analysis, is a type offinancial analysis designed to identify changes in a company’s financial statement values over thecourse of several financial reporting periods.7 A health plan may conduct trend analysis tocompare a health plan’s financial information across different accounting periods, such asmonths, quarters, or years. Trend analysis may use either dollar amounts or ratio values. Wediscuss trend analysis in the context of a health plan’s financial performance in FinancialStatement Analysis in health plans.

Choosing meaningful time periods and units of measurement is critical in conducting trendanalysis. Maintaining consistency in tracking trends is also important. Suppose a health planconducts trend analysis on a health plan on a quarterly basis. In this case, each year, the healthplan will use the same quarterly time periods in conducting trend analysis. Similarly, a healthplan that elects to analyze the trend associated with PMPM, for example, would use this sameunit of measure in subsequent time periods.

Over time, a change in one trend may have a significant impact on cost per service or PMPM.Therefore, health plans not only monitor each trend separately, but also with respect to eachtrend’s possible impact on another trend. For example, an increase in outpatient utilizationusually results in an increase in drug utilization. In addition, health plans typically conduct trendanalysis on each product, such as an HMO, PPO, or HMO with a POS option. For each product,health plans regularly monitor key trend elements, including provider reimbursement trend,which also consists of residual trend.

Provider Reimbursement Trend

Provider reimbursement trend represents the change in the reimbursement that a providerreceives over time for the same service. For most health plans, the provider reimbursement trendhas the most impact on total trend. A health plan usually monitors the provider reimbursementtrend by tracking utilization and provider contract changes that affect reimbursement.

Examples of provider reimbursement trends include a 10% increase in the per diem levels for aparticular hospital and an 8% increase in a primary care physician’s capitation rate. To calculatethe financial impact of provider reimbursement trend on premium rates, health plans generallyanalyze each type of provider reimbursement trend by product, then by type of service withineach product.

Residual Trend

The residual trend, also called the residual component of trend, is the difference between totaltrend and the portion of the total trend caused by changes in provider reimbursement levels. Theresidual trend results from a number of causes, which Figure 9A-4 summarizes.

Unlike the provider reimbursement trend, the residual trend is more difficult to quantify.However, careful monitoring of the provider reimbursement trend helps a health plan to estimatemore accurately the residual trend. The magnitude of the residual trend often determines thedegree of effort that a health plan spends in analyzing the trend’s various components. Also, thepattern of the residual trend may indicate specific areas that should be more closely analyzed.

Analyzing a health plan’s experience helps a health plan to quantify the total trend rate.Monitoring trends provides a health plan with vital information for more accurate cost projectionsand health plan pricing, which, in turn, provides the plan with greater stability in the marketplace.

Endnotes

1. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life andHealth Insurance Companies (Atlanta: LOMA, © 1996), 267–273. Used withpermission; all rights reserved.

2. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life andHealth Insurance Companies (Atlanta: LOMA, © 1996), 264–266. Used withpermission; all rights reserved.

3. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life andHealth Insurance Companies (Atlanta: LOMA, © 1996), 225–239. Used withpermission; all rights reserved.

4. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life andHealth Insurance Companies (Atlanta: LOMA, © 1996), 239–248. Used withpermission; all rights reserved.

5. Portions of this section adapted from William F. Bluhm, ed., Group Insurance, 2nd ed.(Winsted, CT: ACTEX Publications, Inc., 1996), 315, 325–326. Used with permission.

6. Adapted from Dewayne E. Ullsperger, Daniel E. Freier, and Lynette L. Trygstad,Monitoring and Projecting Pricing Trends in a Health Plan Environment (Washington,D.C.: The Group Health Association of America, 1992), 453–457. Used with permissionof the American Association of Health Plans, Washington, D.C.; all rights reserved.

7. Susan Conant et al., Managing for Solvency and Profitability in Life and HealthInsurance Companies (Atlanta: LOMA, 1996), 494.

AHM Health Plan Finance and Risk Management: Rate-Setting in Health Plans

Course Goals and ObjectivesAfter completing this lesson you should be able to

Describe the rate-setting process for HMOs, traditional indemnity plans, PPOs, and plansin a multiple-choice environment

In Rating and Underwriting, we introduced key underwriting principles and rating methods usedin health plans. In Small Group Underwriting and Individual Underwriting discussed the issuesand risks associated with underwriting small groups and individuals. In the previous lesson, itdiscussed the components used in determining a health plan’s premium. This lesson builds on thisfoundation with examples of premium rate-setting for an HMO.

HMO Premium Rate Calculations

As with any major managed care methodology, there is no one right way to calculate a premiumrate for a health plan. While various state regulatory requirements, federal guidelines for federallyqualified HMOs, and actuarial and industry standards set some parameters, individual healthplans have plenty of room to develop their own specific models for rate-setting a health plan.

Most health plans have customized the rate-setting process to meet their specific needs. Still,there is a classic model on which many health plans base their own specific rate-setting model.This basic rate-setting model starts with an actuarially determined premium PMPM.

HMO Premium Rate Calculations

One-Tier (Composite) Rates- same premium applies, regardless if the subscriber is singleor has any number of covered dependents

Two Tier Rates—(1) Single and (2) Family. The family rate includes any combination ofsubscriber plus dependents.

Three Tier Rates—(1) Single, (2) Couple, and (3) Family. Couple means the subscriberplus spouse (or partner). In some plans, couple means the subscriber plus any onedependent. In this context, the family rate applies to the subscriber plus all othercombinations of two or more dependents.

Four Tier Rates—(1) Single, (2) Couple, (3) Family, and (4) Subscriber plus child(ren).Here, couple means subscriber plus spouse (or partner), family means subscriber, spouse(or partner), plus additional dependents. The fourth tier means subscriber with no spouse(or partner), plus any number of other dependents

Five Tier Rates—(1) Single, (2) Couple, (3) Family, (4) Subscriber plus children, and (5)Subscriber plus child. 'The definitions are the same as a four-tier plan except the split ofthe fourth tier.

Rate Ratios

To convert the premium PMPM into single rates for any of these tiers, a health plan applies aformula, which considers the assumed mix and family size of each of the rate categories, and therate ratio for each tier. While the basis for the formula is constant, it must be adjusted for eachtier. For example, the calculation for a two-tier rate is different than the calculation for a four-tierrate.

What is a rate ratio? A rate ratio is the "markup" factor from a single rate to any other ratecategory. Suppose the rate ratio for a couple rate category is 2.0. In this case, you would multiplythe single premium times 2.0 to get the premium for the couple rate category. Suppose a familyrate has a rate ratio of 2.7. To calculate the family rate premium, you would multiply the singlepremium times 2.7.

How are rate ratios determined? They are assigned by a health plan to a health plan. Rate ratiosshould consider family size, but most often they are based on competitive factors, including theratios that competitors are using and what ratios employers and other plan sponsors arerequesting.

A rate ratio for a rate category can be arbitrarily increased or decreased, but the premiums forother rate categories will be affected as well. The end result of a typical family rate ratio is thatthe family rate is subsidized by the single premium rate. In other words, the single rate issomewhat higher than it otherwise should be, and the family rate is somewhat lower than itotherwise should be.

The reason for this subsidization has to do with employer contributions and coordination ofbenefits. Many groups contribute 100% of the subscriber premium, but contribute only a portion(or none) of any other rate category. Therefore, in open enrollments in a multiple-choiceenvironment, family rates become more price competitive.

Also, some subscribers with families choose single coverage and let their spouse include alldependents on the spouse’s health plan. A higher single rate helps to maximize revenues for thehealth plan that enrolls only the subscriber, and not his or her spouse and dependents.

The exact formulas for the single rate, couple rate, family rate, and so on, are beyond the scope ofthis course. Rate adjustments may be applied to the beginning premium PMPM. This means thepremium PMPM is multiplied by a risk adjustment factor to increase or decrease the startingpremium rate. The most common adjustments are for age and sex, where groups composed ofpeople of younger ages get a lower risk adjustment factor, resulting in a lower premium rate, thanthose composed of people at older ages. There are countless other adjustments, includingeffective date, location, industry class, and group experience.

Pricing Policy and Pricing Strategy

The above discussion focused on the calculation of a health plan’s premium rate calculation foran HMO. The premium rate formula that a health plan uses to develop premium rates depends inpart on the health plan’s pricing policy and pricing strategy.

Pricing Policy

A health plan’s pricing policy typically addresses how the health plan will calculate planpremiums. A health plan’s pricing strategy indicates the health plan’s approach to the type ofmarket—for example, commercial, small group, or Medicare—and the level of premiumscharged, compared to those of competing products. Figure 9B-1 outlines the effects that a healthplan’s pricing policy may have on its market.

Pricing Strategy

The pricing process for most health plans involves the calculation of expected claims costs thatresult from utilization of (1) in-network providers, (2) out-of-network providers, and (3) out-of-area providers for a health plan. These various claims costs are then combined, according to thehealth plan’s assumptions on how often each type of utilization will occur. Other costs, such asadministrative expenses, and a provision for profit or contribution to surplus are then added to theexpected claims costs.

A health plan also considers several other items in the process of calculating premium rates. Notethat all items will not be applicable in every situation. Figure 9B-2 lists some critical items thathealth plans consider in pricing a health plan.

Pricing Traditional Indemnity Plans

In some health plan products that include an out-of-area or out-of-network component, a healthplan must be able to effectively price traditional indemnity benefits. The estimation of claimscosts is also a key element in pricing traditional indemnity benefits.

Cost Sharing1

Cost sharing features in a traditional indemnity plan often include deductibles, coinsurance, out-of-pocket maximums, and plan maximums. One example is a $100 deductible, 80/20 coinsurance,a $1,100 out-of-pocket maximum (including the deductible), and a $1,000,000 lifetime maximumbenefit. In terms of who pays charges for medical benefits, the plan pays 80% of charges between$100 and $5,100, and 100% of the charges over $5,100, until the lifetime maximum is reached.

A health plan’s actuaries incorporate the effects of a health plan’s cost sharing features into theplan’s price by developing a claims probability distribution, from which the value of the plandeductible can be derived. Factors that are considered in developing a claims probabilitydistribution include the range of charges, the frequency of charges, the average charge, annualclaims costs, and the accumulated frequency of those costs.

Cost sharing features are more complex in determining family deductibles and out-of-pocketmaximums. Typically, a health plan’s actuaries develop family claims probability distributionsfrom available claims data or by adjusting individual claims probability distributions to derivefamily deductibles and out-of-pocket maximums. A complete discussion of this derivation isbeyond the scope of this course.

Besides calculating the value of the deductible and coinsurance from a claims probabilitydistribution, a health plan’s actuaries also consider adjusting for utilization. Suppose a healthplan’s actuaries have data for the claims probability distribution for Plan A (a $100 deductible,80% coinsurance plan) and they are trying to price Plan B (a $500 deductible, 80% coinsuranceplan).

In this case, the actuaries would most likely adjust downward for utilization because Plan B has ahigher deductible (higher cost sharing feature). Although it may be difficult to determine howmuch a utilization adjustment is a result of cost sharing, a health plan can monitor the claimsprobability distribution of each block of business and adjust rates when necessary.

Pricing PPOs2

Pricing a PPO plan is typically based on pricing techniques of traditional indemnity plans. Toprice an indemnity plan, actuaries would start with the claims experience of an existing indemnityplan. If the indemnity plan had no information or no credible information on claims experience,then the actuaries would adjust for various risks and conduct a trend analysis on the resultingclaims.

The first step in pricing a PPO would be to develop a base indemnity claims cost, which resultsfrom adjusting the indemnity plan as though the entire eligible group of employees had beenenrolled in the indemnity plan. Once actuaries have developed the base indemnity claims cost, theclaims cost for the in-network PPO plan and the out-of-network indemnity plan can be developed.

To develop the expected claims costs for the in-network PPO plan, a health plan’s actuaries adjustthe base indemnity claims costs to reflect pertinent characteristics of the plan, including the

Specific network plan design Provider discount arrangements Impact of utilization review and any other cost containment procedures

Actuaries develop the expected claims costs for the out-of-network indemnity plan and any out-of-area plan in a similar manner. After developing these expected claims costs, actuaries thenconsider which employees would be likely to select which provider groups. Such assumptions,generally called selection assumptions, can be developed using a range of approaches.

Regardless of the approach used, however, the health plan’s actuaries must first determine whichemployees are in the network service area. For these employees, actuaries estimate whatpercentage of employee utilization will be in-network utilization. This percentage may be brokendown by age, sex, active versus retiree status, type of medical service, and so on.

In practice, however, typically one or two overall percentages are determined. For example, thepercentage calculation is often based on how many employees will use the network and assumesthat these employees will use in-network providers 100% of the time.

Other assumptions about employee in-network utilization include the number of in-networkproviders, benefit differences among plans offered, employee contribution levels, the ease ofprovider access, historical data, and the mix of medical services that employees may need.

The issue of selection is inherent in such assumptions. Employees tend to select providersaccording to the likelihood of utilization, the relative contribution cost, and their out-of-pocketexpenses. Sometimes this selection takes the form of choosing an in-network provider for aperceived less serious illness or for new medical services, and a non-network provider forongoing care or perceived life-threatening illnesses. This phenomenon will usually adverselyaffect the claims experience of the indemnity plan.

Next, the health plan’s actuaries will use risk adjustment factors to adjust the existing claims costsfor selection issues. Once that has been done, the actuaries then weight the in-network and out-of-network costs to arrive at a composite claims cost for the PPO plan.

Pricing in a Multiple-Choice Environment3

Pricing a health plan or several health plans in a multiple-choice environment—for example, anHMO, a PPO, and an indemnity plan—combines many of the techniques described above. Thefirst step is to develop a base indemnity claims cost, then the in-network and out-of-network PPOclaims costs. The health plan’s actuaries also price the HMO as described earlier in this lesson.

Again, each of these claims costs must be adjusted for migration (movement among plan options)and antiselection. To avoid the risk presented by selection issues, some health plans developclaims costs for each plan component after actual plan selection is known, before developing theactual premium for each plan.

AHM Health Plan Finance and Risk Management: Principles for Maintaining Accounts

Course Goals and ObjectivesAfter completing this lesson you should be able to

Discuss the main points in the cost concept, the measuring-unit concept, the full-disclosure concept, and the time-period concept with respect to financial reporting inhealth plans

Discuss the realization principle and the matching principle with respect to revenue andexpense recognition under generally accepted accounting principles

Distinguish between accrual-basis accounting and cash-basis accounting

To ensure that a company maintains its accounts according to the qualitative characteristicsdiscussed in the previous lesson, the accounting profession has developed specified concepts,principles, and guidelines that all companies should follow. Among these ideas are the costconcept, the measuring-unit concept, the full-disclosure concept, the time-period concept, therealization principle, the matching principle, and the various accounting bases. We discuss eachof these in the following sections.

Cost Concept

An extension of the going-concern concept is the cost concept, also called the historical-costconcept, initial-recording concept, or the acquisition-cost concept, which states that companiesshould report items on their financial statements according to the actual cost of those items at thetime of purchase. For example, the value of an asset that a company will report in its accountingrecords is the actual amount paid for an asset—its historical cost—not the asset's current marketvalue.

The current market value, also called fair market value or simply market value, is the price atwhich an asset can be sold under current economic conditions. On the date of purchase, an asset'shistorical cost is equal to the asset’s book value. An asset's book value is the value at which theasset is "booked," recorded, or carried in the company's accounting records, specifically itsgeneral ledger. Periodically and systematically, an asset’s book value may be adjusted underspecified circumstances.

An underlying assumption of the cost concept is that the original acquisition cost represents theasset's market value at the time of purchase. The basis for this assumption is the concept ofreliability, because a company's acquisition cost of an asset is more objective and reliable, forexample, than is an appraisal of the asset's current market value or a manager's opinion of theasset's value. Also, a company can objectively verify the asset's historical cost through sourcedocuments such as sales invoices or property deeds.

Conversely, while the historical cost of an asset offers objectivity and reliability, it may lackrelevance, particularly for assets held for a long period of time. When investors and otherinterested parties consider the value of a company's assets, they are usually less interested in thevalue of those assets at the time of purchase than in their current market value.

The only certain way to identify an asset's current market value is to sell the asset. All othermethods of determining current market value are only estimates, and estimates can be misleading.Appraisals, management influence, and constant market fluctuations make it difficult to assigncurrent market values to many assets. Further, the cost and time required to determine the currentmarket value of many assets on a recurring basis is impractical for most companies. Therefore,accounting authorities have decided that the reliability provided under the cost concept generallyoutweighs the loss of relevance.

Measuring-Unit Concept

The measuring-unit concept, also called the stable-monetary-unit concept, the unit-of-measurement concept, or the stable-dollar concept, states that a company should record theamounts associated with its business transactions in monetary terms, such as U.S. dollars. Thereare two assumptions regarding the measuring-unit concept: (1) that the appropriate unit ofmeasure for business transactions is money and (2) that the measuring unit's value is stable overtime. Recall that a company includes in its financial statements only those transactions that it canrepresent in monetary terms.

In the United States, companies report virtually all financial statement items in dollar amounts.Some exceptions occur on financial statements. For example, the number of outstanding shares ofa company's common stock is not a dollar amount. Similarly, verbal descriptions of a company'saccounts as well as supplementary information and notes to the financial statements providevaluable accounting information that is not given solely in dollar amounts. Ultimately, though,the bulk of accounting information consists of monetary values.

The measuring-unit concept has two major limitations. First, significant items or facts that do nothave a precise, measurable monetary value are not quantified or included in a health plan’sfinancial statements. These items include, for example, a health plan's effectiveness in providingcustomer service, the morale of its employees, its intellectual capital, its goodwill (in effect, thevalue of the health plan’s brand name), and the condition of the health plan's property, plant, andequipment. These factors, while significant, are not easily measurable in monetary terms.

Second, unlike most measuring units, money is not stable over time. From one year to the next,for example, the square footage of land in an acre does not change. However, the value of a dollarchanges over time. The amount of office supplies that a dollar will buy this year may not be thesame amount it will buy next year. Therefore, if the purchasing power of a measuring unitchanges significantly, then the measuring-unit concept can limit our ability to analyze andcompare a company's financial statements over time.

Suppose a company purchases a piece of real estate for $50,000. Ten years later, it sells the realestate for $100,000. The company then reports a $50,000 capital gain (the excess of sale priceover purchase price) on the sale of the real estate. However, if the purchasing power of the dollarhas declined by half during the 10-year period, the company is no better off in terms ofpurchasing power than it was 10 years before. That is, because $50,000 ten years ago could buythe same amount as $100,000 today, the company has made no real "gain" in purchasing powerbecause of the changing value of the dollar, which is the measuring unit.

Despite these limitations, accounting authorities still consider the measuring-unit concept to be avaluable tool. Like the cost concept, the measuring-unit concept provides objectivity andreliability, even though its relevance may fluctuate as the value of the measuring unit itself

fluctuates. Accounting authorities prefer that companies avoid the subjectivity involved incontinually estimating the changing value of a measuring unit. They do, however, recognize thatwhen significant changes occur in a measuring unit's value, users of a company’s financialinformation should become aware of the fact. For example, during periods of high inflation (ageneral increase in the price level of goods and services), the FASB has required U.S. companiesto disclose in their annual reports the potential impact that high inflation has on the dollar valueslisted in their financial statements.

Full-Disclosure Concept

The full-disclosure concept, also called the adequate-disclosure concept, states that financialstatements must contain all material information about a company and that the company mustdisclose any additional information or fact that, by its omission, could mislead an interested userof the accounting information. The full disclosure concept implies the inclusion of every item thatis material, relevant, reliable, and comparable, as well as understandable, to provide to aninterested user a fair presentation of a company's financial statements.

The full-disclosure concept points to the critical role of notes, schedules, and supplementaryinformation that accompany financial statements. The full-disclosure concept does not require theinclusion of excessive details, however. For example, an independent financial analyst is no betterinformed about a company's financial strength if the company clutters its balance sheet withdetailed descriptions of every government security that the company owns. In this case, summaryinformation is more useful.

Typical disclosures are notes and supplementary information regarding the nature and substanceof contingent liabilities (to provide a cushion against various special risks), other commitments,significant lawsuits, potential losses, and the accounting methods and policies used in preparingthe financial statements. Beyond these points, other information requiring disclosure is open toprofessional judgment. Decisions rendered in recent U.S. court cases have broadened thedefinition of the types of information that must be disclosed, so company management has tendedto disclose supplementary information as a matter of course. The Securities and ExchangeCommission (SEC), the FASB, and other sources of accounting standards have also reinforcedthe importance of fair, accurate, and complete financial statements.

Time-Period Concept

The time-period concept, also called the concept of periodicity, states that a company's financialstatements should report the company's business operations during a specified time period. Thistime period, called an accounting period, is a specified length of time during which a company'sbusiness transactions are recorded, summarized, and reported.

Typical accounting periods are one month, one quarter, and one year. Any specific accountingperiod is in itself arbitrary, given the assumed indefinite life associated with the going-concernconcept. However, the alternative to artificially imposed accounting periods is to postpone acompany's financial statements until the end of the company's life, when all debts are paid and allinvestor claims are settled. Because many individuals need financial information periodicallyduring the life of the company, the time-period concept has evolved.

The time-period concept assumes that a company can identify an accounting period, reach asuitable cut-off date, and provide summary financial information as of that date. All regulated

companies must file certain financial statements at the end of each one-year period. Mostcompanies also produce financial statements or reports more frequently. These statements, suchas monthly budgets and quarterly statements, are known as interim financial statements or interimreports to distinguish them from annual accounting period statements and reports.

Nearly two-thirds of all companies use the calendar year—that is, from January throughDecember—as a standard accounting period. Most health plans select an accounting period basedon the calendar year because this is the accounting period required for tax reporting and AnnualStatement purposes. Other companies choose to operate on a fiscal-year basis. A fiscal year issimply a 12-month accounting period chosen by a company. A fiscal year may or may notcoincide with the calendar year.

The drawback to the time-period concept is that a company does not complete all of itstransactions within one accounting period. A company continues doing business and makingtransactions without regard to the artificial constraints of periodicity. This is an extremelyimportant issue for health plans because of the variable nature of the many liabilities stemmingfrom enrollees’ ongoing illnesses. First, many illnesses or accidents occur in one accountingperiod but are not reported until subsequent accounting periods. Second, the treatment of manyillnesses and accidental injuries, as well as the length of provider contracts, often extend beyondone accounting period.

Because not all transactions are easily identified with a single accounting period, a company'smanagement must ask the question, "When should we record each revenue and each expense?"To help answer this question, accountants have developed two principles, the realization principleand the matching principle, to match revenues and expenses to each other and to the appropriateaccounting period.

Much of the rest of this lesson describes the principles behind the accounting process thatanswers this question. We will begin by discussing some of the intricacies of two terms that wewill use throughout the rest of this lesson: costs and expenses.

Recognition of Revenues and Expenses

A cost is the amount of a company's resources (assets) consumed or used for any purpose. A costmay be classified either as an expense or an asset. If a cost represents resources that are consumedduring the current accounting period, then the cost is considered an expense. An expense is areduction in a company's assets that applies to the current accounting period. As a very simpleexample, if a health plan buys office supplies today and uses them all today, the cost of thesupplies is an expense for the health plan. Because expenses represent resources consumed duringthe current period, they are sometimes referred to as expired costs. Employee salaries, office rent,and utility charges are all expenses because they are costs paid in exchange for resourcesconsumed during the current accounting period.

If, however, a cost represents a resource that can provide benefits for future periods, then that costmay be considered an asset. Suppose a health plan buys a computer system that the health planassumes will provide it with benefits for the next five years. Because the cost of the computersystem will provide benefits in future accounting periods, this cost is accounted for as an asset ofthe health plan.

Recognition of Revenues and Expenses

We have seen that costs eventually become, or are recognized as, expenses. Both expenserecognition and revenue recognition are critical in determining the amount of a company’s netincome for an accounting period. In accounting terminology, recognition refers to the process ofclassifying an item in a financial statement as one of the following accounting elements: assets,liabilities, owners' equity (or net worth), revenues, or expenses. These accounting elements aredefined in Figure 10B-1.

Generally, a company recognizes revenue when a product is sold and delivered, when a service iscompleted, or when cash changes hands as part of a business transaction. For an item to berecognized, the item must be one of the accounting elements. In addition, the item must bemeasurable, relevant, and reliable. Although revenue recognition (the realization principle) andexpense recognition (the matching principle) are interrelated, we describe them separately.

The Realization Principle

Just as a health plan’s costs do not always become expenses in the same period the costs wereincurred (for example, IBNR claims), a health plan does not necessarily receive all of its revenuesin the same accounting period in which it earned them (for example, premium revenues). As aresult, the health plan follows certain guidelines to match the revenue with its proper accountingperiod, that is, the period in which the health plan has earned the revenue. Under GAAP, therealization principle, also known as the revenue principle or revenue recognition principle, statesthat a company should recognize revenue when it is earned. Generally, revenue is earned at thetime a service is rendered or when a good passes from the legal ownership of a company to thelegal ownership of the customer.

The realization principle requires a company to recognize revenues during the accounting periodin which they have been earned, regardless of when cash changes hands. If the company does notreceive immediate payment in cash, a legal and reasonable expectation should exist that the clientor customer will remit payment in full. A clothing store earns revenue when it sells a sweater, anauto repair shop earns revenue when it repairs a car.

The realization principle applies primarily to the receipt of a health plan’s premiums orgovernment program payments such as Medicare. A health plan earns revenue when itprovides promised healthcare coverage. However, health plans typically receivepremiums in advance of the period during which healthcare services are provided.Suppose a health plan receives an employer’s premiums in advance of when thepremiums are earned (for example, at the beginning of the month of coverage). In thiscase, when the premiums are received for healthcare services provided to or for plan members,the health plan would account for them as an asset, such as Cash, with an offsetting liability, suchas a claims liability account.

The Matching Principle

While the realization principle governs revenue recognition, the matching principle governsexpense recognition. The matching principle states that a company should recognize expenseswhen the company earns the revenues related to those expenses, regardless of when the companyreceives cash for the revenues earned.

A company also matches losses with revenues during the appropriate accounting period. Therealization principle and the matching principle work in tandem. First, a company reportsrevenues according to the realization principle. Next, the company identifies, quantifies, andmatches the expenses required to earn those revenues. Then the company records the expensesaccording to the matching principle. The match between revenues and related expenses does notmean that the amounts for revenues and expenses must be equal. However, this process ensuresthat a company’s net income for an accounting period does not appear artificially or misleadinglyhigh or low due to a mismatch in the timing of expense and revenue recognition. Figure 10B-2summarizes the principles, concepts, and guidelines that all companies should follow formaintaining accounts.

By following the guidelines set forth in the matching principle, a company can prepare itsstatement of operations with an accurate net income or net loss amount for the accounting period.Under GAAP, three approaches to expense recognition are generally allowed: (1) associatingcause and effect, (2) systematic and rational allocation, and (3) immediate recognition.

Associating Cause and Effect

Some costs have a direct association with specific revenues. This direct relationship is known inaccounting as associating cause and effect. Using the approach of associating cause and effect,costs that can be recognized as having a direct relationship to certain future earnings or specificelements of revenue are charged to earnings of future accounting periods instead of being chargedto the current accounting period.

The process of deferring the recognition of expenses until future accounting periods is known ascapitalization. For example, a health plan that uses agents for small group business or individualhealthcare coverage would spread agent commissions over the premium-paying period ofhealthcare coverage. Industry experience, and, in some cases, regulations, determine what itemscan be capitalized, rather than expensed in the current accounting period.

Systematic and Rational Allocation

Sometimes a direct association of cause and effect between expenses and revenues is not clearlyrecognizable or measurable. In such cases, a company uses another method to match revenuesand expenses known as systematic and rational allocation. Systematic and rational allocation isan approach to expense recognition that expenses an asset's cost over its estimated useful life,regardless of when the company realizes revenues from using the asset.

One example of such systematic allocation is asset depreciation. Depreciation is the process ofspreading (allocating) the cost of an asset over the asset's estimated useful life. As with themethod of associating cause and effect, a company capitalizes costs under systematic and rationalallocation. Assume that a health plan spends $1,000,000 one year to buy and install a newcomputer system. The health plan’s management cannot know for certain how long the systemwill provide financial benefits or what its financial benefits will be. Without a recognizable andmeasurable association between cause and effect, the health plan’s management uses the expenserecognition approach to capitalize the cost in the present accounting period, recognize the cost asan asset, and begin systematic and rational allocation.

Suppose the health plan estimates that the useful life of the computer system is eight years,anticipates no salvage value (dollar value at the end of the computer system’s life) for the system,and uses the straight-line method of depreciation (which applies an equal dollar amount ofdepreciation for each year of the computer system’s life). In this case, the health plan records$125,000 ($1,000,000 ÷ 8) as a full year's expense during each year of the system's estimated life.After eight years, the health plan will have expensed (allocated) the entire $1,000,000 cost of thecomputer system.

Immediate Recognition

Sometimes a company cannot match its incurred expenses with earned revenues within anaccounting period, nor can it match the expenses with revenues that it expects to generate in thefuture. Under GAAP, sometimes expenses cannot be matched with revenues, and incurred costsprovide no objectively recognizable future benefits. Neither associating cause and effect norsystematic and rational allocation is an applicable approach for expense recognition. In suchcases, the company uses the immediate recognition approach.

Under immediate recognition, a company recognizes all applicable costs as expenses during thecurrent accounting period. Immediate expense recognition is common under SAP. The fees that acompany pays to lawyers and consultants are typically reported as expenses under the immediaterecognition approach under both GAAP and SAP. Some expenses, such as utility bills, cannot beattributed to one particular type of revenue earned. In such cases, a health plan reports theseexpenses in the accounting period in which they occur, whether or not the health plan can matchthese costs directly with revenues earned.

A company can change its approach for recognizing expenses if the nature of a cost changes overtime. For example, suppose a health plan capitalizes the cost of computer equipment. Thecompany recognizes the cost associated with the equipment over several accounting periods. Butbefore the end of its estimated useful life (and before its total cost has been recognized andexpensed), the equipment becomes obsolete and is discarded. At this point, the health plan canuse the immediate recognition approach to recognize the remainder of the cost as an expense andwrite this amount off as a lump sum in the current accounting period. Figure 10B-3 summarizesthese approaches to expense recognition.

Accounting Bases

The realization principle and the matching principle are both central concepts for a manner ofaccounting called accrual-basis accounting. Another base of accounting that health insurers andsome health plans use in certain circumstances is cash-basis accounting. In the remainder of thislesson, we discuss accrual-basis accounting and cash-basis accounting.

Accrual-Basis Accounting

In accrual-basis accounting, a company records revenues when they are earned and expenseswhen they are incurred, even if cash has not actually changed hands. Accrual-basis accountingrecords revenue according to the realization principle and expenses according to the matchingprinciple. The purpose of the accrual basis of accounting is to record a transaction when thecompany incurs a financial obligation either as the payor or payee. Thus, accrual-basis accountingenables an interested party to view the consequences of obligations incurred by a companywhether or not the company ultimately completes a business transaction.

For this reason, the accrual basis is suitable for measuring a company's profitability, which is aprimary focus of GAAP. For this reason, accrual-basis accounting is a central concept in financialaccounting conservatism. The FASB mandates the use of accrual-basis accounting in financialstatements. Both GAAP and SAP require companies to record their financial transactions on anaccrual basis.

Accrual-basis accounting provides information on the consequences of transactions, including acompany's earnings potential and financial performance. Companies that use accrual-basisaccounting must make adjusting entries to their accounting records at the end of each accountingyear to match revenues and expenses in their financial statements for that accounting period.Typical adjusting entries include

IBNR claims Unearned premiums Unpaid employee wages and salaries

Cash-Basis Accounting

Cash-basis accounting is a system in which a company recognizes revenues or expenses onlywhen it receives or disburses cash. Thus, neither the realization principle nor the matchingprinciple applies under cash-basis accounting. Instead, cash receipts and cash disbursements aretwo of the most important components of cash-basis accounting. A cash receipt is a check,money order, electronic funds transfer (EFT), or other cash transaction that is remitted to acompany as some form of payment. A company records a cash receipt in the same accountingperiod in which it receives the cash. A cash disbursement is the payment of cash by a companyto a recipient.

Under cash-basis accounting, a company records a cash disbursement in the same accountingperiod in which it remits payment. In a pure cash-basis system, a company makes no entries torecord unpaid bills or pending income. Also, the company calculates net income by subtractingpaid expenses from revenues received. In addition, health insurance companies and health plansthat fall under the jurisdictions of state insurance commissioners must report some items on acash basis for statutory reporting purposes.

Accrual-basis accounting helps to match expenses with revenues, a process that typically enablescompanies to develop more relevant, reliable, and comparable financial statements. Because cash-basis accounting does not apply the realization principle or the matching principle, misleadingfinancial statements can result. For this reason, few companies use a pure cash-basis accountingsystem. Further, under GAAP, financial statements must report the results of noncashtransactions, such as depreciation, as well as cash transactions that occur during an accountingperiod.

Most cash-basis accounting is actually a combination of cash-basis and accrual-basis accounting,known as modified cash-basis accounting. For example, because certain premium revenue maynot be legally collectible (such as certain premiums for individual healthcare coverage), it canonly be recorded on a health plan’s books when it is received. On the other hand, a health plan’sinvestment income is legally collectible and earned as of the due date. A health plan thereforetypically recognizes investment income when it comes due rather than waiting until the income isreceived.

Many medical groups use modified cash-basis accounting. Many hospitals use accrual-basisaccounting, except for large capital expenditures. Also, the nature of health plans may lend itselfto modified cash-basis accounting if its use would not result in misleading results concerningIBNR claims, for example. These and other factors are considered before a health plan determineswhether to use a particular base of accounting.

Endnotes

1. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life andHealth Insurance Companies (Atlanta: LOMA, 1997), 141.

2. Ibid., 67.

AHM Health Plan Finance and Risk Management: Financial Statements

Course Goals and ObjectivesAfter completing this lesson you should be able to

Describe the components and purposes of a health plan’s balance sheet, incomestatement, cash flow statement, and statement of owners’ equity

Explain the importance of notes and supplementary information

Provide an example of the relationships among the various financial statements

A health plan’s financial statements are analyzed by both internal and external parties. Internally,for example, managers use a company's financial statements to identify general business trends sothat they can develop appropriate strategies for improving performance in problem areas.Similarly, by studying a company's financial statements, external parties such as investors, ratingagencies, and regulators learn about the company’s financial activities. They gain insight into itsfinancial soundness and its profitability. As a result, they are better able to make informeddecisions about the company's financial prospects.

In this lesson, we introduce you to the primary financial statements and reports used tocommunicate accounting information to external users. General-purpose financial statementsprepared according to GAAP comprise a health plan's annual report. Health plans that areregulated by state insurance departments also prepare an Annual Statement, which must conformto SAP. This lesson focuses on GAAP and the annual report.

An annual report is the yearly report that a company's management sends to its stockholders,policyholders, and other interested parties to describe the company's performance during theprevious year. By law, for-profit, publicly owned health plans must provide an annual report tostockholders.

Generally, the financial statements included in the annual report must be prepared according toGAAP. Typically, if a mutual insurance company provides an annual report to its stockholders,the company prepares its financial statements according to SAP. Not-for-profit health plans arenot required by law to provide interested parties with an annual report. However, some not-for-profit health plans may send an annual report to their policyholders and to other interested partiesas part of communicating their service strength, for example.

Most companies regard the annual report as an important document, not only from an accountingpoint of view, but also from a promotional point of view. An annual report is an opportunity for acompany to promote itself to its current owners and to potential investors and customers.Generally, companies print their annual reports on high-quality paper and include numerousillustrations and graphs.

A company's typical annual report consists of

A letter from the president to stockholders or policyowners A description of financial highlights Financial statements (balance sheet, income statement, cash flow statement, and

statement of owners' equity)

Notes to the financial statements and supplementary information An independent auditor's report

The heart of the annual report consists of the four financial statements and accompanying notesand supplementary information. These financial statements contain the information thataccounting specialists believe is essential for an external user to gain a general understanding ofthe financial condition, activities, and prospects of the company providing the report. This lessonfocuses on these four financial statements and their accompanying notes and supplementaryinformation.

The preparation of financial statements is the end product of financial accounting. The dollaramounts in a health plan's financial statements represent thousands, millions, and even billions ofdollars. Companies usually round these amounts off to the nearest thousand or million. Theheading of every financial statement generally includes three pieces of information: (1) the nameof the company to which the financial statement applies, (2) the name of the statement, and (3)the date of the statement or the accounting period covered by the statement. The date that appearson a company's financial statements is generally the last day of the company's fiscal year or otherapplicable accounting period.

A company that owns more than 50% of the stock of a subsidiary company will usually compileits financial statements for the annual report on a consolidated basis. Consolidated financialstatements are financial statements that include the assets, liabilities, owners' equity, revenues,and expenses of the subsidiary company with those of the parent company. Because the parentcompany controls the subsidiary company, the parent and its subsidiary are considered a singleoperation, despite being separate legal entities.

Parent companies usually provide separate financial information for each subsidiary or line ofbusiness in the annual report. Maintaining separate financial information is particularly useful inmanagement decision making. Separate financial information on subsidiaries and lines ofbusiness is also useful for external parties in situations in which a parent company is consideringthe sale of a particular subsidiary.

Balance Sheet

The balance sheet is a snapshot of a company's financial position as of a specified date andsummarizes what a company owns (assets), owes (liabilities), and its owners’ investments in thecompany (owners’ equity or net worth). We defined assets, liabilities, and owners’ equity inPrinciples for Maintaining Accounts. The amounts listed on the balance sheet represent thecompany’s summarized account balances on the date shown at the top of the balance sheet. In thiscontext, a balance sheet is a static measure of a company’s financial position.

The essential components of the balance sheet are the three account classifications: Assets,Liabilities, and Owners' Equity (sometimes called Net Worth). Every business compiles a balancesheet. The main purpose of the balance sheet is to measure the owners' wealth—typically thismeans what remains after subtracting what a company owes from what it owns on a specifieddate. Figure 10C-1 illustrates the basic components of the balance sheet for a typical health plan.Figure 10C-2 presents an example of GAAP-prepared consolidated balance sheets for a for-profitstock company.

Figure 10C-2. Example of Consolidated Consolidated, , GAAP GAAP--Based Balance Sheets.Sheridan Health Networks, Inc.Consolidated Balance Sheetsas of December 31, 1998($000s)ASSETSCurrent Assets:Cash and cash equivalents $ 290,963Investment securities, at market value 775,652Receivables, net 234,363Other current assets 13,001Total Current Assets $1,313,979Property and equipment, net 28,798Intangible assets 174,627Long-term investments 25,705Other noncurrent assets 12,148Total Assets $1,555,257LIABILITIES AND STOCKHOLDERS’ EQUITYCurrent Liabilities:Medical claims payable $ 330,665Reserves for future policy benefits 120,000Unearned premiums 52,584Accounts payable and accrued expenses 93,110Experience rated and other refunds 63,906Other current liabilities 77,428Total Current Liabilities $ 737,693Reserves for future policy benefits, noncurrent 83,008Long-term debt 217,000Other noncurrent liabilities 11,771Total Liabilities $1,049,472Stockholders’ Equity:Common stock $ 175Treasury stock, at cost (26)Additional paid-in capital 220,578Net unrealized gains (losses) (1,271)

Retained earnings 286,329Total Stockholders’ Equity $ 505,785Total Liabilities and Stockholders’ Equity $1,555,257

Balance Sheet

Not every company or even every health plan has exactly the same account titles as on thebalance sheet depicted here. For example, within the three balance sheet account categories, somebalance sheet accounts are unique to health plans, such as the liability account Medical ClaimsPayable. A detailed discussion of each item that appears on a health plan’s balance sheet isbeyond the scope of this course.

A balance sheet is fundamental to accounting because itdemonstrates a company's fulfillment of the basicaccounting equation:

Not-for-profit health plans typically used the term net worth in place of owners’ equity. Considerthe basic accounting equation as follows:

The left side of the equation (Assets) represents what a health plan, as a separate legalentity, owns.

The right side of the equation (Liabilities and Owners' Equity) represents what the healthplan owes to its creditors and stockholders or policyowners.

Similarly, on the account form of the simplified balance sheet, the left side reports on the healthplan's assets, and the right side reports on the health plan's liabilities and owners' equity. The totalof the left side of the balance sheet must equal the right side—they must balance—just as in thebasic accounting equation.

Remember that the annual report presents GAAP-prepared financial statements that focus on thecompany as a going concern. Thus, a balance sheet answers the following general question: As ofa certain date, what and how much does a company own, what and how much does it owe, andwhat remains for the company's owners? For a health plan, a large portion of what it owns(assets) consists of various investments, such as bonds and other debt securities, stocks and otherequity securities, provider networks, premiums receivable, and goodwill.

Most of health plan’s obligations (liabilities) are medical claims payable and ongoing healthcarebenefits to plan members and individual policyowners. When you review a list of a health plan’sassets, you see, in summary form, what the health plan's managers purchased with the fundsprovided by the health plan's creditors, policyowners, and stockholders.

Under GAAP, a company uses a variety of methods to value its assets depending on the type ofasset and its purpose. For example, a company generally lists its holdings of common stock attheir current market value as of the balance sheet date. Besides current market value, otherbalance sheet accounts may be valued according to historical cost, amortized cost (book value), orthe lower of cost or market. The lower-of-cost-or-market rule values certain assets at historicalcost or current market value, whichever is lower.

The rules for valuing each balance sheet account classification may differ between GAAP andSAP. You should be aware that the GAAP-prepared balance sheet that a health plan presents inits annual report differs from the SAP-prepared balance sheet it presents in the Annual Statement.For example, SAP might result in lower values for admitted assets than would be presented on aGAAP-prepared balance sheet. Admitted assets are those assets that state insurance law permitsto be included on the Assets page of the Annual Statement.2

A balance sheet contains much valuable information about a company's financial position.However, it does not reveal how or why the company obtained particular assets or liabilities. Bycomparing several years of the company's balance sheets, it is possible to form some conclusionsabout the dollar amounts associated with each account classification. It is also possible to discerncertain company performance trends, such as whether the company is increasing its assets or itsliabilities over time.

However, to fully understand the balance sheet in the annual report, you must study theaccompanying notes and supplementary information that apply specifically to the balance sheet.These notes, which may appear on the same page as the balance sheet or in a separate section ofthe annual report, are an integral part of the balance sheet. We discuss these notes later in thelesson.

Income Statement

An income statement shows how much money a company has realized from its operations duringan accounting period, and, ultimately, to what extent the company's general operations during thatperiod resulted in an increase or decrease in its assets. A company's income statement answers thequestion: Do revenues exceed expenses? If so, the company earns net income. Net income is theexcess of an entity’s total revenues over its total expenses. A net loss results when an entity’stotal expenses exceed its total revenues. We defined revenues and expenses in Principles forMaintaining Accounts. Thus, the basic formula for the income statement is

Earlier we compared the balance sheet to a snapshot of a company's financial position as of aspecific date. A balance sheet is in essence a static measure of a company’s financial position ona particular date. In contrast, the income statement is a moving picture of a company's financialperformance over a specific accounting period. In this context, an income statement can bedescribed as a dynamic measure of a company’s operations over time.

Figure 10C-3 shows the general form of a health plan's income statement. Figure 10C-4 depictsthe consolidated income statements for Sheridan Health Networks, Inc. As you can see in Figure10C-4, Sheridan first lists its sources of revenues. Next, Sheridan subtracts its expenses from itsrevenues to obtain its earnings before income taxes. Then, Sheridan subtracts income taxes toobtain its net income or net loss for the accounting period.

While the balance sheet measures a company's financial condition, the income statementmeasures profitability, which is one key to survival for all health plans. Profit is the extra incomeabove that needed to pay for all costs associated with providing benefits, and this profitcontributes to the health plan's retained earnings, an owners' equity account. We discuss retainedearnings later in this lesson.

A company must disclose in its GAAP-based income statement any gains or losses that resultfrom transactions involving (1) the disposition of a business segment called discontinuedoperations or (2) any extraordinary items that are not likely to occur in the future. In addition, thecompany must disclose the impact of any changes in accounting policies on income statementaccounts. Figure 10C-5 defines gains, losses, and extraordinary items.

Because they occur independent of a company's normal business operations, gains and lossesappear separately on a company’s income statement to avoid distorting the company’s incomefrom continuing operations. Suppose a health plan suffered a $1,000,000 extraordinary loss as aresult of a fire at its home office. The health plan would separate this $1,000,000 extraordinaryloss from its income from continuing operations.

Proceeds that a health plan receives from the sale of its home office furniture represent a gain or aloss, not revenue, because the health plan's primary business involves providing healthcarebenefits, not selling furniture. A retail furniture store, however, includes the proceeds from thesale of furniture from its inventory in a revenue account because selling furniture is part of itsprimary business operations. Thus, the account classification of a company's gains and lossesdepends on the company's core business functions.

Income Statement

Earlier we stated the basic formula for the income statement as

We can now expand this basic formula to include gains and losses:

Net income ultimately determines, among other things, whether owners' equity will increase andwhether a publicly traded health plan will be able to pay cash dividends to stockholders. Netincome increases owners' equity while a net loss decreases owners' equity. Generally, this bottomline figure—so called because net income is usually found on the last line of the incomestatement—indicates whether a company is profitable and is likely to remain in business, at leastfor another year.

Cash Flow Statement

The third major financial statement presented in a company’s annual report is the cash flowstatement. The cash flow statement, also called the statement of cash flows, provides informationabout a company's cash receipts (inflows) and cash disbursements (outflows) during a givenaccounting period.

The cash flow statement reconciles the cash the company has on hand at the beginning and at theend of the accounting period. In providing information about a company's cash flows, thisstatement also provides insight into a company's operating, investing, and financing activities. Itanswers the following questions:

How did the company raise cash during the accounting period? How did the company spend cash during the accounting period? Did the company have to sell assets or borrow funds to generate cash? What are the company's likely prospects for generating cash in the future? What is the relationship between the company's cash flows and its net income? Is new product development being financed with debt (borrowing money) or equity

(offering company stock for sale)?

Cash Flow Statement

Figure 10C-6 depicts the typical components of a company’s cash flow statement. Figure 10C-7illustrates Sheridan’s consolidated, GAAP-based cash flow statements.

Like the income statement, the cash flow statement is a dynamic measure that shows a changeover time. In essence, the cash flow statement is a rearrangement of the changes that occurredbetween the current and previous balance sheet, which as we noted earlier, is a static measure of acompany's financial position. The importance of a positive cash flow cannot be overemphasized.A company may have billions of dollars worth of assets, but if it does not have enough cash onhand to cover current expenses, then it may be insolvent—that is, unable to pay bills andobligations as they come due.

Many health plans are cash rich because premiums are received in advance of the provision ofhealthcare services. If a health plan does not accurately estimate its IBNR claims, the health planmay be unable to pay those claims as they come due. On the other hand, having too muchavailable cash may result in idle cash that is not being put to more productive use. As you mightexpect, managing cash effectively is one of a company’s most important tasks.

Figure 10C-7.Example of Consolidated Consolidated, , GAAP GAAP--Based Cash FlowStatements.

Sheridan Health Networks, Inc.Consolidated Cash Flow Statementsfor the year ended December 31, 1998($000s)CASH FLOWS FROM OPERATING ACTIVITIES:Net income $ 56,851Adjustments to reconcile net income to net cashprovided by operating activities:Depreciation and amortization 7,100Gains (losses) on sales of assets, net (9,168)(Increase) decrease in certain assets, net of acquisitions:Receivables, net (6,884)Other current assets (2,327)Other noncurrent assets 719Increase (decrease) in certain liabilities, net of acquisitions:Medical claims payable 70,728Reserves for future policy benefits 7Unearned premiums 5,798Accounts payable and accrued expenses 6,926Experience rated and other refunds 954Other noncurrent liabilities (6,421)Net cash provided by (used in) operating activities $ 124,283CASH FLOWS FROM INVESTING ACTIVITIES:Investments purchased $(686,801)Proceeds from investments sold 463,746Property and equipment purchased, net (28,442)Net cash provided by (used in) investing activities $(251,497)CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from long-term debt $ 60,000Repayment of long-term debt (47,000)Proceeds from the issuance of common stock 60,126Common stock repurchased (53)

Net cash provided by (used in) financing activities $ 73,073Net increase (decrease) in cash and cash equivalents $ (54,141)Cash and cash equivalents at beginning of year 354,104Cash and cash equivalents at end of year $ 299,963

Cash Flow Statement

A company prepares the cash flow statement from information obtained in its balance sheet andits income statement. The cash flow statement is similar to a check register in that both show theamount and the source of any increases or decreases in receipts (cash inflows) and disbursements(cash outflows). In accounting terminology, a cash inflow is a source of funds. The cash receivedby a health plan when it sells an asset becomes a source of funds. A cash outflow is a use offunds. A cash payment to purchase a bond is a use of funds. With respect to balance sheet andincome statement accounts, a company's cash inflows—its sources of cash—increase as a resultof:

Selling an asset for cash (a decrease in an asset account other than Cash) Establishing a reserve for IBNR claims (an increase in a liability account) Issuing common stock (an increase in a stockholders' equity account) Receiving premiums (an increase in a revenue account

Cash outflows have the opposite effect on an insurer's balance sheet and income statementaccounts. A company's cash outflows—its uses of funds—increase as a result of:

Purchasing an asset (an increase in an asset account other than Cash) Paying claims (a decrease in a liability account) Repurchasing a company’s own common stock (a decrease in a stockholders' equity

account) Paying expenses (a decrease in an expense account)

You can calculate a company's net cash flow for an accounting period by using the followingformula:

The net cash inflow or outflow represents the net increase or decrease in cash for the accountingperiod. Net increase or decrease is also known as the net change in cash. Theoretically, the netchange in cash equals the difference between the cash balance (as shown on the balance sheet) atthe beginning of the period and the cash balance at the end of the period.

For example, a cash flow statement dated for the year ended December 31, 2000, accounts for thedifference in the cash balance between the company's December 31, 1999, balance sheet and itsDecember 31, 2000, balance sheet. Changes in a company's cash flow occur as a result of threeactivities:

Operating activities are transactions associated with a company’s major lines ofbusiness; these transactions directly determine a company’s net income. A health plan’soperating activities are generally associated with the sale and maintenance of healthcareservices. These activities include (1)selling healthcare benefit contracts and providingadministrative services, (2)administering and adjudicating claims payments, (3)payingexpenses associated with healthcare services, (4)developing and maintaining providernetworks, and, to a lesser extent, (5)receiving investment income (such as bond interestand dividend income on stocks

Investing activities are transactions that involve the purchase or sale of assets and thelending of funds to another entity. A health plan’s investing activities include(1)purchasing and selling bonds, stocks, real estate, equipment, and other assets, and(2)investing and disposing of subsidiaries.

Financing activities are transactions involving borrowed funds and cash payments to orfrom owners of a stock company. Financing activities include transactions associatedwith (1) issuing, repurchasing, or retiring common stock and (2) borrowing and repayingfunds loaned by creditors. Financing activities for not-for-profit health plans includetransactions that involve additional paid-in capital or contributed capital.

Cash Flow Statement

If for any of the three activities the cash inflows exceed the cash outflows, the result is a net cashinflow from or provided by that activity. If the reverse is true, then the result is a net cash outflowused in or used by that activity. For example, under operating activities, if the company receives$10,000 in revenue and pays $8,000 in expenses, the cash flow statement shows a $2,000 net cashinflow provided by operating activities. Further, under investing activities, if the company sells$150,000 worth of bonds and purchases $160,000 of another corporation’s common stock, thecash flow statement would show a $10,000 net cash outflow generated by investing activities.

The distinction among the cash flows from operating, investing, and financing activities isimportant when a company prepares its cash flow statement. Companies use one of twomethods—the direct method or the indirect method—to prepare this statement. The onlydifference between the two methods is in the computation of cash flows from operating activities.

When using the direct method to prepare the cash flow statement, a company determines net cashflow from operating activities by taking its major types of operating cash receipts and thensubtracting each major type of cash disbursement. The difference between cash receipts and cashdisbursements is the net cash for the period. Although this method seems straightforward, it canbe quite expensive and time consuming to track every cash transaction.

Therefore, many companies uses the indirect method, which begins with the net income figure asreported on the income statement, then reconciles this amount to operating cash flows through aseries of adjustments (additions and subtractions). Cash flows from investing and financingactivities are calculated the same under either method. The cash flow statement depicted in Figure10C-7 was prepared using the indirect method.

The final financial statement we discuss is the statement of owners' equity, which shows thechanges that occurred in the Owners’ Equity portion of the balance sheet. Stock companiestypically call this statement the statement of shareholders’ equity or the statement ofstockholders’ equity. Not-for-profit health plans often refer to this statement as the net worth

statement. Mutual insurers may voluntarily include in their GAAP-based annual report a similarstatement called the statement of policyholders’ equity or statement of policyowners' equity.

A stock company uses the statement of owners' equity to reconcile, or explain, any changes inequity accounts that occur from one balance sheet to the next. This reconciliation is similar to thereconciliation of changes in cash on the cash flow statement.

Events that cause owners' equity accounts to change include the (1) issuance of stock, (2)purchase of treasury stock, (3) retention of net income, and (4) payment of cash dividends onstock. Figure 10C-8 lists and describes the typical components of a stock health plan’s statementof owners’ equity. Figure 10C-9 provides a simplified example of Sheridan Health Networks’consolidated statements of stockholders' equity.

Figure 10C-8 http://www.educode.com/Images/z10c-8.pdf

Figure 10C-9 http://www.educode.com/Images/z10c-9.pdf

Notes and Supplementary Information

Although not considered separate financial statements, notes and supplementary disclosures tofinancial statements are an integral part of a company's annual report. Therefore, analysts do notreview a company's annual report without reading the notes and supplementary information.

Notes to the financial statements, which are factual in nature and disclose the details behindsome of the amounts presented in the financial statements, usually accompany or immediatelyfollow the financial statements in a company's annual report. These notes enable users tounderstand some of the more complex items in the published financial statements. Notes alsoappear on the financial statement pages themselves, either in footnote form or as parentheticalcomments beside a particular line on the financial statement.

Supplementary information usually follows the notes in an annual report. An explanatory note fora company's fixed assets, such as company-occupied real estate, is one example of the additionalinformation that you may obtain from notes to the financial statements. The balance sheetgenerally lists one total for Property, Plant, and Equipment. An accompanying note orsupplemental information will disclose the depreciation method and itemize each component ofthis particular asset. The notes to the financial statements often take up a significant amount ofspace in a company's annual report.

Financial Statement IntegrationA company's financial statements are integrative—that is, they relate to, explain, and complementeach other. The income statement and the cash flow statement are dynamic measures and providethe critical links between the changes in two consecutive balance sheets, which are staticmeasures. Recall that net income in the cash flow statement minus cash dividends paid tostockholders equals the change in retained earnings on the balance sheet between two accountingperiods.

Another relationship between the balance sheet and the income statement is that an increase invarious expenses (income statement accounts) decreases cash or increases short-term or long-term liabilities (balance sheet accounts), depending on the nature of the expense. Note also that

The $56,851 of net income on Sheridan Health Network’s income statement appears inthe statement of owners’ equity and helps explain the change in owners’ equity

The net income figure of $56,851 is also a cash flow provided by operating activities onthe cash flow statement

The owners’ equity section of the balance sheet is a summary of the figures obtainedfrom the statement of owners’ equity, which includes the amount of net income

A net loss in the income statement results in a decrease in retained earnings in the statement ofowners' equity. A net loss is also a cash outflow generated by operating activities on the cashflow statement. Net income is thus the balancing figure between retained earnings on thestatement of owners' equity and retained earnings on the balance sheet.

The indirect method of preparing the cash flow statement demonstrates the interrelationshipbetween the income statement, the balance sheet, and the cash flow statement. Recall that, underthe indirect method, the cash flow statement begins with net income, which is taken directly fromthe income statement. This figure is then adjusted up or down according to changes on thebalance sheet, such as increases or decreases to claims liabilities, and expenses due and accrued.

Endnotes

1. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMA’s Glossary of Insurance Terms,3rd ed. (Atlanta: LOMA, 1997).

2. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life andHealth Insurance Companies (Atlanta: LOMA, 1997), 143.

AHM Health Plan Finance and Risk Management: The Strategic Plan

Course Goals and ObjectivesAfter completing this lesson you should be able to

Define strategic planning, mission statement, and vision statement

Explain the steps in a health plan’s typical strategic planning framework

Describe the purpose of a SWOT analysis and list some attributes that health plansevaluate to determine their strengths, weaknesses, opportunities, and threats

Like the practice of medicine, strategic planning is both an art and a science. Key personnel mustbuy into a health plan’s strategic planning process and commit to the health plan’s strategic plan.The strategic plan itself must be reality-based and operate according to sound finance andaccounting principles. The execution of the plan by personnel is the art, and the operation ofsound accounting principles is the science.

Besides developing an overall strategic plan, a health plan must develop a strategic financial planto support the financial aspects of the health plan’s strategic plan. We discuss the development ofa health plan’s strategic financial plan in the next lesson.

Strategic Planning

Strategic planning is the process of identifying an organization’s long-term objectives and thebroad, overall courses of action that the organization will take to achieve those objectives.1 In thecontext of health plans, strategic planning is the development of a roadmap of how a health planwill achieve success. Before developing this roadmap, however, it is essential that a health planfirst define its purpose and where it would like to go.

The Strategic Planning Process

While there are many frameworks that define the strategic planning process, in this lesson wediscuss a simplified strategic planning process, as illustrated in Figure 11A-1.

The first step in the strategic planning process is to define an organization’s mission and visionstatements. Then the organization conducts both an internal analysis and an external analysis ofits current position. Next, the organization develops its strategic plan, followed by its strategicfinancial plan. Implementation and ongoing monitoring of the organization’s strategic planfollows.

Admittedly, Figure 11A-1 oversimplifies the strategic planning process. The vertical two-wayarrow that runs to the right of the description of the steps in the strategic planning processillustrates that strategic planning is neither linear nor static. Organizations constantly adjust someof their strategies in response to changing conditions and occasionally revise their mission andvision statements as a result of such adjustments.

For example, a health plan may alter its strategic plan as a result of changes in state solvencyrequirements that require the health plan to maintain a higher amount of capital and surplus.Although this change in the health plan’s external environment would not change its mission orvision statements, greater capital and surplus requirements could significantly impact the healthplan’s strategy for entering certain markets. In the following sections, we describe each of thesteps in the strategic planning process

Define Mission and Vision StatementsA health plan defines its purpose and direction bydefining its mission and vision. A mission statement is astatement that succinctly sums up an organization’sreason for existence and overall purpose.2 It is essentiallythe reason for the organization’s existence. One example

of a health plan’s mission statement is

A vision statement, also called a vision, is a statement ofan ideal that an organization would like to achieve; it isintended to inspire enthusiasm and commitment in theorganization’s employees.3 The vision statement defineswhether or not the organization is successful in fulfillingits mission. An example of one health plan’s visionstatement is

Conduct an Environmental Analysis

Figure 11A-1 shows that once a health plan has determined where it wants to go by defining itsmission and vision statements, the health plan must then perform an assessment of the currentinternal and external environment it which it operates. One way of performing this assessment isby using a SWOT analysis. A SWOT (Strengths, Weaknesses, Opportunities, and Threats)analysis is a means of organizing information so that an organization can assess the currentplaying field and determine possible changes in the environment and options for internaladjustments in response to those changes.4

An assessment of a health plan’s strengths and weaknesses looks at the health plan’s internalcapabilities relative to the strengths and weaknesses of its competitors. Similarly, an assessmentof a health plan’s opportunities and threats is a view of external market attractiveness from thehealth plan’s perspective.

Conduct an Environmental Analysis

Ideally, a health plan would be the strongest competitor in an attractive market, and the healthplan’s strategic plan would focus on exploiting the health plan’s strengths to sustain itscompetitive advantage. If the health plan were a strong competitor in an unattractive market, thenthe health plan may use its resources to strengthen the market through advertising. Alternatively,the health plan may choose to build market strength within a more attractive market.

However, after performing a SWOT analysis, a health plan may find that it is a weak player in anunattractive market. In this case, the health plan would probably develop a quick exit strategy. Ifthe market is attractive, but the health plan is a weak player in that market, the health plan willeither focus its strategy on improving its market position or exiting that market to use itsresources to become stronger in other attractive markets. Because local market share is critical toa health plan, a national health plan needs to develop strategic plans that are appropriate to thelocal markets in which they compete and in their national operations. Besides market share, ahealth plan may perform a SWOT analysis to analyze its relationships with the major providers ineach market in which it conducts business.

Strengths and Weaknesses

In the process of developing a strategic plan, the health plan first prepares an objectiveassessment of its internal strengths and weaknesses relative to its competitors. Over time, thesestrengths and weaknesses will change. For example, if a previous SWOT analysis had identifiedas a weakness the benefit design of the health plan’s key product, and the current SWOT analysismay conclude that the new benefit design is a strength. There is no single list of attributes that a

health plan must evaluate, but Figure 11A-2 explains how several key attributes relate to thehealthcare industry.

Note that many of these attributes are linked. For example, distribution, quality, and service areclosely related in that convenient access to healthcare is usually perceived as a positivecomponent of service and quality.

Opportunities and Threats

Threats and opportunities are external factors that could impact the future business of the healthplan. It is critical that a health plan constantly evaluate these external factors and take appropriateaction to defend against the threats and seize the opportunities. In some cases, threats can beturned into opportunities.

For example, legislation that increases expenses for one type of health plan, such as an HMO, iscertainly a threat to a health plan that has a high market penetration of HMO membership. On theother hand, such legislation can also be an opportunity for the health plan to increase the marketshare of its PPO business.

Similarly, changing medical practice patterns can be both a threat and an opportunity, dependingon whether or not a health plan has at least anticipated the changes and adjusted its plan benefitsand price appropriately. The most difficult part of determining a health plan’s threats andopportunities for a SWOT analysis is evaluating whether or not current trends in external factorswill continue. Figure 11A-3 describes some changes which are typical threats to, andopportunities for, a health plan.

Develop the Strategic Plan

A health plan that has developed its mission and vision statements and evaluated its currentposition using the SWOT analysis, is ready to develop its strategic plan. The health plan’sstrategic plan must take advantage of the health plan’s strengths and opportunities and defendagainst its weaknesses and threats.

One framework for developing an health plan’s strategic plan involves using the marketingvariables—product, price, place (also called distribution), and promotion—in combination withhuman resources and information technology. A health plan can manipulate these four marketingvariables as needed in the strategic planning process to help the health plan achieve its goals.

Human resources are a critical component of a health plan’s strategic plan because, in healthplans, often the product is less important than the size and the quality of the product’s providernetwork. Another critical element of a health plan’s strategic plan is information technology,which is essential to provide healthcare services and to comply with financial reportingrequirements. Let’s examine these marketing variables in more detail.

Product, Price, Place, and Promotion

A health plan’s strategic plan must address how the health plan will differentiate its products(product and price), as well as where and how it will sell them (place and promotion)6. A healthplan can differentiate its products by offering a wide variety of benefit choices or achieving asuperior brand name for quality and service.

Alternatively, the health plan can choose to differentiate itself on price alone. The providernetwork is among the most important parts of a health plan’s product because the providernetwork directly affects the health plan’s ability to deliver quality care at a competitive price. Ahealth plan can also differentiate its products through the use of alternate distribution channels oradvertising formats that its competitors are not using.

The strategic plan also addresses the geographic service areas in which the health plan chooses tocompete. Expansion strategies may be called for if the health plan feels it can obtain acompetitive advantage in an attractive market. In this context, expansion can be achieved eitherby (1) entering the market and building a market share, or (2) acquiring an existing market sharefrom a health plan that has been operating in that market.

In addition, a health plan’s strategic plan addresses how the health plan will promote its products.For example, a health plan can choose to sell its products through a direct sales force or throughbrokers and agents. Most health plans use both.

Human Resources

Investments in technology, brand, distribution systems, and the like are important, but to achieveits strategic goals, a health plan will also have to hire and retain highly committed employees whotend to outperform their competitors. Perhaps this is the area where a sustainable competitiveadvantage is most viable for many health plans. For this reason, a health plan’s strategic plan alsotypically includes a plan for attracting and retaining the right employees, who are critical toachieving the health plan’s mission and goals.8

Information Technology

Health plan is an information-intensive industry. Therefore, an information technology (IT)strategy is another critical element in successfully implementing a health plan’s strategic plan. Ahealth plan faces risks and benefits in adopting new IT systems, whether it develops the systemsinternally or purchases them externally. Being the first health plan in a particular market toimplement a state-of-the-art IT system may lead to a service advantage or cost advantage, or both.

If the IT system fails to perform as expected, however, that failure could lead to large costincreases and extensive service problems. Consequently, a health plan should consciously decidewhether to be a leader or fast follower in the use of new IT systems. This decision should be apart of the health plan’s strategic plan. Because acquiring a new IT system is a considerableexpense, a health plan typically conducts a financial evaluation of potential IT capitalexpenditures, and monitors promised results, as a critical part of its IT strategy. If the health planchooses the right IT system—for example, an excellent call center management system ormedical management system—then the health plan will enjoy a competitive advantage untilcompetitors are able to purchase or develop an IT system with similar or superior qualities.

Implement and Monitor the Strategic Plan

Once the health plan has developed its mission and vision statements, conducted a SWOTanalysis, and developed its strategic plan, it must identify the specific actions that it will take toimplement the strategic plan. For example, a statement like “we will achieve a sustainable costadvantage” does not describe how the cost advantage will be accomplished. An example of amore specific action item to achieve a cost advantage is a statement like “we will renegotiate ourhospital contracts to obtain a 10% unit cost reduction.”

A health plan must assign responsibility to specific managers for carrying out such action items.To achieve their assigned action items, the health plan’s managers should also have the authorityand support necessary to undertake their assigned action items. The implementation of a healthplan’s strategic plan is a complex process. As a result, some parts of the health plan’s strategicplan will not go exactly as expected.

Adjustments to the original strategic plan may become necessary. For this reason, health planstypically also develop contingency plans, which are plans designed to minimize the possiblenegative impacts and take advantage of opportunities that changes in the health plan’s operationalenvironment may present. Contingency plans are typically used only if the health plan’s strategicplan is not working. Most contingency plans contain corrective actions. We discuss in the nesxtlesson how a health plan uses contingency planning in developing its strategic financial plan.

A health plan must monitor the effectiveness of its strategic plan in supporting the health plan’smission and vision statements. To determine whether or not a health plan is achieving its vision,the health plan faces a critical task: it must develop and apply means of measuring where it standsin relation to its goals. These measures, called metrics, are developed around key dimensions,such as

Quality—for example, the National Committee for Quality Assurance’s (NCQA’s)Health Plan Employer Data and Information Set (HEDIS)

Service—for example, average telephone wait time Finance—for example, cash flow or net income

Leadership could be defined in terms of market share (service), public policy influence (quality),financial success (finance), or a combination of all three. Other metrics of interest to health plansinclude the health plan’s market share and growth rate. To measure progress toward achieving ahealth plan’s stated vision of being the recognized industry leader, the health plan may measureits outcomes against the performance of other health plans.

Endnotes

1. Academy for Healthcare Management, Health Plans: Governance and Regulation(Washington, D.C.: Academy for Healthcare Management, 1999), 1-16.

2. Ibid.3. Ibid., 10-18.4. Sharon B. Allen, Dennis W. Goodwin, and Jennifer W. Herrod, Life and Health

Insurance Marketing, 2nd ed. (Atlanta: LOMA, 1998), 65.5. “New Marketing Research Definition Approved,” Marketing News (January 2, 1987): 1.6. Philip Kotler, Marketing Management: Analysis, Planning, Implementation, and Control,

8th ed. (Englewood Cliffs, NJ: Prentice-Hall, Inc., 1994), 98–100.7. Henry Mintzberg, Bruce Ahlstrand, and Joseph Lampel, Strategy Safari: A Guided Tour

Through the Wilds of Strategic Management (New York: The Free Press, 1998), 29.8. Stephen W. Forbes, The Life Insurance Company as a Learning Organization (Atlanta:

LOMA, 1998), 67–68.9. Academy for Healthcare Management,Managed Healthcare: An Introduction, 2nd ed.

(Washington, D.C.: Academy for Healthcare Management, 1999), 8-11.10. Ibid., 8-15.

AHM Health Plan Finance and Risk Management: The Strategic Financial Plan

Course Goals and ObjectivesAfter completing this lesson you should be able to:

Distinguish between a health plan’s strategic financial plan and operational budget

Describe the purpose of the financial planning function in for-profit and not-for-profithealth plans

Define debt and equity with respect to a health plan’s capital structure

Define cost of capital and the capital asset pricing model

Calculate a health plan’s weighted average cost of capital

Explain the purpose of a health plan’s pro forma financial statements

List some key drivers of a health plan’s pro forma income statements and balance sheet

Define sensitivity analysis and describe how a health plan uses the optimistic, mostlikely, pessimistic scenario modeling and Monte Carlo simulation

After a health plan has developed a draft of its overall strategic plan, the health plan can begindeveloping its strategic financial plan. One of the main goals of a health plan’s strategic financialplan is to assess the long-term financial feasibility of the health plan’s overall strategy. The focuson long-term goals distinguishes a strategic financial plan from an operational budget, which is acomponent of the strategic financial plan that has a short-term focus.

A strategic financial plan is a long-term plan, expressed in monetary terms, that describes howan organization will achieve the goals established in the overall strategic plan. An operationalbudget is a short-term budget that covers all or part of an organization’s operations.1 Figure 11B-1 presents a comparison of a health plan’s strategic financial plan and its operational budget. Wediscuss budgets and other short-term financial management tools in Management Control.

A health plan’s strategic financial plan must be consistent with the health plan’s financial policyand realistically project the desired financial results with an acceptable level of risk. Before wediscuss the development of a health plan’s strategic financial plan, we examine the role offinancial planners in a health plan and the development of a health plan’s financial policy.

The Financial Planning Function

A health plan must be financially sound to fulfill its mission and meet its vision. The financialplanning function in a health plan ensures that the health plan remains financially healthy andcomplies with all external and internal financial reporting requirements. This statement is truewhether the organization is a publicly held, for-profit health plan or a not-for-profit health plan.

Both types of organizations need to generate cash and accounting profits to reinvest in corebusiness functions to ensure ongoing operations. The tasks associated with the financial planningfunction are typically performed by a health plan’s employees in the finance, accounting,investments, and/or contracting areas. The difference in the finance role between for-profit andnot-for-profit health plans is relatively minor, as shown in Figure 11B-2.

Financial Policy

In setting financial policy, a health plan essentially determines the amount of financial risk thehealth plan is willing to accept. Typically, there is a tradeoff between the possibility of fastergrowth and the assumption of higher financial risk.

Although a health plan should establish adequate internal controls to ensure that its assets are notbeing misused, some health plans may want to, or even have to, tolerate more financial risk withrespect to their assets than other health plans tolerate. However, there can be negativeconsequences if a health plan assumes too much risk. The following scenarios show the potentialconsequences associated with a health plan's assumption of too much financial risk.

If a health plan experiences several catastrophic cases during the year as a result ofrelaxing its underwriting guidelines to enter a new market. This scenario could cause thehealth plan’s capital and surplus to fall below the minimum thresholds set by regulators.

If a health plan increases the amount of its debt significantly to develop a new product.This scenario could cause the health plan’s activity ratios to fall below levels set forth indebt covenants, which stipulate the conditions with which the health plan must complyfor the health plan to continue to borrow money. (We discuss activity ratios in FinancialStatement Analysis in health plans.)

If a health plan invests in long-term assets such as real estate, which generally cannot besold quickly for cash. This scenario could cause a temporary cash shortage for the healthplan, which would be unable to pay its providers, creditors, or vendors on a timely basis.

Any of the above examples of financial risk can lead to a health plan’s insolvency if not quicklycorrected. Health plans, therefore, must set policies to minimize the exposure to these financialrisks, which relate to capital structure, the cost of capital, and investments.

Capital Structure

Like all companies, health plans have essentially two sources of capital: equity and debt. Equityis a form of ownership in an organization. In an existing organization, equity can typically begenerated through (1) surplus or retained earnings or (2) a stock issue. Equity owners of a for-profit organization expect a return on their investment and eventually hope to receive futureprofits, either through dividends or through an increase in the stock price.

The other key source of capital is debt, which is a form of creditor interest in an organization.Debt can be obtained typically through (1) bank loans or (2) a bond issue. An organization’s debtholders are also investing in the organization and expecting periodic interest payments and theeventual return of their principal (the borrowed amount). Depending on the amount of debt andequity an organization has, the organization may have either a debt structure or an equitystructure.

From an organization’s perspective, debt is obviously more risky than equity, but is almostalways less expensive than equity. Debt is less expensive than equity for the following tworeasons:

1. Compared to an organization’s equity holders, its debt holders have a prior legal claim tothe organization’s assets. From the investors’ perspective, debt has less risk than equity,so investors typically are willing to accept a lower return on debt.

2. Because the interest that an organization pays on its debt is tax deductible (for a for-profitorganization), the tax shield (or savings) lowers the total cost of the organization’s debt.Although not-for-profit organizations typically do not pay income taxes or receive thebenefit of the tax shield, they can sometimes issue debt and pay tax-free interest to theinvestor, who in turn accepts a lower interest rate.

To manage the financial risks associated with conducting its business, a health plan needs todetermine what it costs the health plan to obtain capital by each of the different capital financingmethods. An organization’s cost of capital is the overall rate of interest or dollar amount that theorganization pays for the long-term funds that it employs.5 Calculating a health plan’s cost of debtis relatively easy. It is essentially the same as the average interest rate the health plan is paying todebt holders, adjusted for the tax shield.

Estimating a health plan’s cost of equity is a bit more complicated, however. The cost of equity isusually calculated using the capital asset pricing model (CAPM), which uses beta and the marketreturn to help investors evaluate risk-return tradeoffs in making investment decisions. Accordingto the CAPM, the cost of equity is equal to an investor’s risk-free rate—for example, the interestrate on a U.S. Treasury bond—plus an adjustment that considers the market rate, at a given levelof systematic (nondiversifiable) risk.6 Investors can diversify to eliminate nonsystematic(diversifiable) risk. In the CAPM, beta is a measure of systematic risk.

A common misconception is that a not-for-profit health plan has a zero percent cost of equitysince it has no investors expecting a return. Because not-for-profit health planlth plans obtaintheir equity primarily from retained earnings, their cost of capital is typically related to operatingcosts. Also, a not-for-profit health plan’s customers, which can be thought of as its owners, valuetheir cash and will want it used in such a way that will generate value for them. Therefore, a not-for-profit health plan might reasonably apply a beta from a similar publicly held company incalculating its cost of equity.

After a company determines its cost of debt and its cost of equity, then the company can calculateits weighted average cost of capital. The weighted average cost of capital (WACC) is the overallcost that a company pays to obtain new funds from all sources.7

Suppose a health plan’s capital structure consists of 25% debt and 75% equity and that the healthplan’s average after-tax cost of debt is 5% and its cost of equity is 11%. Using WACC, the healthplan has a weighted average cost of capital of 9.5% [(5% × 25% debt) + (11% × 75% equity)], asshown in Figure 11B-3.

The 9.5% rate calculated using WACC can be used as a hurdle rate for setting the health plan’sfinancial policy. In our example, if the health plan establishes 9.5% as the hurdle rate for capitalinvestments, any investment that is expected to earn a return of more than 9.5% should add valueto the health plan. Ultimately, establishing a policy for capital structure involves a tradeoffbetween increasing financial risk and decreasing the cost of capital.

Investment Policy

A typical company must generate working capital (current assets – current liabilities) to operate.A typical health plan, however, collects its premium from its customers before the month inwhich healthcare services are provided, while it often pays providers several months after theyhave performed healthcare services for plan members. Between the time a health plan collects itspremium and pays all of the associated claims or medical expenses, it holds cash, which ismanaged by the health plan’s treasury function. For many health plans, investment income issignificant in dollar amount, even if it is not significant in percentage terms of the health plan’stotal income.

In many cases, regulators provide some parameters on the type and amount of investments ahealth plan can make, but a health plan also has some latitude in its choice of investments. Stockshave historically yielded the highest returns, followed by long-term bonds (those with maturitiesof 10 years or longer), with short-term bonds (those with maturities of one year or less) yieldingthe lowest returns.

A health plan develops an investment policy that guides the health plan’s mix of debt and equityinvestments. A health plan’s investment policy typically must be approved by the health plan’sboard of directors. Such a policy usually establishes guidelines for matching the expected cashflows from investment income to the expected cash outflows for provider reimbursementexpenses, for example. A health plan’s investment policy also establishes risk and return targetsfor the health plan’s investments.

Developing the Strategic Financial Plan

Once a health plan develops its financial policy, including the debt and equity targets it needs tofund its business, and determines the policy it will follow in making investments, the health plancan develop its strategic financial plan. The core of the strategic financial plan is the developmentof the pro forma financial statements: income statement, balance sheet, and cash flow statement.

Pro Forma Financial Statements

Pro forma financial statements are financial statements that project what a company’s financialcondition will be at the end of an accounting period, assuming that the company achieves itsobjectives.14 Because the pro forma financial statements are a forecast (projection), a companyhas to create, review, and revise pro forma statements several times to make them useful in thestrategic financial plan.

After developing a few iterations of pro forma financial statements, a health plan reviews itsstrategic financial plan to see if the plan produces acceptable and reasonable financial results. If itdoes, the health plan then conducts sensitivity analysis, discussed later in this lesson, to determineif the assumptions made in the health plan’s strategic plan are likely to occur.

A health plan also typically develops contingency plans for use in the event of changes in themarket environment or in the health plan’s underlying assumptions. After the strategic financialplan is developed and reviewed, the health plan can begin implementing its plan. As part of theimplementation process, a health plan develops a list of early indicators of success and failure.We discuss each of these steps in developing, reviewing, implementing, and monitoring a health

plan’s strategic financial plan in the following sections. After the strategic financial plan isdeveloped and reviewed, the health plan can begin implementing its plan. As part of theimplementation process, a health plan develops a list of early indicators of success and failure.

It is critical that the same senior management that developed the overall strategic plan activelyparticipates with the finance function in developing and evaluating the pro forma financialstatements. Key assumptions that are used in developing a health plan’s pro forma financialstatements must be aligned with both the health plan’s SWOT analysis and its overall strategicplan. Minor, or more predictable, assumptions can be made by the finance function with little orno outside help.

Before developing the pro forma financial statements, it is useful for a health plan’s seniormanagement to agree on some global assumptions. For example, in developing the pro formafinancial statements, a health plan must decide on what rates to assume for

Overall inflation Medical services inflation Utilization Interest

Upon determining these rates and any other necessary global assumptions, a health plan can begindeveloping its pro forma financial statements. Typically, health plans spend most of their time onthe key assumptions that will drive the projected financial results. The first pro forma financialstatement that we examine is the pro forma income statement.

Forecasting the income statement is the most critical of the three financial statements, as it alsodrives the development of the balance sheet and cash flow statement. As a result, errors inforecasting the income statement will flow through to the balance sheet and cash flow statements.For this reason, forecasting the income statement typically requires much participation from ahealth plan’s senior management.

In forecasting the income statement, a health plan starts with the key drivers of revenues andexpenses. Figure 11B-4 shows some high-level drivers and the impact strategic decisions willhave on making these forecasts. The health plan’s management forecasts premium revenues andmedical expenses by product type (for example: HMO, PPO, POS, etc.), estimating price and unitcosts (for example, PMPM) and then multiplying by volume (membership).

It is critical that the assumptions used in developing the pro forma income statement beconsistently linked to the overall strategic plan. For example, if a health plan’s strategy calls for a15% annual increase in premium revenues, then the health plan’s prices and membershipassumptions must realistically support this. If the assumptions cannot support this, the strategymust be revisited.

Health plans that have allowed the desired financial results to drive the assumptions, instead ofhaving the assumptions drive financial results, risk developing unrealistic strategic financialplans. Therefore, a health plan’s senior management attempts to resist any pressure to useunrealistic assumptions in order to make the financial results acceptable.

One question that is often asked in the process of developing a pro forma income statement is“How aggressive should the net income projection be?” There is no single answer to this

question, but many health plans use a 50% probability of achieving or exceeding the forecastednet income level. Projections set too low do not cause the organization to perform to its potential,while unrealistically aggressive forecasts tend to frustrate and de-motivate the organization.

Pro Forma Balance Sheet

Much of the pro forma balance sheet is derived from the operating assumptions a health planmade in developing the pro forma income statement. As a result, a realistic pro forma incomestatement will usually result in a realistic pro forma balance sheet. Recall that a health plan’sbalance sheet lists the health plan’s assets, liabilities, and owners’ equity as of a specified date.

Figure 11B-5 describes some of the key drivers of assumptions used in developing the assets andliabilities portions of a health plan’s balance sheet. This figure also provides examples of somestrategic questions that a health plan must consider in developing its pro forma balance sheet.

Note that changes in the product or payor mix can impact a health plan’s current assets andcurrent liabilities. For example, a health plan whose product mix contains an HMO, rather than aPPO, may experience a lower IBNR liability if more providers are paid on a capitated basis.

In creating a health plan’s pro forma balance sheet, financial assumptions, such as the assumptionthat the health plan will issue debt or equity, must be supported by the health plan’s overallstrategic plan. Also, the health plan must ensure that it will have the needed cash available toimplement its strategic plan. We explore these types of assumptions in the next lesson.

Pro Forma Cash Flow Statement

Recall that the cash flow statement is derived from the income statement and the balance sheet.Nonetheless, it is essential that a health plan review its pro forma cash flow statement, becausethis review provides insight into whether the health plan can achieve the forecasted incomestatement and balance sheet.

Another key use of the pro forma cash flow statement is that it can be used to calculate the netpresent value of the health plan’s strategic plan. In other words, the pro forma cash flowstatement shows, in terms of cash inflows and cash outflows, the impact of a health plan’sstrategic plan on the health plan’s cash.

Reviewing the Strategic Financial PlanBecause the development of a health plan’s pro forma financial statements is an iterative process,it requires a number of revisions until the health plan has a set of workable (reasonable) financialstatements. In reviewing the pro forma financial statements, the health plan may want to seekanswers to the following questions in determining if desired results are to be reflected in thesefinancial statements:

Do results reflect a historical performance trend? Have predicted growth rates andearnings ever been sustained in the health plan industry in this market? Althoughchanges in the market and changes in the health plan’s strategic plan will producedifferent results from the past, it is especially important to look for forecasts thatresemble hockey sticks—that is, flat in the beginning with steep improvementsprojected—without a reasonable explanation for the performance improvement.

If the forecasted results look outstanding, wouldn’t they invite a competitorresponse, such as a new market entrant? Has this prospect been accounted for in thepro forma financial statements?

Are the forecasted operating ratios and financial ratios within the limits of the healthplan’s financial policy and investment policy? Do they meet the externalrequirements of regulators and lenders? Are measures such as net income growthand return on equity acceptable to the health plan and its owners? (We discussfinancial ratios in Financial Statement Analysis in health plans.)

If the forecasted financial results are still unacceptable, it is critical for the health plan to revise itsstrategy. Changing the assumptions so that they produce the desired financial outcomecompletely defeats the purpose of preparing both the strategic plan and the strategic financialplan.

Sensitivity Analysis

The strategic financial plan we have so far developed is based on a single set of assumptions andresults in a single outcome. The probability of that single set of assumptions occurring isessentially zero because there is uncertainty concerning the assumptions used in developing thestrategic financial plan. Because of this uncertainty, sensitivity analysis is recommended as partof the strategic financial planning process.

Sensitivity analysis is a process of taking the key assumptions made in the strategic plan andestimating a range of uncertainty concerning these assumptions. In this way, sensitivity analysismeasures the downside risk and upside potential of the strategic financial plan, and it allows forthe development of contingency plans for use when the plan’s implementation does not go asintended.

Sensitivity Analysis

In performing sensitivity analysis, a health plan typically models only the key assumptions thatare likely to make a significant financial impact on the health plan. These key assumptions mightinclude market growth, pricing and cost assumptions, and new market entrants. Predicting markettrends and competitor actions is a necessary, though imprecise, activity.

There are several recommended methods of performing a sensitivity analysis. A commontechnique used in health plans is to perform a what-if analysis of a range of values for key factors.For example, a health plan might conduct a what-if analysis for medical inflation rates in a rangeof 0% to 10% to see how a percent change in the assumed medical inflation rate would affect thepotential outcome of its strategic financial plan. In the following sections, we discuss the use ofoptimistic, most likely, pessimistic scenario modeling and a Monte Carlo simulation. Figure 11B-6 compares the results obtained under these two methods.

Optimistic, Most Likely, Pessimistic Scenario Modeling

As the name implies, optimistic, most likely, pessimistic scenario modeling involves preparingtwo more sets of pro forma financial statements, in which key assumptions are revised to projecta set of optimistic outcomes and a set of pessimistic outcomes to accompany the forecasted plan,which represents the most likely scenario.

A health plan defines what the optimistic scenario and pessimistic scenario mean in terms of itsprobability (likelihood) of occurring. Some health plans use a 10% probability that the outcomeswill be optimistic and a 10% probability that the outcomes will be pessimistic, with respect to thestrategic financial plan, which represents the most likely scenario. In this example, the health planexpects that its most likely scenario will occur with an 80% probability. There is a 10%probability that the financial outcomes will be lower than expected and a 10% probability that thefinancial outcomes will be higher than expected.

Monte Carlo Simulation

Although optimistic, most likely, pessimistic scenario modeling is useful, it yields only threepossible outcomes out of a distribution of infinite possibilities. To obtain a distribution ofpossible outcomes, a health plan may conduct a Monte Carlo simulation.

A Monte Carlo simulation is a risk analysis technique in which probable future events aresimulated on a computer, using a random number generator, to produce a distribution of possibleoutcomes.17 A Monte Carlo simulation defines the strategic financial plan’s key assumptions—such as medical inflation rates and utilization rates—in terms of mathematical formulas that canbe correlated to each other or analyzed independently. A health plan might use a Monte Carlosimulation to predict the distribution of expected claims. This information would be useful innegotiating risk-sharing arrangements with the health plan’s providers.

A Monte Carlo simulation results in more robust insights about the potential outcomes of a healthplan’s strategic financial plan, as illustrated in Figure 11B-6. In our example, the Monte Carlosimulation shows that there is a 6.7% probability (calculated by adding all the probabilities of netincome below zero: 2.6% + 4.1%) that the health plan will have a net loss in the year 2003. Theoptimistic, most likely, pessimistic scenario model cannot address this possibility.

Contingency Planning

After performing a sensitivity analysis, a health plan then prepares contingency plans to minimizethe downside risk that changes in the market environment can exert on the health plan. Inaddition, contingency plans enable the health plan to take advantage of opportunities that suchchanges may present. Contingency plans contain alternative actions that a health plan can take to

respond to market changes. Examples of events for which a health plan may develop contingencyplans include

Price wars New competitor entrants Low cost strategy failing Bad publicity

Admittedly, it is impossible to prepare plans for every contingency. However, it is important for ahealth plan to have plans drafted and ready to implement when critical assumptions do not go asplanned.

Implementing and Monitoring the Strategic Financial Plan

After a health plan’s senior management has approved the strategic plan and the strategicfinancial plan, management may present these plans to the board of directors to obtain formalapproval. In such cases, the health plan’s board of directors periodically reviews managementreports on the health plan’s progress toward achieving its strategic objectives.

Parts of the approved strategic plan should be communicated throughout the health plan.Everyone in a health plan should know the health plan’s mission and vision, as well as thesupporting goals and values. Communicating the health plan’s mission and vision statements andits strategic goals to employees and other interested parties helps focus the efforts of the healthplan to achieve its mission. The strategic financial plan, however, is a document that should beclosely guarded, because the health plan would not want it to end up in the hands of competitors.

A health plan’s strategic financial plan is a working document that the health plan uses to manageits progress toward achieving strategic goals. This means that health plans need to compare theiractual performance with their forecasted performance to determine the amount of any variance(difference). These variances, which include not only financial performance, but also quality andservice performance, must be analyzed and corrective actions must be taken.

Early Indicators of Key Success Factors

The healthcare environment is changing far too quickly for a health plan to wait until the end ofan accounting period to determine whether or not its strategy is working. Therefore, a health planshould develop a short list of early indicators of key success factors and closely monitor theachievement of these factors. A health plan must constantly monitor early indicators of keysuccess factors and make the appropriate adjustments to the strategic financial plan as changesoccur. For this reason, the early indicators of key success factors must be performance measuresthat a health plan can use to track progress toward achieving its strategic goals.

Early Indicators of Key Success Factors

Assume that a health plan’s strategic plan includes a goal to increase plan membership by 30%next year. The health plan intends to achieve this objective by holding premium rate increases to4% in a market in which competitors typically increase their annual premium rates by 12%.Suppose the health plan then learns that its competitors are matching the health plan’s 4%premium rate increases.

If the health plan has already hired additional employees to accommodate its anticipated 30%increase in plan membership, then the health plan’s administrative expenses could increasesignificantly without an accompanying increase in premium revenues. In this case, the health planwould have to make the necessary adjustments in its strategic financial plan, perhaps throughdeveloping alternative means of achieving the plan membership increase or otherwise offsettingthe increased administrative expenses that would result from hiring additional employees.

Management Incentives and the Strategic Plan

Assume that a health plan’s strategic plan includes a goal to increase plan membership by 30%next year. The health plan intends to achieve this objective by holding premium rate increases to4% in a market in which competitors typically increase their annual premium rates by 12%.Suppose the health plan then learns that its competitors are matching the health plan’s 4%premium rate increases.

If the health plan has already hired additional employees to accommodate its anticipated 30%increase in plan membership, then the health plan’s administrative expenses could increasesignificantly without an accompanying increase in premium revenues. In this case, the health planwould have to make the necessary adjustments in its strategic financial plan, perhaps throughdeveloping alternative means of achieving the plan membership increase or otherwise offsettingthe increased administrative expenses that would result from hiring additional employees.

For publicly held health plans, stock options provide a vehicle for linking incentives to achievingthe strategic financial plan, because better financial results ultimately lead to higher stock prices.Stock options are an executive incentive whereby a company offers to sell its stock to itsexecutives at an identified price on a specified date. It is in the executive’s interest for thecompany to do well, so the stock’s value will rise. If the stock’s value does rise, the executivemay, by exercising the stock options, be able to buy the company’s stock at a price below thestock’s market value.18

Privately held health plans can use management incentives such as long-term bonuses, which aretypically based on obtaining three-year results, or they can issue phantom stock. A phantom stockis an incentive, issued to a privately held company’s employees, that is similar to a publiclytraded stock, but its price is set by a formula. The formula is typically described in the company’sstrategic plan, and the value of the phantom stock is dependent on the company’s achievement ofits strategic goals.

Endnotes

1. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life andHealth Insurance Companies (Atlanta: LOMA, 1997), 535.

2. Thomas Reichmann, Controlling: Concepts of Management Control, Controllership, andRatios (Berlin: Springer-Verlag, 1997), 211.

3. Mulligan and Stone, 126.4. Ibid., 188.5. Susan Conant et al., Managing for Solvency and Profitability in Life and Health

Insurance Companies (Atlanta: LOMA, 1996), 34.6. Lawrence J. Gitman and Michael D. Joehnk, Fundamentals of Investing, LOMA ed.

(New York: HarperCollins, 1995), 160–161.7. Conant et al., 497.

8. Gitman and Joehnk, 157.9. Ibid., 141.10. Ibid., 336.11. Ibid., 154.12. Ibid.13. Conant et al., 386.14. Mulligan and Stone, 525.15. Conant et al., 167.16. Ibid., 133.17. Eugene F. Brigham, Fundamentals of Financial Management, 7th ed. (Fort Worth, TX:

The Dryden Press, 1995), 397.18. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMA’s Glossary of Insurance Terms,

3rd ed. (Atlanta: LOMA, 1997).

AHM Health Plan Finance and Risk Management: Case Study: Lifelong Health, Inc.

Course Goals and Objectives

After completing this lesson you should be able to

Apply the concepts discussed in The Strategic Plan and The Strategic Financial Plan in acase study environment

In this lesson, we present a simplified case study to illustrate the development of a strategicfinancial plan, including sensitivity analysis techniques and the development of contingencyplans.

The case study begins with a brief overview of the market and competitive situation facing afictitious health plan, Lifelong Health, Inc. (Lifelong). We examine the development ofLifelong’s pro forma income statement, balance sheet, and cash flow statement. Next, we see howassumptions made on Lifelong’s pro forma income statement flow through to its pro formabalance sheet and cash flow statement. In Financial Statement analysis in health plans, we willreturn to Lifelong in our discussion of ratio analysis.

Although Lifelong’s pro forma financial statements are in the form of high-level summaries, theycontain enough information so that you may conduct an internal analysis. Note that there aremany other ways to present internal statements. For example, many health plans do not includeinvestment income as part of operating income, but group it with other income or in a separate netof investment expenses category.

Background Information

Lifelong is the largest provider of healthcare in Major City, a large, midwestern city. Lifelong is ahealth plan that has two products: an HMO and a PPO. Lifelong, along with its three keycompetitors—Global Health, Graymount HMO, and Sage Healthcare— has a 75% share of themarket in their city. Figure 11C-1 provides a Summary SWOT analysis that includes adescription of Lifelong and its competitors, as well as an analysis of the competitive playing field.

Lifelong’s Strategic Plan

Lifelong’s mission statement is “to provide superior healthcare at a reasonable cost to employersand plan members.” Lifelong’s CEO, Dr. Susan Chandler, believes that Lifelong can compete asthe health plan leader in price, quality, and service. Dr. Chandler notes that, “in this business, youcan decrease costs by eliminating unnecessary procedures. Doing so benefits the plan member,the provider, and the payor, and ultimately results in more affordable premiums for healthcarebenefits.”

Dr. Chandler believes that the practice of medicine must become more of a science, particularlythrough using statistically proven medical protocols. Dr. Chandler has identified the followingkey actions in Lifelong’s strategic plan.

Lifelong’s vision is to dominate health plans in Major City and to be recognized as one of themost progressive health plans in the country. Lifelong has recently converted from a not-for-

profit company to a for-profit company and has aspirations of going public. However, Dr.Chandler has asked that the assumption that Lifelong will issue common stock be excluded fromLifelong’s pro forma financial statements. Because financial markets can be unpredictable, Dr.Chandler does not want to rely on a public offering of stock to raise funds for achievingLifelong’s strategic goals.

Current Financial Situation

Lifelong’s finance department has prepared financial statements to reflect Lifelong’s historicalfinancial performance in 1997 and 1998 and has prepared pro forma statements (forecasts) for thenext five years. (Note that, in practice, the transition between the last year of a company’shistorical performance and the first year of its forecasted performance does not always neatlycoincide with the end of an accounting period. For example, forecasting 1999 results typicallyoccurs before a company’s 1998 accounting period is over. As a result, the company’s 1998 yearusually reflects eight or nine months of actual results, combined with forecasted results for therest of 1998. For the purposes of this simplified case study, we assume that Lifelong had access toactual results for the entire 1998 accounting period.)

Figure 11C-2 shows Lifelong’s 1997 and 1998 summary income statements and some data onplan membership and the average prices for its products. In their review of Lifelong’s financialperformance for 1998, Dr. Chandler and senior management agree that 1998 has been adisappointing year for Lifelong. Look at the “Net Income/Loss” line in Figure 11C-2. For 1997,Lifelong experienced net income of more than $14 million, but in 1998 Lifelong suffered a netloss of nearly $7 million—quite a change from the previous year. This net loss is Lifelong’s firstunprofitable year in more than a decade.

Note that, while Lifelong experienced a net loss, plan membership for both its products increased.Look at the “Membership” line in Figure 11C-2. At the end of 1997, total plan membership was507,500, but it increased to 530,100 by the end of 1998, representing more than a 4% increase.This growth in membership occurred despite the fact that Lifelong held its prices nearly flat in1998, as can be seen in the “Average Price” and “Average Price Increase” lines in Figure 11C-2.

Recall that Lifelong’s fourth strategy action item was to increase HMO membership, in part bymigration from its PPO product. This strategy obviously did not occur as planned, so Lifelongmust examine the price relationship between its HMO and PPO products. Dr. Chandler, in ameeting with Lifelong’s board of directors, pointed to the following areas as contributing toLifelong’s poor performance in 1998:

Lifelong’s inability to control costs, particularly pharmacy costs, which were growing ata much faster rate than forecasted

Competitors Graymount, Global, and Sage Healthcare reduced their prices in 1998,leading to lower-than-planned membership growth for Lifelong. Dr. Chandler noted thatLifelong’s key competitors also experienced losses in 1998.

Anti-HMO sentiment sweeping the nation, combined with Lifelong’s low PPO priceincrease, caused HMO membership to grow less than planned.

Dr. Chandler told Lifelong’s board of directors that “the good news is that the price war is over.Lifelong’s competitor analysis points to average price increases in the 6% to 8% range for HMOproducts and 10% to 15% range for PPO products.” Lifelong’s strategic plan calls for greater

price increases for its PPO product than for its HMO product, but price increases are expected tobe lower than those of its competitors.

Development and Review of Lifelong’s Pro Forma Financial Statements

As mentioned earlier, Lifelong’s finance department, working closely with its strategic planningteam and senior management, has produced a set of pro forma financial statements for the years1999–2003. The finance department is about to present these pro forma financial statements toDr. Chandler for her initial review. As with any pro forma financial statement, Lifelong’sstatements were prepared using certain assumptions.

In the following sections, the finance department explains to Dr. Chandler the underlyingassumptions on which the pro forma financial statements were based. Also presented are ananalysis of Lifelong’s current financial situation and recommendations for changes to Lifelong’sstrategic plan to ensure favorable financial results over the next five years.

Review of Assumptions

Figure 11C-3 (saved in AHM 520 as z11c-3)includes the membership and pricing assumptionsthat Lifelong used in developing its pro forma financial statements. Lifelong’s 1997 and 1998historical financial performance are repeated here for convenience.

Note that the assumptions were built around each of Lifelong’s products—the HMO and the PPO.It is impossible to develop a pro forma income statement without looking at an organization’srevenue drivers and cost (expense) drivers. Revenue drivers and cost drivers can best bedetermined by estimating membership and price and costs per member per month. As you can seefrom Figure 11C-3, Lifelong assumes very different membership growth rates and prices for eachproduct over the next five years. In the more complex real world, the assumptions would have tobe built around several different products with different funding mechanisms in several differentgeographic areas.

The Finance Department explained the following points concerning their assumptions to Dr.Chandler:

Pricing will be consistent with Lifelong’s strategy for PPO members to migrate to theHMO.

HMO membership is projected to pass PPO membership by 2001, and will representmore than 60% of Lifelong’s total membership by 2003.

Margin, as a percent of revenue, deteriorated most rapidly in the PPO product in 1998,and even with 12 % annual price increases will never reach 1997 levels. HMO productmargins will quickly approach 1997 levels.

Costs are projected to rise much faster in the PPO product than in the HMO product,mainly as a result of higher utilization rates.

The HMO cases will have a higher medical intensity than the PPO cases, becauseutilization rates are expected to decrease as a result of improvements in medicalmanagement techniques. As a result, only the sickest HMO patients will be hospitalized.

Pharmacy cost increases will slow down, although they will still significantly outpaceinflation.

Lifelong has the following immediate concerns:

Membership increases will not materialize because of premium rate increases that aremuch higher than the previous year. Early indicators by Lifelong’s sales department,however, suggest Lifelong will be well on its way to achieving its 1999 membershiptarget upon completion of the January 1, 1999, open enrollment period.

Medical costs will again increase faster than forecasted, rendering Lifelong’s priceincreases inadequate to cover medical costs. For example, medical costs that rise only1.5% faster than Lifelong’s forecast will cause 1999 to be another year in which lifelongrecords a net loss.

Lifelong’s key long-term risk is that public sentiment and regulations will continue to beunfavorable to the HMO product. In response, Dr. Chandler requested that a contingency plan bedeveloped for possible mid-year price changes and that an early indicator system be developed aswell so that, if needed, the contingency plan could be implemented on very short notice.

Dr. Chandler also asked the finance department to conduct an analysis, using assumptions thataddress an unfavorable market, so that Lifelong can develop an alternate pricing strategy to use inadverse market conditions. Finally, Dr. Chandler recommended that the finance department,along with the sales department, explore the possibility that Lifelong develop a POS productwithin a year.

Review of the Pro Forma Income Statement

In the pro forma income statement shown in Figure 11C-4 (saved in AHM 520 as z11c-4),Lifelong’s premium revenue (membership × price PMPM × 12 months per year) and its medicalexpenses flow from the assumptions depicted in Figure 11C-3. Lifelong’s “Other Revenue,”shown in Figure 11C-4, consists mostly of investment income from its cash and marketablesecurities.

The finance department’s analysis of Lifelong’s pro forma income statement is as follows.Net income as a percent of revenue nearly doubles 1997 levels by the year 2003, in spite of the

fact that Lifelong’s gross margins (revenues minus expenses before interest and taxes) as apercent of revenue are expected to be below 1997 levels.

The projected net income increase is a result of administrative cost projections falling from10.4% of premium in 1998 to only 6.7% of premium in the year 2003. This decrease is driven by(1) unusual severance costs at the end of 1998 due to a one-time 10% work force reduction and(2) productivity improvements due to implementing an information technology system andachieving benchmarking levels.

(Note that Lifelong’s administrative cost percentages would be more realistic if each year’spercentage were increased by 5%—for example: 15.4% of premium in 1998 and 11.7% ofpremium in 2003. Note also that Lifelong needs to address the work force reduction, given itsexpected plan membership increases over the next five years.)

Dr. Chandler’s response was, “I’m committed to both holding 1999 administrative costs flat andaddressing our employee morale problem.” She pointed out that the strategic financial plan allowsa 4% average pay increase per year. In addition, Dr. Chandler asked the finance department to runa scenario to include administrative costs that are 5% higher than the original projections. Dr.Chandler also reiterated the importance of developing a contingency plan in the event of a mid-year price change.

Figure 11C-5 depicts Lifelong’s pro forma balance sheet. Lifelong’s assumptions and its proforma income statement indicate an optimistic five-year period for Lifelong. The financedepartment, however, pointed out the following two concerns on the balance sheet:

Equity as a percentage of Lifelong’s annual premium is projected to fall from more than36% in 1997 to less than 29% in the year 2003. This decrease is expected to occur, inspite of a record net income margin, because fast membership growth outpaced the needfor capital.

Cash and investments as a percent of annual premium are projected to fall from over 79%in 1997 to less than 47% in 2003, as shown in the Key Statistics line in Figure 11C-5. Inother words, Lifelong had cash on hand and investments that total more than ninemonths’ worth of premium in 1997, but by the year 2003, Lifelong’s cash andinvestments are projected to drop to less than six months’ worth of premium.

The projected decrease in the ratio of cash and investments to Lifelong’s premium is beingcaused in part by the

Repayment of $100 million bond in the year 2001, as shown in the Long-Term Debt lineof Figure 11C-5

Decline in claims, including IBNR claims, from 30% (1997) to only 20% (2003) ofannual medical expenses

The decrease in the ratio of claims to annual medical expenses is a result of the higher mix ofHMO plan membership, for which Lifelong compensates a greater proportion of its providersthrough capitation. Recall that, under capitation, a health plan pays its providers at the beginningof the service period, before services are rendered. Therefore, Lifelong has less cash on hand toinvest from premiums received at the beginning of the month if it also has to pay its providers atthe beginning of the month.

Dr. Chandler is uncomfortable with the expected direction of these two ratios because these ratioswould begin to violate Lifelong’s existing financial policy, which specified a minimum 70% ratioof cash to annual premium. In other words, Lifelong’s cash on hand needs to be at least 70% ofLifelong’s annual premium. Dr. Chandler also expressed concern that the direction of therelationship between Lifelong’s equity and its percentage of annual premium eventually mightapproach regulator thresholds. She requested the following scenarios be run:

Assume that Lifelong refinances, rather than pays off, the $100 million in bond debt thatmatures in the year 2000.

Assume that Lifelong raises its premium, which in turn would slow Lifelong’s growth inplan membership (Note that increasing the forecasted price without decreasing planmembership would be letting the answer drive the assumption.).

Assume that Lifelong engages in an initial public offering of stock.

Recall from Assignment 10 that the cash flow statement ties the income statement and balancesheet together, thus providing some interesting insights about a company’s financial conditionand performance. Figure 11C-6 depicts Lifelong’s pro forma cash flow statement.

The finance department made the following points concerning the cash flow statement:

Although 1998 will be a year of negative $6.9 million net income (a net loss), cash flowfrom operations was projected to be a positive $6.5 million. The $13.4 million differenceprimarily results from the increased claims, including IBNR claims. Establishing realistictargets for provider contract negotiations will be critical.

The trend of cash from operations being higher than net income is projected to reverseitself by the end of the forecast period, because Lifelong will pay a greater proportion ofits providers in advance.

Dr. Chandler commented that she felt confident about being close to having a solid forecast. Sheasked that the next review incorporate the changes discussed. She then handed out copies of apage entitled “The Seven Keys to a Sound Strategic Financial Plan,” shown in Figure 11C-7. Dr.Chandler noted that Lifelong’s strategic financial plan has assumptions that are consistent with itsstrategic plan. She also acknowledged that the projected results would stretch the team, but wereachievable.

Dr. Chandler asked that more sensitivity analysis be performed and scheduled a separate meetingto develop contingency plans. She noted that early indicators, including PMPM targets, seemedlike a good way to stay on top of achieving Lifelong’s strategic goals. Dr. Chandler asked thatLifelong’s vice president of human resources be invited to the next meeting so that he could startthinking about linking incentive compensation to the plan. Dr. Chandler concluded her commentsby stating that “the strategic plan and the strategic financial plan are working documents andshould constantly be reviewed to determine what is working and what needs to be changed.”

AHM Health Plan Finance and Risk Management: Financial Statement Analysis

Course Goals and ObjectivesAfter completing this lesson you should be able to:

Differentiate between a health plan’s external analysts and internal analysts and describethe types of financial information each one seeks

Distinguish between horizontal analysis and vertical analysis of an health plan’s financialstatements

Analyze the trends a health plan exhibits using trend analysis

List and apply the information contained in a common-size financial statement

Explain how to use cash flows that are reported in the cash flow statement to revealfinancial information that is not immediately apparent from a health plan’s balance sheetand income statement

Financial statements provide glimpses of a health plan’s past performance and current condition,and they can be one of the tools used to predict its future success. Financial statements are also aprimary means for a health plan to communicate information to various audiences, includinginternal managers, creditors, regulators, stockholders or policyholders, employers and other plansponsors, and plan members. But financial statements require interpretation; otherwise, they arenothing more than columns of numbers.

Financial analysis, also called financial statement analysis, is a process that assesses acompany’s financial performance and position and compares the company with other companieswithin and outside its industry. The balance sheet, the income statement, and the cash flowstatement are the financial statements typically used in conduct

External Analysis and Internal Analysis

Recall from Health Plan Financial Information that a variety of external and internal users offinancial information are interested in a health plan’s financial statements. Many of these peopleand organizations analyze the health plan’s financial statements. Each party has different goalsand purposes for conducting financial analysis.

Just as we discussed users of financial information in the context of internal and external users,we separate the people that are interested in financial analysis into external and internal analysts.Both types of analysts use some or all of the following techniques: horizontal analysis (includingtrend analysis), vertical analysis (including common-size financial statement analysis), ratioanalysis, and benchmarking.

External analysis is financial analysis performed by someone outside of the company beinganalyzed. Most external users of a health plan’s financial information conduct financial analysisthemselves, but some also rely on analysis conducted by other external parties. Examples ofexternal parties that typically conduct their own analysis include investment firms, publicaccounting firms, regulatory authorities, and independent organizations such as the NationalCommittee for Quality Assurance (NCQA), A.M. Best, Standard & Poor’s, and Moody’s.

Employers and other plan sponsors, plan members, and individual stockholders usually rely onpublished analytical materials. Note that most external analysts, whether they conduct financialanalysis themselves or rely on analyses conducted by others, want comparative data—that is, theywant to note a health plan’s financial condition and performance in comparison with that of otherhealth plans.

Internal Analysis

Internal analysis is financial analysis undertaken by employees of the company being analyzed.Usually, a health plan’s managers conduct internal analysis (1) to maintain awareness of theneeds and interests of all external parties and (2) to determine where to allocate health planresources to support growth and ongoing business operations.

Although external analysts usually have available to them only published reports and financialstatements, internal analysts may access additional financial information that is typically notreleased to the public. As a result, internal analysis can be more detailed and more specific thanexternal analysis.

Some types of internal analysis compare two or more accounting periods to determine trends infinancial performance. For example, in the case study in Case Study: Lifelong Health, Inc., thesenior management team at Lifelong Health, Inc. reviewed Lifelong’s historical financialperformance for strategic planning purposes. Other types of internal analysis compare one healthplan’s performance with the performances of other health plans, or even other companies, toevaluate the performance of specific management personnel and individual departments orfunctions within the health plan.

Comparative Financial Statements

A health plan’s financial statements are an important source of financial information for bothexternal analysis and internal analysis. However, numbers on a financial statement, when viewedin isolation, usually do not tell a complete story about the health plan’s financial condition orperformance.

Suppose a health plan made $120 million in claims payments in 2003. The relative importance ofthis amount would depend on the relationship between the amount of claims payments and theamount of premium income the health plan earned in 2003, the number of plan members in thehealth plan’s health plan, the amount of claims payments made in other years, and so on.

Financial analysts obtain additional insight by relating one set of numbers to another set ofnumbers or by analyzing the change in one or more numbers over a period of time. For example,to determine the amount of cash needed to pay IBNR claims, an health plan can analyze thehistorical relationship between the health plan’s premium revenues and IBNR claims. Then thehealth plan can determine an estimated percentage of premiums that will be necessary to meet itsIBNR claims liabilities.

One approach to addressing the limitations of analyzing a health plan’s financial statements out ofcontext is to use comparative financial statements. Comparative financial statements arefinancial statements that present a company’s financial information for two or more accountingperiods side by side. In other words, comparative financial statements enable a financial analystto review any changes in a health plan’s financial statement items from one year (or any other

accounting period) to the next. Both internal and external analysts use some or all of thefollowing techniques: horizontal analysis (including trend analysis), vertical analysis (includingcommon size financial statement analysis), ratio analysis, and benchmarking.

Horizontal Analysis

Comparative financial statements are useful in conducting horizontal analysis. Horizontalanalysis measures the numerical amount that corresponding items change from one financialstatement to another over consecutive accounting periods. Horizontal analysis shows the absoluteamount of the increase or decrease in an item, along with the percentage increase or decrease. Theearliest period being used in the analysis is known as the base period, because all comparisonsare made with the amounts and percentage relationships of items in the base period.

Horizontal analysis is fairly straightforward. Tocompute the percentage change using horizontalanalysis, subtract the base period amount from theamount of the period being studied. Next, divide thatresult by the base period amount. Finally, multiply thetotal by 100 to put the answer in percent form, asindicated in the following equation:

Figure 12A-1 shows Sheridan Health Networks (Sheridan’s) 1997 and 1998 consolidated balancesheets. We will use the information in this figure to conduct a horizontal analysis of Sheridan’sbalance sheet items.

Notice that Sheridan had total assets of $1,555,257 (in$000s) in 1997 and total assets of $1,664,555 (in $000s)in 1998. Recall that the focus of horizontal analysis isthe percentage change between the two periods. In ourexample, assume that 1997 is the base period and that1998 is the period under study. The percentage changein total assets from 1997 to 1998 is:

Thus, Sheridan experienced a 7.03% increase in total assets from 1997 to 1998. Figure 12A-2(saved in AHM 520 file 12A-2) illustrates Sheridan’s income statements from the same twoyears.

To perform a horizontal analysis of Sheridan’s sellingexpenses in 1997 and 1998, look at the selling expensetotals in Figure 12A-2 for each year. Next, notice thatSheridan incurred $65,131 (in $000s) in selling expensein 1997 and $68,259 (in $000s) in selling expense in1998. Once again, the base period is 1997. Thepercentage change in selling expense is

This information indicates that Sheridan’s selling expense increased nearly 5% from 1997 to1998. A health plan’s annual report may contain up to five years of financial statements. A healthplan’s Annual Statement—which is required if the health plan is regulated under state insurancerequirements—includes at least two years of financial statements. Therefore, similar calculations

can be made for every category on two or more of a health plan’s financial statements, whetherthey were prepared under GAAP or under SAP.

Trend Analysis

Although our example compares just two consecutive accounting periods, health plans frequentlyprepare comparative balance sheets, income statements, and cash flow statements across severalaccounting periods. One form of horizontal analysis used to address changes across multipleaccounting periods is trend analysis.

Recall from Pricing and Rating that trend analysis involves the calculation of percentage changesin financial statement items over several consecutive accounting periods, they were preparedunder GAAP or under rather than over just two accounting periods. Trend analysis is useful indeveloping a health plan’s premium rates to charge for a given level of healthcare benefits. Trendanalysis is also useful in constructing an health plan’s strategic plan.

Both the direction and the velocity of trends are important factors that can be determined fromanalyzing a health plan’s comparative financial statements. The term direction refers to whether atrend displays an increase or decrease in account amounts. The term velocity refers to whether theincrease or decrease in an account is gradual or rapid. Examining the direction and velocity oftrends enables an analyst to compare trends in relative items.

Analysts may describe the direction of a trend as positive (an increase in total revenues) ornegative (an increase in total expenses). Likewise, the velocity of a trend may be described asgradual, stable, or rapid. For example, a financial analyst may describe the velocity of Sheridan’sincreasing premium income as

Gradual - if the trend is increasing at a rate greater than 2%, but less than or equal to 3%,per year

Stable- if the trend is increasing at a rate less than or equal to 2% per year, per year Rapid - if the trend is increasing at a rate greater than 3% per year

To conduct trend analysis across multiple accounting periods, first select a base period and assignthe base period an index number of 100. The use of an index number provides a statistical methodfor measuring the change in a variable. The next step in this process is to calculate a series ofindex numbers by reference to the base period.

If the amount of the period being studied is higher than that of the base period, then the resultingindex number will be greater than 100. If the amount of the period being studied is lower thanthat of the base period, then the resulting index number will be lower than 100. For example, anindex number of 120 indicates a 20% increase between the base period and the period beingstudied. An index number of 80 indicates a 20% decrease between the base period and the periodbeing studied.

After determining the index number for the base period, apply the equation for calculatingpercentage changes used in horizontal analysis to determine the percentage increase or decreasefor each period under study. Then, apply the percentage change to the base period’s index numberof 100. Finally, analyze the change in the period under study to determine the trend.

Figure 12A-3 provides information we can use to perform a simplified trend analysis, using thedirection and velocity of trend, as applied to the Wholesome health plan’s comparative incomestatements. Note that, for our simplified example, premium income is Wholesome’s only cashinflow; claims payments and selling expenses are Wholesome’s only cash outflows. Also notethat both premium income and claims payment expenses increased during the three-year periodunder study, but selling expenses remained stable for two years, then declined in 1998.

Let’s apply the equation from horizontal analysis for calculating the percentage changes inincome and expenses to the information in Figure 12A-3. Assume that 1996 is the base period.Figure 12A-4 (saved in AHM 520 as z12a-4) shows how trend analysis is performed for theseincome statement items.

In this case, Wholesome’s net income decreased 50% in 1997 from the base year 1996 and 80%in 1998 from the base year 1996. Let’s focus on analyzing the changes in these four incomestatement items—premium income, claims payment expenses, selling expenses, and netincome—for 1997 and 1998.

Figure 12A-4 , note that the percent increases in claims payment expenses (20% in 1997 and 40%in 1998) outpaced those of premium income (10% in 1997 and 20% in 1998), despite a decreasein selling expenses (0% in 1997 and 5% in 1998). The result is a significant decrease in netincome (50% in 1997 and 80% in 1998).

Keep in mind that, whenever the base period amount is greater than the amount of the periodunder study, the resulting percentage change is a decrease. In our example, the direction of trendfor Wholesome’s net income is a decrease for both years (a 50% decrease in 1997 and an 80%decrease in 1998). The velocity of trend for Wholesome’s net income is rapid—a 50% decrease in1997 and an 80% in 1998—given the same criteria that were given for the Sheridan exampleearlier in this lesson. The disparity between cash flows into and out of a health plan, which isindicated through an analysis of the health plan’s comparative financial statements, would triggeran investigation by the health plan’s management.

Both the direction of trend and the velocity of trend in premium income are positive forWholesome because this represents an increase in cash inflows. Although the direction of trend inselling expenses is positive for Wholesome, it is not enough to offset the direction of trend inclaim payments expenses. Also, the velocity of trend is worthy of serious consideration becausethe flow of money out of Wholesome is increasing each year. This example depicts an extremetrend in net income. In practice, Wholesome’s management should have addressed this disturbingtrend long before 1998.

Comparative financial statements often present the year-to-year (or other accounting period-to-accounting period) changes in absolute amounts as well as percentages. An analyst shouldconsider both the amount and the percentage change. A large percentage change, either in anegative or a positive direction, is significant only if the item being analyzed is consequential. Forexample, a 50% decrease in a health plan’s petty cash may be deemed insignificant, but a 50%decrease in the health plan’s premium income is cause for alarm.

External financial analysts and health plan managers generally use trend analysis to identifyfinancial statement accounts or other items that appear unusual. However, trend analysis cannotbe used to express fluctuations between negative amounts and positive amounts as indexnumbers. For example, index numbers cannot describe the change in net income from -$1,000 (anet loss) in one period to $1,000 (net income) in the next period. Also worth noting is thatpercentage changes are relevant only when compared with the base period amount. To comparepercentage changes between the amounts of two other accounting periods, one of those periodsmust become the new base period.

Insight 12A-1 is an example of the use of trend analysis to note changes in HMO enrollment,revenues, and net income from 1993 to 1997.

Vertical Analysis

As we have seen, horizontal analysis highlights changes in a financial statement item over time.Vertical analysis is a type of financial analysis that indicates the relationship of each financialstatement item to another financial statement item. Usually the item to which all other items arecompared is critical to a health plan’s financial performance.

For example, to conduct vertical analysis of a health plan’s balance sheet, an analyst divides eachasset item by total assets, and divides each liability or stockholders' equity item by total liabilitiesand stockholders' equity (or total liabilities and capital and surplus on a SAP-based balancesheet). The combined percentage totals of all asset accounts or liabilities and stockholders' equityaccounts should equal 100. On a health plan’s income statement, each item is typically stated as apercentage of total revenues, which equals 100%. In other words, an analyst divides each item bythe health plan’s total revenues.

Figure 12A-5 shows a vertical analysis of Sheridan’s consolidated balance sheets for 1997 and1998. The analysis in Figure 12A-5 uses total assets for each respective year as the denominatorfor performing a vertical analysis of Sheridan’s assets.

Sheridan’s balance sheets show that, for 1997, current assets represent 84.5% of Sheridan’s totalassets. Note also that investment securities represent a large percentage of Sheridan’s total assets:49.9% in 1997 and 48.7% in 1998. Sheridan’s percentage of net receivables increased slightly in1998 from 1997.

On the liabilities and stockholders' equity side of the balance sheet, Sheridan’s current liabilitieswere 47.4% in 1997 and 48% in 1998 of total liabilities and stockholders’ equity. Remember thatthe dollar amount of total assets must equal the dollar amount of total liabilities and stockholders’equity on the balance sheet. Sheridan's stockholders’ equity was 32.5% of total liabilities andstockholders’ equity for both years.

Care should be taken when determining the significance of vertical analysis percentages ofdifferent years. Sometimes a percentage change may seem unimportant, but the dollar amount ofthat change may be critical to a health plan. For example, although the percentage increase inSheridan’s net receivables was relatively small—from 15.1% in 1997 to 16.5% in 1998—thedollar amount ($40,573,000) was significant. Recall that net receivables are primarily premiumreceivables that are amounts owed to a health plan for services that have already been provided.In this case, Sheridan’s management would most likely review its collections procedures andother factors to determine the cause of an increase in net receivables, then take the appropriateaction to reduce the amount of receivables.

Common-Size Financial Statement Analysis

Vertical analysis uses percentages to relate different financial statement items to a specified, totalamount on the statement. Vertical analysis can also be used to compile a common-size financialstatement, which is a financial statement that displays only percentage relationships to a specifieditem; there are no dollar figures for each item. Balance sheets and income statements are oftenexhibited as common-size statements.

Figure 12A-6 presents Sheridan's 1997 and 1998 common-size consolidated income statements.Each line item is expressed as a percentage of Sheridan’s total revenues for each respective year.In other words, total revenues is the common size to which all other income statement items arecompared.

Analysts use a common-size financial statement to compare the percentages associated with ahealth plan’s current and previous accounting periods. In addition, common-size statements allowa health plan to compare itself to another health plan or to published industry averages. The use ofcommon-size statements also somewhat facilitates the comparison of companies in differentindustries, which is especially valuable to potential investors.

Because all amounts are stated in relative terms rather than absolutes, common-size financialstatements facilitate the comparison of companies of different sizes in the same industry. Forexample, a staff model HMO may compare its PMPM rates to those of other staff model HMOsin its geographic area.

Assume that health plan A’s net income on its 1998 income statement was $450 million and thathealth plan B's net income for 1998 was $150 million. It would be easy to conclude that healthplan A is more profitable because it had a greater net income that health plan B. However, areview of each health plan’s 1998 common-size income statement reveals additional information.

Suppose health plan A’s common-size income statement indicates that health plan A’s net incomeis 3% of its total revenues. Health plan B’s common-size income statement shows that health planB’s net income represents 5% of its total revenues. From another perspective, expenses are 97%of health plan A’s total revenues, whereas expenses are 95% of health plan B’s total revenues.The information provided by common-size income statements suggests that, although health planB's net income is lower, all other factors being equal, health plan B appears to be operating moreefficiently than health plan A.

In the above example, health plan A and health plan B obtain most of their revenues frompremium income. Suppose health plan C receives most of its revenues from administrativeservices only (ASO) contracts for self funded plans. In this case, health plan C will most likely

have administrative expenses that are a higher percentage of its premium income, and premiumincome that is a smaller percentage of its total revenues, as compared with health plan A andhealth plan B, which have few or no ASO contracts. In order to compare the efficiency of healthplan C with that of health plan A and health plan B, some analysts recognize “premiumequivalents,” which include management fee income from ASO contracts.

Benchmarking

Common-size statements are also a useful tool for benchmarking, which is a process by which acompany compares its own performance, products, and services with those of other companies ororganizations that are recognized as the best in a particular category. Benchmarking measures ahealth plan’s performance and practices and helps identify those practices that will lead tosuperior performance in a variety of financial and non-financial areas.

Benchmarking also helps a health plan to assess which performance areas require improvement.Setting specific goals for improvement within an established time frame is a typical outcome ofbenchmarking. Some examples of healthcare practices or financial performance measures thathealth plans typically benchmark with other health plans include wait time in a doctor’s office,independent quality ratings, inpatient length of stay, claims payment turnaround time, and keyfinancial ratios.

Figure 12A-7 lists some additional examples of practices that health plans typically benchmark inthe health plan industry. Note that it is critical for a health plan to benchmark against the sameline of business. For example, when benchmarking its employer group plan, a health plan wouldnot typically compare its results with those of a Medicare plan.

Suppose that, in our earlier example, health plan A’s management discovered that its expenseswere significantly higher than those of health plan B and most other health plans. A next step forhealth plan A’s management probably would involve a review of internal operations and relatedfactors in an effort to decrease expenses so they are within the industry range. This attention toexpenses would ultimately enable health plan A to increase the percentage relationship betweennet income and total revenues.

Health plans and providers can also benchmark against companies in other industries. Forexample, to improve inpatient service, a hospital may benchmark against other hospitals, but itmay also want to benchmark against the hotel industry or the restaurant industry. A health planmay benchmark the quality of its nurse advice line against “best practices” available throughcustomer service lines and call centers provided for customers in the catalog sales industry or inthe mutual funds industry. Alternatively, a health plan may compare its call wait times and lostcall percentages to those of the airline industry. The ideal benchmarking candidates are thosehealth plans or other companies with a high level of performance in the area being studied, andwith similar asset size, business mix, market, and ownership structure.

A health plan’s benchmarking goals should be as explicit as possible. For example, instead ofsetting the general goal of “reducing operating expenses,” a health plan would typically select asa benchmark a similar-sized health plan that is known as an industry leader in operating expensecost control. Using vertical analysis, the health plan could then set the goal of equaling thebenchmarked health plan’s percentage of operating expenses to revenues by the end of thefollowing accounting period. In this case, the health plan could establish a goal of reducingoperating expenses to less than 95% of total revenues.

Cash Flow Statement Analysis

To this point, we have discussed financial analysis as it pertains to a health plan’s balance sheetand income statement. However, a health plan should also analyze its cash flow statement to gaina complete understanding of the health plan’s financial condition. The cash flow statement can bea valuable aid in determining the health plan’s future direction. Recall that the cash flowstatement details the sources and uses of cash by segregating the statement into cash flows fromoperating activities, investing activities, and financing activities.

Analyzing a health plan’s cash flow statement is important for both internal and external analysis.For example, nearly all interested users of financial information prefer that a health plan obtaincash from operating activities because this indicates that a health plan’s core business operationsare healthy and active. Consider the following three circumstances in which a health plan canacquire a $250,000 net cash inflow:

Higher, profitable sales volume (operating activity) The sale of a line of business (investing activity) A stock issue (financing activity)

If you were a potential plan sponsor, under which circumstance would you prefer to contract witha health plan? You would probably prefer the health plan that obtained most of its net cash inflowfrom operating activities, rather than from investing activities or financing activities. High dollaramounts of net cash inflows from operating activities usually indicate soundness in the healthplan’s core business operations. This financial strength in turn enables a health plan to financeand deliver healthcare services to members of your sponsored group.

Similarly, if you were a potential creditor, under which circumstance would you prefer to lendmoney to a health plan, all other factors remaining equal? As a creditor, you would probablyprefer that the health plan obtain most of its revenues from core business operations, because thisincreases the likelihood that the health plan will be able to repay any loans provided by the healthplan’s current and future creditors. Selling a line of business or issuing stock are one-timeactivities that are not likely to be repeated in subsequent years. However, it is possible that ahealth plan could experience increasing revenues on an annual basis.

As a potential investor, you would probably prefer to invest in a health plan that has increasingsales revenues, again because it increases the likelihood that the health plan will be profitable.You might be uneasy about investing in a health plan that just sold a line of business, particularlyone that might have been profitable, or a health plan that has incurred additional debt or dilutedthe potential value of your stock by issuing additional shares of stock.

All other factors being equal, the health plan that obtained $250,000 from an operating activitywould be more attractive to a plan sponsor, creditor, or investor than a health plan that generatedthe majority of its net cash flows (that is, cash inflows minus cash outflows) from financing orinvesting activities. Generally, the larger the cash inflows from operating activities, the better ablea company will be to pay its obligations and to weather unfavorable changes in the economy.Given this information, a health plan’s management could decide to sell an unprofitable line ofbusiness, then use the proceeds from this sale to expand its relatively strong lines of businessagainst competing health plans.

This brief analysis is admittedly simplistic. The point of this illustration is to provide you with apreview of how you might begin to use financial analysis to make rational decisions about ahealth plan’s financial strength or performance. In this example, the health plan’s interestedparties would go beyond this one scenario to consider other factors.

Suppose the health plan obtained higher sales volume, but at significantly higher expenses. In thiscase, the operating activity could be interpreted as a negative factor. What if the health planobtained $250,000 from the sale of an unprofitable line of business? In this case, the investingactivity could be perceived as a positive factor. Likewise, if the health plan issued stock to raisefunds to finance a potentially profitable expansion or acquisition, interested parties could interpret

this factor as a positive one. Figure 12A-8 summarizes a health plan’s typical operating activities,investing activities, and financing activities.

AHM Health Plan Finance and Risk Management: Fundamentals of Ratio Analysis

Course Goals and Objectives

After completing this lesson you should be able to

List and apply the financial ratios under U.S. generally accepted accounting principles(GAAP) that fall into each of these four categories: liquidity, activity, leverage, andprofitability

Recognize and apply the ratios that are most important to health plans

Managers use the information contained in a health plan’s financial statements and otherdocuments to measure the efficiency with which the health plan is achieving the strategicfinancial plan. Recall that a health plan’s strategic financial plan typically includes goals relatednot only to its current financial performance, but also to its growth rate. Financial statementanalysis is an objective technique for measuring a health plan’s performance and its progresstoward a sustainable rate of growth.

One of the most widely used methods of financial statement analysis is ratio analysis. Ratioanalysis consists of comparing various financial statement values for the purpose of assessing ahealth plan’s financial performance or condition. A ratio is a comparison of two or more numbersin fraction form. A ratio may be stated as a fraction; for example, one-half may be written aseither ½ or 1:2. The 1:2 is read as “one to two.”

Because any financial statement item can be related to any or all other financial statement items,many potential ratios exist. But only a limited number of ratios are meaningful, and not all ratiosare applicable to all types of businesses. For example, acceptable ratio results for a health plan aregoing to be quite different from the acceptable ratio results for a clothing manufacturer or a publicaccounting firm.

Ratio analysis should also be conducted with a general understanding of the health plan beingstudied and its environment. Because healthcare costs, benefits, demographics, and forms ofbusiness typically differ regionally—and sometimes across health plans within a specifiedregion—it is important to compare a health plan’s ratios with similar health plans in terms ofthese and other factors.

Published ratios are available for health plans to use in benchmarking specified performanceareas. Also, health plans that are subject to statutory solvency requirements must comply with theestablished ranges of acceptable ratios for risk-based capital (RBC) requirements, which wediscussed in Risk Management in health plans lesson.

Ratio analysis can answer a health plan’s direct (yes or no) questions, such as: “Can short-termliabilities be paid on time?” or “Is the health plan efficiently using its assets to generate profits?”However, ratio analysis does not address "why" questions such as: “Why are current (short-term)liabilities exceeding current (short-term) assets?” or “Why is the health plan unable to pay claimsor reimburse providers within 30 days?” Meaningful ratio analysis serves best only to point outchanges or trends in operating performance and help illuminate the hazards or opportunitiesassociated with normal business operations.

The relationships created by ratio analysis help to highlight a health plan's strengths andweaknesses, thus revealing areas that need attention or additional research. For example, a healthplan’s current assets may seem adequate on the balance sheet, but only when they are applied inthe current ratio can their adequacy be confirmed or contradicted. For this reason, ratio analysis isan important part of a SWOT analysis, which we discussed in The Strategics Planning Process Inhealth plans.

Before proceeding further, a few words of caution. First, other than regulatory mandates forcalculating specified ratios, there are few standards for calculating financial ratios. For example,sometimes the formula for calculating a health plan’s return on assets ratio and its return oninvestment ratio yield the same results; sometimes there is a slightly different formula for eachratio. Consequently, this assignment cannot provide an exact description for every financial ratioused in every analysis. Instead, we review some commonly used ratios and indicate the type ofinformation typically provided by these ratios.

Keep in mind that the calculations in this lesson represent only one way of describing each ratio.Also, because of the nature of the health plan industry, not all traditional financial ratios areapplicable to all health plans. For example, health plans do not typically have inventories, makepurchases or sales on an installment basis, or acquire large amounts of fixed assets. Therefore,ratios involving inventories, most accounts payable, most accounts receivable, and fixed assets,which are common in many industries, are less critical or even lose meaning when applied tohealth plans.

As we noted in Accounting and Financial Reporting, health plans often prepare financialstatements under two different bases of accounting: generally accepted accounting principles(GAAP) and statutory accounting practices (SAP). Recall that statutory accounting is required forthe Annual Statement, which must be submitted by any health plan that must comply with stateinsurance requirements. Note, however, that ratio analysis is also conducted for taxation purposesand that a health plan’s management team may develop specific financial ratios to use inmonitoring the health plan’s progress toward achieving its strategic goals.

GAAP Ratios

This section describes traditional financial ratios that analysts use to study a health plan’s GAAP-based financial statements. It is important for a health plan’s managers to be familiar with theseratios because they should be able to analyze the health plan’s financial statements, as well asthose of other health plans.

In this section we categorize ratios as liquidity ratios, activity ratios, leverage ratios, andprofitability ratios. We apply each ratio to the 1998 balance sheet and income statement fromLifelong Health, Inc. (Lifelong), which are presented in Figures 12B-1 and 12B-2. Recall that wediscussed Lifelong in a case study in The Strategic Planning Process In Health Plans.

Liquidity Ratios

Liquidity ratios measure a company’s ability to meet its current liabilities. Current liabilities,also called short-term liabilities or short-term obligations, are those debts that a company mustpay within one year. For a health plan, liquidity is critical because a sufficient amount of currentassets—for example, cash and other liquid assets—must be available when needed to pay medicalexpenses—particularly IBNR claims—and general business expenses. Current assets, also called

short-term assets, are those assets that a company expects to use up or convert to cash during thecurrent accounting period, typically one year.1

Because a health plan receives premium income in advance of the provision of healthcareservices, liquidity is typically not a problem, unless the health plan capitates its providers. In suchcases, at the beginning of each month, a health plan may receive cash inflows (from premiumincome), which immediately become cash outflows (for provider reimbursement). Havingsufficient cash on hand is important to meet the obligations to pay IBNR claims when a healthplan becomes aware of them. For this reason, liquidity is particularly important for health plansthat capitate most or all of their providers.

Current assets produce little, if any, return on investment. As a result, health plans try to maintainas low a level of liquidity and as high a level of invested cash as possible, while ensuring thattheir current liabilities can be met. Let’s look at some key liquidity ratios as they apply toLifelong’s balance sheet.

Current Ratios

The current ratio is the ratio of a health plan’s current assets to its current liabilities. Wecalculate this ratio as current assets (the numerator) divided by current liabilities (thedenominator). In our example, Lifelong’s 1998 balance sheet has current assets of $588,028,000and current liabilities of $260,625, 000, so its current ratio is

A current ratio of 1.0 means that a company theoretically has enough current assets to cover all ofits current liabilities. Lifelong’s current ratio is 2.26; this means that Lifelong has more than twicethe amount of current assets necessary to fulfill its current obligations. There is no standardcurrent ratio result for all companies in all industries. An average current ratio in the health planindustry is 1.2 to 1.4.

The higher a health plan’s current ratio, the greater its liquidity and the greater the ease withwhich the health plan can cover its short-term obligations. A current ratio that falls below 1.0generally indicates that a health plan’s liquidity may be too low. In this case, the health plancould be forced to sell long-term assets to cover current liabilities if an unexpected event, such asseveral multiple births or an epidemic, occurred. On the other hand, if a health plan experiencespredictable cash flows, the health plan generally can accept a lower current ratio.

The Quick Ratio and the Cash Ratio

The quick ratio and the cash ratio are more restricted variations of the current ratio. The quickratio is similar to the current ratio, but excludes the dollar amount of a health plan’s inventoryfrom the health plan’s current assets. A health plan calculates the quick ratio by subtractinginventory from current assets and dividing the result by current liabilities. For companies, like

many health plans, that do not have inventories, the quick ratio equals the current ratio. In ourexample, Lifelong has no inventory, so its quick ratio and its current ratio are equal.

The cash ratio is the ratio of a health plan’s cash to its current liabilities. In other words, theamount included in the numerator excludes all other current assets. In our example, Lifelong’scash ratio is

Lifelong’s cash ratio indicates that Cash is a relatively small percentage of Lifelong’s currentassets. In this case, it appears that Lifelong’s management has chosen to maintain as little cash aspossible and to invest the remainder.

Days in Accounts Receivables

The days in accounts receivable, also called the average collection period, is calculated bydividing a health plan’s accounts receivable by its average daily revenues. Suppose a health planhad $20 million in premiums receivable and $365 million in annual revenues. In this example, thehealth plan would have an average collection period of 20 days:

Because most of a health plan’s accounts receivable are premiums receivables, the averagecollection period is the number of days that the health plan takes to collect premium income fromplan sponsors and others. In the event that healthcare benefit services are rendered by a healthplan before the health plan receives premiums for those services, the average collection periodwill increase.

The longer it takes for a health plan to collect premium income, the higher the risk that a healthplan has a collection problem. Should premium income become uncollectable, the health planmay have to write off the amount of uncollectable premium income as a bad debt. In this case, thehealth plan would have to report lower premium income—and, ultimately, lower net income—than it otherwise expected.

Again, because plan sponsors typically pay premiums a month in advance of receiving healthcarebenefits, a health plan usually has a sufficient amount of cash on hand to pay its ongoingobligations, such as claims obligations and provider reimbursement. A typical circumstance inwhich a health plan may not receive premium income prior to providing healthcare benefitsoccurs when increases in the number of eligible plan members have not been reported to thehealth plan in time for that month’s premium payment.

Net Working CapitalAnother common method of measuring a health plan’sliquidity is to calculate its net working capital. Networking capital is obtained by using the elements of thecurrent ratio, but in subtraction form: Current Assets -Current Liabilities. The amount of a health plan’s networking capital indicates the amount of excess cash(sometimes called “free cash available for long-terminvestments”) that the health plan may consider using forinvestment purposes. We discuss the investment ofexcess liquid assets in Management Control. In ourexample, Lifelong’s net working capital is:

Lifelong appears to have excess cash available for investment. Upon calculating the liquidityratios, we see that Lifelong’s liquidity is one of its strengths as a health plan.

Figure 12B-3 presents these liquidity ratios in summary form.

Activity Ratios

Activity ratios, also called operating efficiency ratios or operating ratios, measure how quickly ahealth plan converts specified financial statement items into premium income or cash. Activityratios gauge a health plan’s productivity and efficiency. In other words, activity ratios measurehow well a health plan utilizes its assets to generate revenues. Below is a discussion of severalkey activity ratios for health plans.

Total Asset Turnover Ratio

One activity ratio, asset turnover, is a standard activitymeasure in most industries, including the health planindustry. There are several versions of the asset turnoverratio, each of which is found by dividing a health plan’stotal revenues by some measure of assets, such as cash,invested assets, or fixed (long-term) assets. Animportant asset turnover ratio for health plans is thetotal asset turnover ratio, which is a health plan’s totalrevenues divided by its total assets. Below is thecalculation for the total asset turnover ratio andLifelong’s total asset turnover.

This information indicates that, for every $1.00 invested in assets, Lifelong was able to generate$1.11 in revenues. Note that total asset turnover generally relates an item from the incomestatement (total revenues) to an item on the balance sheet (total assets

Some versions of this activity ratio use average total assets during a specified accounting periodas the denominator. For the purposes of our discussion, the denominator is the amount of totalassets on a health plan’s balance sheet. In the numerator, we use total revenues because, for ahealth plan, generating investment income is part of its core business operations.

Generally, the higher a health plan’s total asset turnover, the more efficiently it has used itsassets. For example, assume that the total asset turnover for health plan A is 1.0 and the total assetturnover for health plan B is 2.0. This information indicates that health plan B has generated $2for each dollar invested in total assets, while health plan A has generated only $1 for each dollarinvested in total assets. Thus, we could infer that health plan B has used its assets moreefficiently. Note that health plans that own their medical facilities may have a lower total assetturnover tha health plans that do not own their own facilities. In this case, a health plan that ownsits medical facilities is not necessarily less efficient than a health plan that has leased its facilities.

Fixed-Charge Coverage Ratio

The fixed-charge coverage ratio is the ratio of earnings before interest and taxes (EBIT) dividedby all fixed-charge obligations, which include interest payments, taxes, principal payments, andpreferred stock dividends. Unlike dividends on common stock, preferred stock dividends are afixed obligation that must be paid to preferred stockholders, regardless of a health plan’s earningslevel. The fixed-charge coverage ratio indicates a health plan’s ability to meet fixed payments,given its earnings during a specified accounting period, as follows:

Fixed-Charge Coverage Ratio

A health plan incurs fixed-charge obligations if it owes taxes or if it decides to issue bonds orpreferred stock. The more fixed-charge obligations that a health plan has, the higher the risk it hasassumed, so the health plan will have a lower fixed-charge coverage ratio. For example, a health

plan with a fixed-charge coverage ratio of 2.4 has EBIT that is more than twice its fixed-chargeobligations. This health plan is not likely to default on (be unable to pay) its obligations,assuming that the health plan has the cash flows to pay its obligations on a timely basis. On theother hand, a health plan with a fixed-charge coverage ratio of less than 1.0 does not havesufficient earnings to cover its fixed payments.

The fixed-charge coverage ratio includes all fixed payments that a health plan is obligated to pay.Other activity ratios attempt to isolate specified components of a health plan’s contractual fixedcharges such as interest payments. Variations of the fixed-charge coverage ratio include the timesinterest earned ratio and the debt-service coverage ratio.

Times Interest Earned Ratio

The times interest earned ratio is calculated by dividing a health plan’s EBIT by its contractualinterest payments only. This ratio directly relates a health plan’s interest payments to its EBIT, asfollows:

Debt Service Coverage Ratio

The debt service coverage ratio relates a health plan’s EBIT, not only to all its inter-est paymentobligations, but also to all its principal and lease payment obligations, as specified in thefollowing equation:

Again, the higher the times interest earned ratio and the debt service coverage ratio, the morelikely that a health plan would be able to cover its fixed, contractual obligations.

Figure 12B-4 presents these activity ratios in summary form.

Financial Leverage Ratios

Leverage is an important concept in finance. Leverage, also called trading on the equity, is afinancial effect in which the use of fixed-cost funds magnifies both risks and returns to a healthplan’s owners.

A health plan’s total leverage consists of two types of leverage: operating leverage and financialleverage. Operating leverage is the effect whereby incurring fixed operating costs automaticallymagnifies a company’s risks and potential returns.2 We are most interested in financial leverage,which involves financing company assets with debt or other borrowed funds.

If the assets in which a health plan’s borrowed funds are invested earn a rate of return greater thanthe fixed rate of return required by the health plan’s creditors (i.e., suppliers of borrowed funds),the result is positive financial leverage. This positive difference boosts overall returns for thehealth plan’s owners. On the other hand, if the assets in which the borrowed funds are investedearn a rate of return lower than the fixed rate required by lenders, the result is negative financialleverage.

Recall from Pricing and Rating our discussion of margins in the context of pricing a managedhealthcare product. In the context of financial leverage, the difference between the cost ofborrowing the funds and the return earned using these funds is called the margin, also called theprofit margin or the spread.

Suppose a health plan borrows money at a 9% interest rate. If the health plan earns an 11% returnon those borrowed funds, it has realized positive financial leverage with a 2% margin. On theother hand, if the health plan earned only 6% on those borrowed funds, it would have realizednegative financial leverage with a –3% margin.

The preceding examples illustrate the leverage effect, or the effect that fixed costs have onmagnifying a health plan’s risk and return. The leverage effect applies to all companies. The moremoney a health plan borrows, the more debt the health plan has, and the greater the fixed costsassociated with making payments on the debt. Thus, financial leverage exposes the health plan torisk. But financial leverage also provides funds that the health plan can use to increase netincome. Increasing financial leverage by borrowing money simultaneously increases a healthplan's risk and potential return." The leverage effect is an illustration of the risk-return tradeoffthat we discussed in Risk Management in health plans.

Traditional leverage ratios compare some measure of a health plan’s liabilities to some indicatorof the firm's financial strength. For many non-health plans, liabilities on the balance sheet consistlargely of accounts payable and long-term debt (bonds payable or notes payable). For healthplans, most liabilities are for claims payments, including IBNR claims, and other contractualobligations such as provider reimbursements.

Because financial leverage ratios measure a health plan’s debt burden in relation to the assets itowns to cover its debts, these ratios are sometimes called solvency ratios. Two important GAAPratios that apply to all companies, including health plans, are the debt ratio and the debt-to-equityratio.

Debt Ratio

Health plans use the debt ratio to measure the proportion of total assets financed with liabilities.Specifically for health plans, the debt ratio measures the proportion of total assets against whichplan contractors and others have legal claims, such as healthcare benefits, including IBNR claims.The higher the debt ratio, the greater the health plan’s financial leverage. The debt ratio is abalance sheet ratio that is found by dividing a health plan’s total liabilities by its total assets.Lifelong’s debt ratio is:

A debt ratio of about 85% is considered average for a health plan, so Lifelong’s debt ratio is wellbelow the industry average.

For most non-health plans, the debt-to-equity ratio measures the relationship between the amountof assets provided by the health plan’s creditors and the amount of assets provided by itsstockholders. For a stock health plan, the debt-to-equity ratio measures the relationship betweenthe amount of liabilities to plan sponsors, providers, and creditors and the amount of equityprovided by the health plan’s stockholders.

The higher a health plan’s debt-to-equity ratio, themore the health plans relies on borrowed funds tocover future and current benefit payments, to pay forongoing business operations, and to finance growth.The debt-to-equity ratio is calculated as total liabilitiesdivided by stockholders' equity. Lifelong’s debt-to-equity ratio is:

The healthcare industry average for this ratio is about 0.83, so Lifelong has a significantly higherdebt-to-equity ratio than does its peers. Health plans usually have high debt-to-equity ratiosbecause of pending claims payments. A health plan’s current liabilities typically represent a largeportion of its liabilities, which in turn must be supported by the health plan’s assets.

Figure 12B-5 presents these financial leverage ratios in summary form.

Profitability Ratios

Companies are in business to earn a profit. Profitability ratios relate the returns of a health plan toits sales, total revenues, assets, stockholders' equity, capital, surplus (if applicable), or stock shareprice. Profitability ratios enable a health plan’s interested parties to

Determine if management has operated the health plan efficiently to cover its costs Calculate the return that compensates the health plan’s owners for the risk of their

investment Measure the efficiency with which management has used the health plan’s assets and

stockholders' equity to generate revenues

For these reasons, both internal and external users of a health plan’s financial information payclose attention to the health plan’s profitability ratios. Relating a health plan’s net income to itsrevenues is one way to determine how efficiently health plan costs are managed. Common-sizefinancial statements, described in previous lesson, are a handy tool for evaluating health planprofitability in relation to revenues. For example, a frequently cited profitability ratio that can befound in the common-size income statement is net profit margin, which is explained later.

Comparing a health plan’s net income to its assets or stockholders' equity used in generating thatincome is one method of measuring the effective management of health plan assets and equity.Two useful ratios for this task are (1)return on assets and (2) return on equity. In the followingsections, we also describe several other measures of profitability: earnings per share, theprice/earnings ratio, and the dividend payout ratio.

Net Profit Margin

Net profit margin, also called rate of return on net sales or return on sales, shows how muchafter-tax profit is generated by each dollar of total revenue. This ratio is found by dividing netincome, sometimes called net gain from operations, by total revenues. Lifelong’s net profitmargin is:

The average net profit margin for a health plan is 2.8%. Lifelong's net profit margin is negativebecause Lifelong had a net loss in 1998. Lifelong’s management will likely take steps to improveits operating efficiency in the next accounting period.

Return on (Total) Assets

The return on assets (ROA) ratio measures a health plan’s success in using its assets to earn aprofit. This ratio indicates the productive use of business resources and is often used to rankcompanies within the same industry. A health plan’s ROA is a strong indicator of management's

efficiency and is one of the most widely used measures of a health plan’s overall success.Generally, the higher a health plan’s ROA, the better.

There are several variations of the ROA ratio, such as return on total assets (ROTA) and return oninvested assets (ROIA). Alternatively, a health plan may use the average of the current year’stotal assets and the previous year’s total assets as the denominator to obtain the return on averagetotal assets ratio. Many health plans also calculate the ratio using different assets to compare theefficiency of various asset categories. In addition, different health plans may employ differentvaluations of assets to make these calculations. For the purposes of our discussion, we calculateROTA using the end-of-period value for assets on the health plan’s balance sheet. Using thesecriteria, Lifelong’s ROTA is

The managed healthcare industry average for return on assets is 2.1%. In this case, Lifelong islower than average because it suffered a net loss in 1998.

Return on Equity

The return on equity (ROE) ratio, also called the return on stockholders' equity ratio, measuresthe rate of return on the book value of the stockholders' investment in the firm. Alternatively, ahealth plan could calculate its ROE by using the average stockholders’ equity for the current andprevious years in the denominator. For the purposes of our discussion, we calculate ROE bydividing a health plan’s net income by its stockholders' equity as of the end of the period.

Generally, the higher and health plan's ROE, the better for the health plan's stockholder.

Earning per Share

Investors purchase shares of a health plan’s stock to realize a return in the form of cash dividendsand capital gains (capital appreciation). In this context, a capital gain is the amount by which theselling price of an asset exceeds its purchase price. A health plan’s net income forms the basis forstockholder dividend payments and any future increases in stock values that will provide forcapital gains. Therefore, a health plan’s reported earnings per share on stock is one of the mostimportant ratios to investors.

Earnings per share (EPS), also called earnings per share of common stock, is the amount of netincome per share of a company’s common stock. To calculate EPS, divide the amount of netincome that is available to common stockholders by the number of common shares outstanding

(outstanding common stock). Note that preferred stock dividends are subtracted from net incometo determine the amount of income available to common stockholders.

In our example, Lifelong’s equity consists of retained earnings, but no common stock, so we willuse another company to calculate EPS. If health plan A has a net income of $10 million, nopreferred stock, and 6,000,000 shares of common stock outstanding, then health plan A’s EPS is

Because health plans generally do not issue preferred stock, the numerator of this ratio is thehealth plan’s net income. Earnings per share is the only ratio that all companies that havecommon stock must include in their financial statements. Not-for-profit health plans do notcalculate EPS because they do not have common stock. This ratio appears on the incomestatement in a health plan’s annual report. Most health plans strive to increase EPS by 10% to20% annually.

health plan’s EPS can be affected by several factors, including extraordinary items. For thisreason, these factors must be considered when calculating a health plan’s EPS or when comparingthe EPS of several health plans. Recall from Assignment 10 that an extraordinary item, alsocalled an extraordinary gain (loss), is an item that is unusual or infrequent, such as damage causedby fire at a health plan’s home office.

A health plan that reports an extraordinary item on its income statement also reports two EPSfigures. The first EPS is calculated using earnings before the extraordinary item, and the second iscalculated using earnings after the extraordinary item. For example, assume that a health plan hadearnings after interest and taxes of $1,560,000, a $600,000 (net) extraordinary gain, and1,200,000 shares of common stock outstanding. Figure 12B-6 demonstrates the way to report theearnings per share before and after the extraordinary gain. By computing the EPS both ways, thecompany avoids artificially inflating its EPS, which would have overstated its normal income-producing ability.

Price/Earnings (P/E) Ratio

An often-quoted relationship between a health plan’s earnings per share and the current marketprice of its stock is the price/earnings ratio. The price-earnings (P/E) ratio, also called theearnings multiple, represents the amount of money that investors are willing to pay for eachdollar of a health plan’s earnings. Recall that health plan A's EPS was $1.67. If we assume thatthe market price of health plan A’s stock is $35 per share, then health plan A’s P/E ratio is

There is a wide range of interpretations of the P/E ratio. Generally, the higher the P/E ratio, thegreater the investor confidence in a company. In our example, health plan A’s common stockprice per share is selling for about 21 times its current earnings per share. Stated another way,investors are willing to pay $21.00 for each dollar of health plan A’s earnings.

Investors use the P/E ratio as a guideline in evaluating whether to buy stock or acquire acompany. Price/earnings ratios vary widely among companies and industries and are mostmeaningful when compared to selected industry groups or market averages so that comparisonsof relative performance can be made. An average P/E ratio for a health plan is between 10 and 15.In our example, health plan A’s common stock is overvalued with respect to the industry average.

Dividend Payout Ratio

Investors generally hold shares of stock for two reasons: (1) to realize current income in the formof cash dividends and (2) to realize appreciation in stock market values. One function of a stockhealth plan’s board of directors is to determine the portion of net income, if any, to pay out individends to stockholders. To make this decision, the board must balance stockholders'expectation of dividends with the health plan’s need for capital.

The dividend payout ratio represents the proportion of earnings (net income) paid out tostockholders in the form of cash dividends. This ratio, which is presented in percentage terms, iscalculated by dividing dividends per share by earnings per share. Because the numerator anddenominator are in per share terms, we can simplify the dividend payout ratio to dividendsdivided by earnings (net income). The dividend payout ratio is not applicable to stock healthplans that do not pay dividends to their stockholders.

Dividend Payout RatioSuppose health plan A had net income of $10,000,000and that health plan A’s board of directors decided topay $2,729,511 in dividends to stockholders. Below isthe general formula for the dividend payout ratio,followed by health plan A’s calculation of its dividendpayment ratio.

Generally, investors who seek growth in a company want the dividend payout ratio to remainsmall, because a low dividend payout ratio means that the company has retained most of itsearnings to fund future growth. Investors who seek current income prefer the dividend payoutratio to be larger. The dividend payout ratio tends to be somewhat similar for many firms within aparticular industry.

Figure 12B-7 presents these profitability ratios in summary form

Endnotes

1. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life andHealth Insurance Companies (Atlanta: LOMA, 1997), 38, 40.

2. Susan Conant et al., Managing for Solvency and Profitability in Life and HealthInsurance Companies (Atlanta: LOMA, 1996), 501.

AHM Health Plan Finance and Risk Management: Health Plan-Specific Ratio Analysis

Course Goals and Objectives

After completing this lesson you should be able to:

List and apply to the Annual Statement statutory ratios of liquidity, capital, financialleverage, and profitability (for health plans that must comply with state insuranceregulations)

Recognize and apply the ratios that are most important to health plans

Earlier in this assignment, we stated that health plans that must comply with state insurancerequirements must file the Annual Statement in every state in which they conduct business. Thefinancial statements contained in the Annual Statement include a balance sheet, an incomestatement, and a cash flow statement. However, the calculations for items listed in the financialstatements contained in the Annual Statement follow statutory formulas, rather than traditionalGAAP-based formulas.

As a result, many traditional financial ratios cannot be applied directly to the statutory financialstatements that appear in the Annual Statement. The result has been a modification of thesetraditional ratios for statutory purposes. In some cases, new ratios were created specifically foranalysis of statutory health plan statements. These "statutory ratios" are commonly divided intofour categories: liquidity ratios, capital and surplus ratios, financial leverage ratios, andprofitability ratios.

Liquidity Ratios

Two primary liquidity ratios for statutory purposes are (1) the quick liquidity ratio and (2) thecurrent liquidity ratio.

Quick Liquidity Ratio

The quick liquidity ratio compares a health plan’s liquid assets to the health plan’s contractualreserves. Liquid assets include a health plan’s cash and other readily marketable assets such asshort-term investments. Recall from Fully Funded and Self-Funded Health Plans that reserves areestimates of money that a health plan or insurer sets aside to pay future business obligations.Contractual reserves typically include a health plan’s claims liabilities and IBNR claimsliabilities. To calculate a health plan’s quick liquidity ratio, divide the health plan’s liquid assetsby its contractual reserves:

The usual range for this ratio is between 10% and 20%. The quick liquidity ratio providesregulators with information about a health plan’s solvency.

Current Liquidity Ratio

The current liquidity ratio compares all of a health plan’s total assets not invested in its affiliatesto all the health plan’s total liabilities, not just its claim liabilities and IBNR claims liabilities. Thecurrent liquidity ratio is calculated as follows:

The average range for this ratio is 95% to 120%. A ratio lower than 95% is considered below theaccepted norm.

Capital and Surplus Ratios

Health plans measure their financial strength using capital and surplus ratios, which aresometimes referred to as capital ratios for stock companies. Both capital and surplus are owners’equity accounts on a health plan’s balance sheet. Capital accounts include Common Stock,Additional Paid-in Capital, and Preferred Stock.

Recall from Fully Funded and Self-Funded Health Plans that, under statutory accountingpractices (SAP), surplus is the amount that remains when an insurer subtracts its liabilities andcapital from its assets.1 Recall from Accounting and Financial Reporting that retained earnings isthe cumulative amount of a company’s earnings that has been kept (retained) in the company overtime.

In this context, Surplus on a SAP-prepared balance sheet is similar to Retained Earnings on aGAAP-prepared balance sheet. Not-for-profit health plans and certain insurers that do not issuestock do not have capital accounts. As a result, their owners’ equity accounts typically consist ofRetained Earnings (GAAP) or Surplus (SAP).

The basic capital and surplus ratio for a healthplan is calculated by dividing a health plan’scapital and surplus by its total liabilities, asfollows:

Generally, the greater the value of this ratio, the stronger the health plan’s financial position. Theaverage industry range is between 4% and 12%. A health plan’s capital and surplus position canweaken because of

Poor profitability Payment of excessive dividends relative to the health plan’s actual profit Excessive capital losses from investments

Reserve valuation changes that increase the health plan’s reserves (Increases in a healthplan’s reserve valuation may result from changes in statutory requirements or from adecision by a health plan’s managers to increase its reserves, including IBNR claimsliabilities.)

One weakness of the basic capital and surplus ratio is that it is an unweighted ratio that fails torecognize the factors that can cause significant changes to a health plan’s capital position. Toobtain a more accurate measure of a health plan’s solvency and financial strength, many internaland external financial analysts use a specified set of capital ratios.

These capital ratios, which are called risk-based capital (RBC) requirements, are weight-adjustedto account for different levels and types of risk as well as different practices of determining theappropriate amount of claims liabilities that are unique to each health plan. The formula fordetermining a health plan’s RBC requirements considers five different kinds of risk: affiliate risk,asset risk, underwriting risk, credit risk, and business risk. We discussed RBC requirements inRisk Management in Health Plans.

Independent rating agencies also apply various capital ratios to determine a health plan’s financialstrength. Insight 12C-1 summarizes how one rating agency assigns a value to the financialsecurity of health plans.

Financial Leverage Ratios

As noted earlier, financial leverage ratios compare a health plan’s obligations to its ability to meetthose obligations. In the context of healthcare benefits, such obligations can be measured in termsof claims liabilities or in terms of claims liabilities in combination with other miscellaneousliabilities. Financial leverage ratios typically relate a health plan’s liabilities to its capital. A keyfinancial leverage ratio for health plan's is the insurance leverage ratio.

Insurance Leverage Ratio

The insurance leverage ratio, also called the gross leverage ratio, relates a health plan’scontractual reserves (claims liabilities, including IBNR claims liabilities) to its capital and

surplus. This ratio is similar to the basic debt-to-equity ratio, which is the ratio of total liabilitiesto total equity. A low result for this ratio is more desirable than a high result, within a normalrange. However, there is no absolute standard for determining what is too low and what is toohigh for all health plans. The insurance leverage ratio is found as follows:

Profitability Ratios

Specialized profitability ratios are available to meet the needs for diverse measures of a healthplan’s profitability. Some of these ratios evaluate a health plan’s overall results on a gross basis(before deducting expenses and taxes) or a net basis (after deducting all expenses and taxes).These ratios include the gross profit ratio and the return on capital ratio. The following sectionsdiscuss these two ratios and the statutory return on assets (ROA) ratio, the investment yield ratio,and the net gain to total income ratio.

Gross Profit Ratio

The gross profit ratio is a simple measure of thegrowth of a health plan’s capital and surplus. Thegross profit ratio compares a health plan’s gross gainfrom operations before interest expenses and taxeswith its beginning capital and surplus for a specifiedaccounting period. To calculate the gross profit ratio,a health plan divides its gross gain from operations byits beginning capital and surplus amount for aspecified accounting period, as follows:

Return on Capital Ratio

To determine a health plan’s overall success in generating returns to stockholders, an analystcalculates the health plan’s return on capital ratio. The return on capital ratio is similar to theGAAP-based return on equity (ROE) ratio. Whereas ROE is stated as the ratio of net income tostockholders' equity, the return on capital ratio is the ratio of net gain from operations tobeginning capital and surplus. A health plan calculates the return on capital ratio by dividing itsnet gain from operations by its beginning capital and surplus:

The beginning capital and surplus is the amount of capital and surplus that the health plan had atthe beginning of the specified accounting period. The result of the return on capital ratio indicateshow efficiently management is using a health plan’s capital and surplus to earn a return for thehealth plan’s stockholders. The average industry range for this ratio is 8% to 14%.

Statutory Return on Assets Ratio

The statutory return on assets (ROA) ratio is the ratio of a health plan’s net gain from operationsto its average invested assets. The statutory ROA ratio shows the efficiency of a health plan’smanagers in using the health plan’s investments to earn a return for stockholders.

This ratio is similar to the GAAP-based ROTA,which is the ratio of a health plan’s net income to itstotal assets. However, statutory ROA considers onlygains from an health plan’s normal businessoperations, like premium income and investmentincome, rather than net income, and only the healthplan’s average invested assets, rather than its totalassets, as follows:

To determine a health plan’s average invested assets, the health plan adds its beginning-of-yearinvested assets balance to the end-of-year balance from the same accounting period and dividesthe sum by two.

Investment Yield Ratio

The investment yield ratio, also called the net yield ratio, measures how effectively a health plancan earn adequate or higher returns on the health plan’s investment portfolio. The calculation forthis ratio is a version of the traditional ROA ratio, as follows:

Note that the investment yield ratio uses a health plan’s investment income in the numerator andinvested assets in the denominator, rather than net income divided by total assets, as does thebasic ROTA ratio. The investment yield ratio is an important indicator of a health plan’s potentialreturns.

Health plans prefer an investment yield that is neither too high nor too low, although a definitionof these extremes varies among health plans. How well a health plan manages the cash it receivesfrom plan sponsors is critical to the health plan’s solvency and profitability. An unusually highinvestment yield could indicate excessively risky investments, while a very low yield probablyindicates inadequate returns.

Net Gain to Total Income Ratio

Another performance indicator of interest to regulators is the net gain to total income ratio. Thenet gain to total income ratio is calculated by dividing a health plan’s net gain from operationsby the sum of its total income, plus realized capital gains, minus realized capital losses:

In this context, net gain means net gain from operations, which is the net gain before anydividends to stockholders and federal income taxes. This ratio also highlights the share of thehealth plan’s income that is not used to cover expenses. A result of less than zero for this ratiousually indicates that a health plan has experienced a net loss from operations. The usual industryrange is 1.5% to 6.0%.

Figure 12C-1 summarizes the GAAP-based financial statement ratios with the ratios used toanalyze SAP-prepared statements.

Additional Financial Analysis

Besides the financial ratios discussed above, health plans track other ratios and financial datarelating specifically to health business written. Among the most important ratios for health plansare the medical loss ratio and the expense ratio, which are key components of the combined ratio.The following sections discuss these ratios and the operating expense ratio, months of surplus,months of claims reserve, the IBNR claims ratio, the selling, general, and administrative expenseratio, the cash and investments to premium income ratio, the cash to claims payable ratio, and theequity to premium income ratio.

Medical Loss Ratio

The medical loss ratio (MLR), also called the loss ratio, is the percentage of a health plan’sincurred claims to its earned premiums. For the purposes of calculating the MLR, incurred claimsinclude those that have been paid as well as those that have not yet been reported. A health plan’searned premiums consist of both collected and uncollected premiums.

The MLR is a measurement of a health plan’s overall claims levels. Monitoring the MLR iscritical to a health plan. Health plans use the MLR to determine if their healthcare benefits are inline with the premiums charged. Because the denominator of the MLR is earned premiums, MLRautomatically adjusts for growth in a health plan’s business. The industry average for the MLR is83%.

To calculate the MLR, divide a health plan’s incurred claims by its earned premiums. Assumethat health plan Q had $82 million in incurred claims and $100 million in earned premiums. Thecalculation of health plan Q’s MLR is as follows:

There are several variations of the MLR. One variation is the paid loss ratio, which is based onpaid claims rather than incurred claims. Keep in mind that a health plan’s MLR should be basednot only on the health plan’s paid claims, but also on the best estimate of its IBNR claims for theaccounting period being evaluated.

Calculating the paid loss ratio is easier because the data for paid claims are readily available anddo not have to be estimated. However, using the paid loss ratio instead of the MLR can result inan inaccurate assessment of the magnitude and trend of a health plan over time. Also, paid lossratios can be unusually low for new or rapidly growing blocks of business. It is therefore difficultto determine with certainty the profitable and unprofitable blocks of business using only paid lossratios.

Another variation of the MLR is the tolerable loss ratio (TLR), also called the acceptable lossratio. The TLR indicates the ratio of losses that a health plan can tolerate without losing moneyon a particular block of business. If a health plan’s medical loss ratio exceeds its tolerable lossratio, then profits may disappear.

In addition, health plans that must comply with state insurance regulations are required undercertain circumstances to calculate the lifetime loss ratio, which measures the ratio of losses for theentire lifetime of each product. Circumstances under which a health plan must calculate thelifetime loss ratio occur when a health plan applies for a premium rate increase on an existingproduct. State regulations stipulate the minimum percentage requirement for a health plan’slifetime loss ratio.

Expense RatioThe second component of the combined ratio is theexpense ratio. The expense ratio measures thepercentage of health plan expenses, other thanmedical expenses, paid for each dollar of the healthplan’s premium income. Suppose Green HMO hashealth plan expenses of $15 million and earnedpremiums of $100 million. In our example, GreenHMO’s expense ratio is 0.15:

This information indicates Green HMO's health plan expenses are 15% of its earned premiums.The industry average is 14%. Note that a health plan’s expense ratio may be somewhatmisleading if the health plan has a new or growing block of business, because expenses aregenerally higher in the first year of a sale. A health plan’s expense ratio can also be misleading ifthe health plan has a lot of administrative services only (ASO) business, small group business, orindividual business. It is therefore necessary to track the expense ratio over a number of years ifthe level of earned premiums varies from year to year.

Combined Ratio

The combined ratio is used to determine whether a health plan is collecting enough premiums topay both its claims obligations and its operating expenses. The combined ratio, which is aprofitability ratio, is the sum of the medical loss ratio and the expense ratio. Stated as a formula,the combined ratio, (0.97 for health plan Q in our example), is the sum of its MLR (0.82 forhealth plan Q), and its expense ratio (0.15 for health plan Q), as follows:

If a health plan’s combined ratio is less than 100%, then the health plan’s premium incomecontains a margin for profit or for managing adverse conditions. In our example, health plan Qhas a 3% potential profit margin. To the extent that a health plan’s combined ratio exceeds 100%,the health plan must rely on investment income to avoid losses. In such cases, investment incomeis critical for a health plan to maintain solvency.

Months of Surplus

A health plan may need to know how long it could meet its incurred obligations if it relied solelyon funds in its surplus account. To answer this question, a health plan calculates its months ofsurplus. A health plan’s months of surplus is calculated by dividing the health plan’s end-of-period surplus by the average underwriting deduction. The average underwriting deduction is thesum of claims incurred and operating expenses incurred divided by the number of months. Theformula for calculating a health plan’s months of surplus is

The more months of surplus that a health plan has, the lower the risk that the health plan cannotmeet the obligations that it has incurred. The average months of surplus for a health plan is 2.3months.

When a health plan establishes a claims reserve, it does so under the assumption that there areenough assets available to match claims liabilities. If applicable, statutory requirements may alsomandate the amount of a health plan’s claims reserve.

The months of claims reserve is obtained by dividing the sum of a health plan’s adjusted, unpaidclaims liabilities by its average claims expense. A health plan adjusts its unpaid claims liabilitiesto reflect changes in its business and in inflation. The average claims expense is the sum of claimsand the adjustment for claims expenses incurred, divided by the number of months in the periodbeing evaluated. The formula to calculate a health plan’s months of claims reserve is as follows:

The more months of claims reserve that a health plan has, the stronger its financial position. Theindustry average for the months of claims reserve is 1.67 months.

IBNR Claims Ratio

Knowing the ratio of a health plan’s IBNR claims to total claims is useful in estimating futureclaims obligations. The IBNR claims ratio is obtained by dividing the estimate of IBNR claimsby total claims liabilities:

Selling, General, and Administrative Expense RatiosEarlier we discussed the expense ratio with respect toa health plan’s combined ratio. To control operatingexpenses, a health plan’s managers often find ituseful to break down the expense ratio into itscomponents according to selling expenses, generalexpenses, and administrative expenses. In this way, ahealth plan can identify what percent of the overallexpense ratio comprises selling expenses, generalexpenses, and administrative expenses. To isolate aparticular type of expense, a health plan divides thatexpense by the health plan’s earned premiums

Cash and Investments to Premium Income RatioA health plan is also interested in the relationship between the amount of cash and investments ithas and its premium income, in part because the health plan needs to manage its cash inflows andcash outflows carefully. Premium income results in a cash inflow for a health plan and investmentpurchases result in a cash outflow for the health plan.

Remember that premium income consists of earned premiums, which include both collectedpremiums and uncollected premiums. The investments in this case are primarily marketablesecurities that can be readily sold if necessary.

Suppose health plan Q has $42 million in cash, $500million in investments, and $700 million in premiumincome. The formula for the cash and investments topremium income ratio, and health plan Q’s ratiocalculation, is:

The amount of health plan Q’s cash and investmentsis about 77% of the amount of health plan Q’spremium income. This information indicates thathealth plan Q has the equivalent of 77% of itspremium income in current assets—that is cash andreadily marketable investments. The industry averagefor this ratio is 75%.

Cash to Claims Payable Ratio

Another liquidity ratio that is of interest to health plans is the cash-to-claims payable ratio, whichindicates the relationship between a health plan’s cash and its claims payable. Assume that healthplan Q has $42 million in cash and $192 million in claims payable. The formula for this ratio,along with health plan Q’s ratio calculation, is as follows:

A health plan’s claims payable includes both IBNR claims and reported claims. In our example,health plan Q has enough cash to cover approximately 22% of its outstanding claims liabilities.The average ratio of cash to claims payable is 20%.

Equity to Premium Income Ratio

A health plan is also interested in learning the ratio of equity to premium income. The higher thehealth plan’s premium income, the more likely the health plan will have a higher net income,assuming the health plan can manage its expenses effectively. Higher net income in turn becomespart of the health plan’s retained earnings or surplus, which ultimately increases the health plan’sequity.

The equity to premium income ratio is obtained bydividing a health plan’s equity by its premiumincome. Suppose health plan Q has $250 million inowners’ equity and $700 million in premium income.This ratio, and health plan Q’s calculation, is

This information indicates that the amount of healthplan Q’s equity is approximately 36% of the amountof its premium income. The industry average is 30%.

Endnotes

1. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life andHealth Insurance Companies (Atlanta: LOMA, 1997), 41.

AHM Health Plan Finance and Risk Management: Management Accounting

Course Goals and ObjectivesAfter completing this lesson you should be able to:

Explain the purpose of management accounting Identify the distinguishing features of a cost center, profit center, and investment center Discuss volume-related variances, cost-related variances, and revenue-related variances

in a health plan setting

The Role of Management Accounting

With respect to management, we can identify four core functions: (1) planning, (2) organizing,(3) leading, and (4) controlling. Although the four functions of management have distinctcharacteristics, they are interrelated and often difficult to distinguish in practice. Implicit withinthe four management functions is decision making, in which a company’s management selects acourse of action.

To make effective decisions about a company, a manager needs financial information. Forexample, a health plan manager might need to know how much money the health plan paid inprovider reimbursement last year or the economic effects of installing a new computer system.Management accounting, also called managerial accounting, is the process of identifying,measuring, analyzing, and communicating financial information to assist managers in makingdecisions. With the information provided through management accounting, a health plan’smanagers can

Hire an appropriate number of employees Price products and services to cover costs and produce a desired profit Forecast premium income and investment income accurately Pay claims as they come due

Accurate and timely feedback is essential for effective management. Providing feedback is one ofthe most important purposes of management accounting. Feedback allows managers to locate thesources of its financially successful and unsuccessful operations and to analyze why certain areasof the company perform well while others do not. Management accounting information is mostuseful in the management functions of planning, organizing, and controlling.

Planning

Planning occurs at all levels of a company. Typical financial planning activities in a health planinclude the study of costs, budgeting for short-term and long-term expenditures, and evaluatingpotential acquisitions or divestitures.

Generally, we can divide a company's planning activities into two major segments: strategicplanning and tactical planning. Recall from The Strategic Planning Process in health plans thatstrategic planning is the process of identifying an organization’s long-term objectives and thebroad, overall courses of action that the company will take to achieve those objectives. Strategicplanning forces a company to look beyond tomorrow or next year and establish a long-term plan.Most health plans today develop a strategic plan for at least the next three to five years as well as

a short-term tactical plan (with measurable objectives) for the first one or two years of thestrategic plan.

Planning

Tactical planning, also called operational planning, is the process of determining how toaccomplish specific tasks with available resources. Tactical planning is primarily concerned withthe short-term, day-to-day activities of a company. In tactical planning, each functional areawithin the health plan develops specific plans based on the health plan’s overall strategic goalsand business objectives. Figure 13A-1 (save in AHM 520 as z13a-1) lists some areas that areoften associated with strategic planning and tactical planning in a health plan.

Note that overlap can exist between the topics covered by the two types of planning. For example,forecasting premium income (strategic planning) directly affects a health plan’s cash flowplanning (tactical planning). Also, both types of planning involve the preparation of budgets.Approaches to budgeting are numerous and diverse, as we discuss in The Budgeting Processlesson.

Organizing

During the organizing function, a health plan’s management takes explicit actions to ensure thatthe necessary resources are available to achieve the health plan’s strategic plan. Suppose a healthplan’s management has projected what it will cost the health plan to enter a new market with itsHMO product. In this case, management can use the cost projection to decide which employeesand how many employees will be involved, and the role that each employee will take if the healthplan enters a new market.

Controlling

The control function of management involves ensuring that a company’s performance results inthe achievement of the company’s strategic plan. Management control activities involve the (1)establishment of standards of performance, (2) measurement and evaluation of actualperformance against the standards, (3) detection of deviations from the standards, and (4) thedetermination of appropriate action to correct deviations.

The most complete managerial control would consist of close physical supervision of eachemployee. However, this type of control is not usually practical or desirable. Therefore, managersrely on the concept of management by exception, which states that managers should focus onoperational results or activities that differ from expected norms by a certain amount orpercentage. Such information comes from management accounting reports that indicatedeviations or exceptions. A manager can then investigate these exceptions to learn the causesbehind them.

For example, one management accounting report could show the projected costs and actual costsfor a health plan’s claims department. Instances where the actual costs differ from the projectedcosts are known as variances. One way to gauge the performance of the health plan’s claimsdepartment is to examine these variances. A report of variances is an example of feedback thatinforms management how well the organization is achieving its plan. We discuss varianceanalysis later in this lesson.

Decision Making

To make sound decisions, a manager needs financial information that is relevant, reliable, andcomparable across accounting periods and departments. Management accounting provides thisinformation, as well as analytical techniques that help managers understand the implications of adecision.

Suppose a health plan decides to launch a new product. In this case, management accountinganalysis can indicate the number of members that must be enrolled, at a specified PMPM rate, togenerate enough premium income to achieve the health plan’s strategic plan.

Management accounting analysis can also indicate the cost savings and useful life required of anew piece of equipment for a health plan to recover the cost of the equipment. Although theinformation provided by management accounting does not itself solve the problems that a healthplan faces, the use of management accounting reports enables the health plan’s managers toweigh the consequences of various actions so that the managers can make well-informeddecisions.

Responsibility Accounting

Responsibility accounting is a form of management accounting that is used primarily to prepareand monitor a company’s budgets and to analyze the company’s performance. Responsibilityaccounting, sometimes called profitability accounting, is a people-oriented system of policiesand procedures that assigns revenues and costs to individual employees or to the organizationalunits that are accountable for these revenues and costs.

Responsibility accounting focuses on the status of a company’s internal operations and onspecific areas of managerial responsibility. In responsibility accounting, the person who has themost influence over an area—the manager of a department, function, activity, or product—is heldaccountable for the operations and financial outcomes of that area. This means that only thoseitems, such as investments, revenues, and costs that can be directly attributable to a particular areaare the responsibility of that area’s manager.

A direct cost, also known as a traceable cost, is a cost incurred for or traceable to one specificproduct, line of business, or department or function. A cost that is not incurred for or cannot betraced to one specific product, line of business, or department or function is called an indirectcost, also called a common cost or a shared cost. For example, the salary of the manager of ahealth plan’s accounting function is a direct cost of that function. However, the salary of thehealth plan’s president is an indirect cost of the accounting function.

Responsibility Centers

When a manager has control of, and thus responsibility for, an organizational unit of thecompany's business, the area or unit is commonly known as a responsibility center. Aresponsibility center defines the sphere of its manager's responsibility. In other words, only thoseitems, such as investments, revenues, and costs, that can be directly attributable to a responsibilitycenter are the responsibility of that center's manager. A responsibility center can be a department,division, line of business, or any other business segment. Responsibility centers typically aredivided into three types: cost centers, profit centers, and investment centers, which are listed inFigure 13A-2.

One way we can differentiate these centers is based on the extent of overall operational controlaccorded to the manager. The degree of control ranges from lowest (cost center) to highest(investment center). Note that, in many companies, the distinction between a profit center and aninvestment center is blurred. Therefore, some companies use the term profit center to refer toboth investment centers and profit centers. In this course, we maintain the distinction between thetwo.

The manager of a responsibility center, called a responsibility manager, is evaluated according tothe responsibility center's performance. The responsibility manager should have (1) objectivesthat are consistent with the company's objectives, (2) a clear understanding of the responsibilitycenter's objectives, and (3) the necessary authority to establish formal reporting and budgetingcontrol over the resources required to meet those objectives.

By assigning responsibility to specific individuals, a health plan’s senior management has a toolfor controlling revenues and costs and an objective means of evaluating its managers andsupervisors. The basic tenet of responsibility accounting is that responsibility managers should beheld accountable for only the costs and revenues over which they have direct control.

A critical component of responsibility accounting is goal congruence, which we discuss in thenext section. Then we describe methods of measuring and evaluating the performance of

responsibility centers and responsibility managers. Last, we discuss various factors that canimpact performance evaluation.

Goal Congruence

Successful health plans are those that create an operational condition called goal congruence, inwhich the goals of a company and the goals of its managers are mutually supportive. When thebusiness goals of a company are congruent with the personal goals of the company's managers,the managers are motivated to make decisions that are in the best interest of the company. Themanagers can achieve their own goals by helping the company achieve its goals.

Goal incongruence occurs when management goals and the company's goals are in conflict; inother words, the goals are not mutually achievable. Suppose a health plan’s strategic planincludes a goal of rapid growth in market share, even at the expense of short-term profitability. Atthe same time, the health plan’s underwriting department manager decides to establish moreconservative (that is, more stringent) underwriting guidelines. In this case, the more conservativethe health plan’s underwriting guidelines, the less likely that the health plan will achieve itsstrategic goal for market share growth. The ultimate effect is goal incongruence.

Management by Objectives

Responsibility managers manage with the intention of achieving stated goals, a process known asmanagement by objectives (MBO). A typical goal for a responsibility manager is to meet abudget. Management by objectives also includes the establishment and achievement ofnonfinancial goals, such as improved customer service or more favorable responses on an opinionsurvey of the responsibility center's employees.

In successful MBO programs, senior management and responsibility managers collaborate ondeveloping objectives, and these objectives support the company's overall objectives. Typically,objectives that are devised by a third party and then imposed on the responsibility manager areless likely to be attained. Note, however, that in recent years, health plans have devoted asignificant amount of their resources to attaining quality standards established by externalorganizations.

When the objectives of responsibility center managers conflict, goal incongruence may result. Ahealth plan’s senior management would typically review such conflicts and resolve them.Suppose a health plan’s product development manager establishes a goal to reach a certain levelof new product sales. The health plan’s actuarial department manager may argue that the newproduct objective conflicts with the health plan's profit objectives because of the high first-yearexpenses that a new product typically incurs. In this case, the health plan’s senior managementwould have to analyze the effects of increased sales on profit and recommend a course of action.

Effectiveness vs. Efficiency

All responsibility centers should share a common goal: to be both effective and efficient.Effectiveness (doing the right things) is the extent to which a responsibility center is able toestablish and achieve the appropriate objectives. Efficiency (doing things right) is the extent towhich a responsibility center is able to achieve objectives with a minimum of waste.1 Whileeffectiveness generally fosters goal congruence, efficiency, on its own, does not. In other words,

it is possible for a company to have an efficient responsibility center whose goals do not supportthe company's goals.

For example, a health plan’s investment department that executes investment transactions on timeand at a low cost is efficient. But if the investments that the department makes result in a lowerinvestment returns or significantly higher risks for the health plan, then the investmentsdepartment has not met its goal of maximizing investment return and is therefore not effective.

A company’s responsibility accounting system should incorporate methods of simultaneouslymeasuring both effectiveness and efficiency. The first step in implementing such a responsibilityaccounting system is to establish responsibility centers, which we discussed above.

Performance Measurement and Evaluation

Responsibility managers know what aspects of a company's operations they are responsible forand understand how their performance is judged. In theory, the characterization of success andfailure is a two-step process: (1) measuring performance and (2) evaluating performance.Measuring performance involves quantifying the responsibility center's results. Evaluatingperformance involves assessing those results. Together, measuring and evaluating performanceanswer two questions: “What did the responsibility manager achieve?” and “What do theachievements mean?”

Responsibility accounting requires the establishment of procedures for fairly and accuratelymeasuring and evaluating the performance of responsibility centers and responsibility managers.Distinguishing between performance measurement and performance evaluation can be difficult.Specific tools for performance measurement and evaluation differ for each type of responsibilitycenter. However, one basic technique applicable to any responsibility center is variance analysis.

Variance Analysis

A basic concept in management accounting is the use of a company’s expected (projected,forecasted) results as a benchmark against which the company’s actual performance is compared.Whenever an actual result differs from the expected result, the difference is called a variance.

Variance analysis is the study of the difference between expected results and actual results.Variances for each responsibility center are usually shown in a responsibility center report,sometimes called a responsibility report, which itemizes projected and actual amounts and thecorresponding variance for each item. Variance analysis is helpful for monitoring and evaluatingperformance because variances quantify the unexpected results under the control of aresponsibility manager. The concept of management by exception, which we introduced earlier inthis lesson, encompasses variance analysis.

Budgets are often used to pinpoint variances. A budget is a financial plan of action, expressed inmonetary terms, that covers a specified time period, such as one year.2 Typical budgets that lendthemselves to variance analysis are sales budgets, expense budgets, and investment budgets.When using budgets to study variances, some degree of variance is not unusual because budgetedamounts and actual amounts are rarely equal. For example, if an amount budgeted for an expenseitem is $10,000, and the actual result for this item is $12,000, the budget variance is $2,000. Wediscuss budgets in The Budgeting Process.

Variance analysis normally studies budgeted and actual results, but managers can also use it tocompare other data. Managers can analyze variances between numbers from different areas orreporting periods by comparing a responsibility center's operating results from a currentaccounting period with those from a prior period. Another version of variance analysis comparesactual costs with standard costs. Standard costs are predetermined costs that a company expectsto incur during normal business operations.

Generally, positive variances—variances in which actual amounts exceed expected amounts—areunfavorable for expenses, because the responsibility center incurred more expenses than it hadanticipated. In contrast, positive variances are considered favorable for revenues because theresponsibility center earned more revenues than it had anticipated. Similarly, negative variances,in which actual amounts are less than expected amounts, are usually considered favorable forexpense items and unfavorable for revenue items.

An effective variance system focuses on matters that require management's attention. Varianceanalysis allows a manager to isolate the problem areas, but it does not suggest solutions toproblems. Most companies conduct monthly or quarterly reviews of their operating expenses andcompare actual expenses to budgeted expenses.

Large variances are a matter of concern, or at least interest, to a health plan’s senior managementbecause they can lead to revised budgets or changes in the health plan’s operations. An importantaspect of responsibility accounting is that managers should be able to explain budget variancesthat are under their control.

We can categorize variances as either price variances or volume variances. The sum of the twoequals the total variance. The price variance, also known as the rate variance or cost-relatedvariance, is the difference between a product's actual rate (or unit cost or price) and its budgetedrate, multiplied by the number of units sold or processed. The volume variance, also known asthe usage variance or the volume-related variance, is the difference between the budgetedquantities to be sold or processed and the actual quantities sold or processed, multiplied by thebudgeted amount.

Figure 13A-3 highlights health plan A’s price variance and volume variance with respect tohealth plan A’s expected PMPM rates. This variance analysis indicates that the health plan Aexperienced lower membership than expected, which, in turn led to lower-than-expectedrevenues. The result is both an unfavorable price variance ($916,700) and an unfavorable volumevariance ($83,500), which lead to an unfavorable total variance of $1,000,200.

A responsibility center report often contains segmented information about a high organizationallevel responsibility center and the lower-level centers contained within it. The performancereports for the lower managerial levels become a part of the performance reports for levels above.We discuss responsibility center reports for profit centers and investment centers in the followingsections.

Segment Reporting in Cost Centers and Profit Centers

The evaluation of a profit center is based on the profits earned by the center. One way to monitorprofit centers is to prepare a document that functions as an internal income statement. Preparingstatements of this type is sometimes referred to as segment reporting.

A segment report for a cost center details the direct costs—those costs that are directly under thecontrol of the cost center’s responsibility manager. A segment report for a profit center includesthe information contained in a cost center report, but it also includes revenues. Further, a segmentreport for a profit center divides these direct costs into fixed costs and variable costs.

Fixed costs are costs that remain constant for all levels of operating activity or products. Oneexample of fixed costs are lease payments for a health plan’s office space because these paymentsstay the same regardless of the health plan’s volume of business or support activity. Variablecosts are costs that fluctuate in direct proportion to changes in the level of operating activity.Claims processing costs are an example of variable costs. The more claims a health planprocesses, the greater the overall cost of providing claims services.

The segment report begins with total revenues (premium income plus investment income)attributable to each level of profit center, then subtracts, in order, the variable costs and fixedcosts incurred by each segment. After all variable costs have been assigned to the propersegments, we can calculate a contribution margin.

The contribution margin for a product is the difference between its selling price and its variablecosts. Similarly, the contribution margin for a segment is the difference between total revenuesand total variable costs. We discuss the contribution margin in the context of cost-volume-profitanalysis in the next lesson.

Fixed costs are categorized as either direct costs or indirect costs to allow for the calculation of asegment margin for each segment of the company. A segment margin is the portion of thecontribution margin that remains after a segment has covered its direct fixed costs. The segmentmargin is found by subtracting the segment's direct fixed costs from its contribution margin.

In segment reporting of profit centers, managers pay close attention to the segment margin, whichis an indicator of a segment's profitability. A segment margin incorporates only those costs andrevenues attributable to the segment. If the segment cannot cover its own costs, it is not profitableand should be investigated. Segment margins and contribution margins are also useful forperformance evaluation when put in ratio form. The segment margin ratio is the segment margindivided by the segment's total revenues:

The segment margin ratio measures a segment's efficiency of operating performance. Thecontribution margin ratio is the contribution margin divided by the segment's total revenues.This ratio is also a measure of segment performance:

Both ratios allow for the comparison of segments of different sizes.

Measuring Investment Center Performance

Unlike cost centers and profit centers, investment centers are also evaluated on the effective useof assets employed to earn a profit. The simplest measure of an investment center's performanceis the amount of net income listed on the investment center's income statement. Traditionalthinking indicates that the best-run segment of the company is the one with the highest netincome, but this is not necessarily true.

Recall that a company’s net income includes the effects of income taxes. Therefore, the use of netincome violates the maxim of responsibility accounting, because taxes are beyond the control ofan investment center manager. Also, a small, well-managed investment center may have lowernet income than a large, poorly managed investment center.

For these reasons, we should not compare two responsibility centers only by net income becausesuch a comparison does not adequately interpret their respective performances. Comparinginvestment centers by the amount of income they generate should not be completely dismissed,however. Two common measures of investment center performance, return on investment (ROI)and residual income (RI), both incorporate income in the context of responsibility accounting.

Return on Investment

Recall that return on assets and return on equity measure the financial performance of an entirecompany. To measure the performance of an investment center, many companies use return oninvestment (ROI), which is the ratio of operating income to controllable investment. The ROIratio is calculated as follows:

Operating income, which can also be called net gain from operations before taxes, is incomebefore subtracting income taxes. Controllable investment includes all balance sheet itemscontrolled by the manager of the investment center. Controllable investment is found bysubtracting controllable liabilities from controllable assets. Sometimes health plans substitutecontrollable surplus for controllable investment in the denominator of the ROI ratio. All otherfactors being equal, the higher the ROI, the better the performance of the investment center.

Return on investment is a better performance measure than net income because ROI overcomesthe problem of comparing investment centers of different sizes. Like the segment margin ratioand the contribution margin ratio, ROI presents a result in percentage terms rather than inabsolute terms. This is not to suggest that absolutes are unimportant. Absolute size is still aconsideration in determining an investment center's contribution to the company as a whole.However, a large absolute can unintentionally prejudice an evaluator against a smaller investmentcenter. Calculating ROI for each investment center helps level the playing field.

Suppose Health Plan Q has two investment centers: Investment Center A and Investment CenterB. Assume that Investment Center A earns $10,000,000 in operating income on controllableinvestments of $60,000,000. Investment Center A’s ROI is 16.7% ($10,000,000 ? $60,000,000).

Assume also that Investment Center B earns $1,000,000 in operating income on $4,000,000 oncontrollable investments. The ROI for Investment Center B is 25% ($1,000,000 ? $4,000,000). Inabsolute terms, Investment Center B's operating income is only one-tenth that of InvestmentCenter A ($1,000,000 versus $10,000,000), yet Investment Center B achieves a much higherreturn on its available resources (25% versus 16.7%).

Besides being valuable as an evaluation tool, ROI can assist company executives in searching forways to improve an investment center's performance. Such assistance arises when the ROIformula is broken down into a return on revenue component and an investment turnovercomponent. Return on revenue measures management's ability to control operating income inrelation to total revenues, which includes premium income and investment income. Return onrevenue is found by dividing operating income by total revenues:

Investment turnover is a measure of the revenue that can be generated for each dollar invested bythe responsibility manager. We calculate investment turnover by dividing total revenues bycontrollable investment:

The ROI formula is the product of return on revenue and investment turnover:

It is important to note that an increase in total revenues alone will not increase an investmentcenter’s ROI. Figure 13A-4, which helps to clarify ROI, presents data for the East and Westregions of a health plan.

Each region is considered to be an investment center. Total revenues for the West region arenearly twice those of the East region, yet West's ROI is much lower than East's. Why? Notice thatEast earned a much better return on revenue than West. East also had a significantly higherinvestment turnover. These two factors led to a much more impressive ROI which, all otherfactors being equal, could earn East's manager a better performance evaluation than West'smanager.

How can the West region attain an ROI similar to that of the East region? As stated earlier, anincrease in total revenues alone is not the answer. Generally, ROI increases in one or more of thefollowing ways: (1) by reducing expenses to increase operating income, (2) by reducingcontrollable investment, or (3) by increasing total revenues, accompanied by a proportionateincrease in operating income.

Figure 13A-5 details these possibilities. Column 1 restates the current data for the West region.The goal is to increase ROI from the current 14.9% to the 23.5% achieved by the East region. InColumn 1, we reduce the West region’s administrative expenses from $3,900,000 to $3,140,000.This reduction in expenses increases operating income, which increases return on revenue andultimately increases ROI to the target 23.5%.

In Column 2, we retain the current levels of total revenue and operating income and reduce theinvestment from $8,850,000 to $5,620,000 to generate an ROI of 23.5%. And in Column 3, anincrease in total revenue from $10,395,000 to $11,155,000, along with a corresponding increasein operating income, increases ROI to 23.5%.

Notice that the increase in operating income (the differences between Column 0 and Columns 1and 3) required to raise ROI to 23.5% is only $760,000. But the decrease in controllableinvestment (between Column 0 and Column 2) necessary to achieve the same ROI is $3,230,000.

Because either of these changes results in the same improvement in ROI, it would seem to bemuch easier for the West region to improve its ROI by either decreasing expenses or increasingrevenues (and operating income) by a relatively small amount than it would be to operate at thecurrent level using far fewer invested assets. In fact, a current trend in all industries is to cutexpenses to improve operating results.

Some health plans require that their investment centers earn a specified ROI. Incentive programsoften encourage responsibility managers to strive for higher returns on investment. Managers ofthese investment centers consider a variety of actions that could increase ROI, such as expansion,capital improvements, and even the sale or discontinuance of a lagging business.

Some companies measure the performance of investment centers using residual income. Residualincome (RI) is the amount of income an investment center earns above a certain minimumrequired rate of return on investment. The minimum required rate of return reflects the company'scost of capital, which we discussed in The Strategic Planning Process in health plans.

To earn a positive ROI and to fostergrowth, companies establish arequired rate of return that is higherthan their cost of capital. Residualincome is found by subtracting theproduct of (1) an investment center'sminimum required rate of return and(2) its controllable investment fromthe center's operating income. Theminimum required rate of return timescontrollable investment is sometimescalled the capital charge. The entireresidual income calculation is asfollows:

Assume that an investment center's operating income is $450,000, its controllable investment is$2,000,000, and its minimum required rate of return is 15%. We calculate the center's residualincome as follows:

The $150,000 in residual income represents the amount of income that the investment centermanager is able to earn in excess of the company’s minimum required rate of return. When usingresidual income to compare two or more investment centers, the investment center with thelargest amount of residual income generally has the best financial performance.

Return on Investment and Residual Income Compared

Goal congruence is a key consideration when a company implements a performance measurementsystem for its investment centers. Performance measurement systems can affect the behavior ofmanagers and thereby affect whether the decisions they make are the right ones for the company.Ideally, the performance measurement system draws managers toward goal congruence.

The RI method of evaluation demands greater goal congruence from managers than does ROI.Evaluation by ROI requires only that investment center managers achieve an acceptable return oninvestment, but residual income encourages managers to accept investment opportunities thathave rates of return greater than the cost of capital. One drawback of ROI is that managers beingevaluated by ROI may be reluctant to accept new investments that might lower their center'scurrent ROI, even though the investment would be in the best interest of the entire company. Thispractice defies goal congruence.

Figure 13A-6 reveals these behavioral characteristics of ROI and RI. Assume that health plan Qrequires its investment centers to achieve an ROI of 20%. The actual results of one investmentcenter, as seen in the top portion of Figure 13A-6, are $610,000 of operating income on

$3,000,000 of controllable investment. As you can see, the ROI of 20.3% indicates that theinvestment center's manager has met health plan Q’s target ROI.

Suppose this manager has the opportunity to invest $500,000 in a project that will provide a 17%annual return or $85,000 (17% ? $500,000). The minimum required rate of return for thisinvestment is 15%. (Note that the minimum required return will be different for different projectsto reflect the level of risk presented by each project.) It is in health plan Q’s best interest for themanager to invest in this project because the project's return exceeds the health plan’s minimumrequired rate of return and the project will generate an additional $85,000 of operating income peryear.

However, this manager, whose performance evaluation is based on achieving an ROI of 20%,might be reluctant to make the investment because it would lower the investment center's ROIfrom 20.3% to 19.9%, as is exhibited in the middle section of Figure 13A-6. This goalincongruence is induced by the use of ROI.

What if the investment center is evaluated by residual income? The bottom portion of Figure13A-6 demonstrates an acceptance of the project. As you can see, because the project's 17%return exceeds the company's 15% minimum required rate of return, the project will increaseresidual income from $160,000 to $170,000. This additional residual income will not onlyimprove the investment center manager's evaluation, it is also in the best interest of health plan Q.Thus, the use of residual income as a performance evaluation method fosters goal congruence.

The major disadvantage of residual income is that it is an absolute figure and tends to favor largerinvestment centers. A disadvantage of both ROI and RI is that, if emphasized too greatly, theycan lead to decisions that improve short-term profits at the expense of long-term objectives. As

shown in Figure 13A-5, residual income and ROI can be improved by reducing expenses. It ispossible that a manager may forgo some important expenditures for the sake of a higher ROI orresidual income.

For example, a health plan’s member services division may need additional staff, but the divisionmanager might not receive approval to hire the necessary employees because the extra salaryexpense would decrease the division's ROI or RI. However, overworked employees could makemistakes and cause delays in service, dissatisfying members and resulting in a high lapse rate atrenewal. In the long run, this would be more costly to the health plan than hiring additionalemployees in the first place. Figure 13A-7 summarizes the main advantages and disadvantages ofROI and RI.

Issues Associated with Performance Evaluation

In the previous section, we examined the ways in which a company’s senior managementmeasures and monitors the performance of its various responsibility centers. In practice, however,achieving an accurate summary of performance is rarely so straightforward as preparing onereport or calculating a simple ratio.

As we discussed earlier, a premise of responsibility accounting is that responsibility managersshould be accountable for only the costs that they directly control. But few costs are clearly theresponsibility of only one individual. Most costs have varying degrees of controllability. Thepurpose of responsibility management is to identify the individual most directly responsible forincurring each cost.

Several related issues must also be considered before giving a final “grade” to a responsibilitycenter or its manager. Some of these issues are problems inherent in the evaluation process. Otherissues may affect a responsibility center’s performance, and, if not considered, may lead to aninaccurate appraisal of the center. In the following sections, we discuss potential problemssurrounding performance evaluation criteria.

The underlying motive behind responsibility accounting is measuring and evaluating theperformance of responsibility centers and responsibility managers. These evaluations guide ahealth plan’s senior management in allocating future resources to each business segment, makingdecisions about segments, and compensating and promoting responsibility managers.

But the evaluation criteria can be as important to the final evaluation as the actual performancethat is being evaluated. Potential problem areas include (1) relying too heavily on varianceanalysis, (2) using only one evaluation criterion, (3) using inappropriate evaluation criteria, (4)setting unattainable goals, and (5) judging a responsibility manager’s performance solely on thebasis of the responsibility center’s performance.

Overemphasis on Variance Analysis

Isolating budget variances is a simple and common method for evaluating performance.Variances, however, can be misleading. For example, when analyzing budget variances,management has a tendency to pay attention only to unfavorable variances. However, seeminglyfavorable variances should also receive close scrutiny to determine whether they are indeedfavorable to the company.

For example, a responsibility center may have been budgeted $38,000 for a given activity butspent only $29,000. On the surface, this variance appears to be favorable. Upon reviewing thefigures, however, management attempts to determine the reason for the seemingly superiorperformance. The favorable variance may have resulted from overly pessimistic (or “padded”)projections, indicating that what at first appeared to be performance that exceeded expectationswas actually an indication of the responsibility manager’s poor judgment in making budgetestimates.

Favorable variances can also occur as a result of overzealous or shortsighted actions that includelowering quality standards, disregarding training, or altering operating procedures to reduceexpenses in ways that diminish a product’s or service’s quality or competitiveness. For example,a dramatic increase in new business that might appear to be a favorable budgetary variance couldactually be the result of using more relaxed underwriting standards. Ultimately, the health plancould experience extensive losses from that new business.

Variance analysis can also mislead when evaluators consider budget variances that are beyond thecontrol of a responsibility manager. Such uncontrollability often arises when one variance causesa second variance. In the following example, an unfavorable variance (a significant increase inthe volume of phone calls) in one area causes another unfavorable variance (a significant increasein departmental salary costs).

Suppose a health plan’s budget for its member services department forecasts call volume similarto that of the previous year. However, this year, the health plan’s marketing departmentintroduces a new product that generates a significant increase in phone calls to the memberservices department, which in turn has to hire several new employees to answer phones.

In this scenario, the member services department experiences an unfavorable variance—even ifthe cost per phone call has actually decreased—because of the increase in wages paid to newemployees who were hired to accommodate the increase in phone volume from the previous year.This circumstance should not be overlooked during the final evaluation of the member servicesdepartment or its manager.

Use of a Single Evaluation Criterion

Another evaluation problem occurs when evaluators reduce a responsibility manager’sperformance evaluation to a single, all-encompassing measure. This practice usually emphasizesonly one goal and ignores all others. For example, if the member services manager in thepreceding example were evaluated almost exclusively on budget variances, then this managerwould be motivated to under staff the department to keep expenses low.

If the manager acted in this way, the result would be a lower member service quality for thehealth plan’s new product. To avoid this problem, responsibility managers are typically evaluatedon a number of criteria. For example, the member services manager might also be evaluated onaverage call hold-times, call abandonment rates, and plan member survey results on the quality ofmember services for the new product.

Use of Inappropriate Criteria

A related evaluation criteria problem is using performance measures that fail to reflect a healthplan’s objectives or its employees’ responsibilities. Again, emphasizing profits in the short runwithout consideration of long-term consequences can negatively affect a company’s financialperformance.

Nonetheless, some companies base management evaluations only on short-term results, such as aquarterly target ROI. Therefore, managers can be tempted to forsake long-term goals and overuseresources to maximize short-term returns if it is the only way to earn a satisfactory performanceevaluation. Such companies may find themselves with insufficient resources in the future.

Unattainable Goals

Evaluation problems can arise when performance standards are not attainable by responsibilitymanagers. For example, a responsibility manager may be evaluated unfavorably for failing toachieve goals that are unrealistic. Evaluators can avoid this problem by becoming aware of howthe budgets and other standards are determined and to what extent controllability is considered inthe comparison of budgeted to actual amounts. A company can reduce the problem ofunattainable goals by involving responsibility managers in the preparation of their centers’budgets. Managers tend to react more favorably toward budgets that they helped prepare.

Responsibility Managers vs. Responsibility Centers

Senior management evaluates responsibility managers apart from their responsibility centers. Amanager may be doing an acceptable job even though the results of the center are unsatisfactory.This situation can happen to the manager of a responsibility center or other business segment in adeclining market.

Conversely, a business segment in a growing market may be thriving through no specialaccomplishment of the manager. In either case, senior management determines whether theperformance of the manager has affected the performance of the segment, or whether the resultsare a function of the segment’s environment.

Transfer Pricing

Evaluating the performance of a company’s profit centers and investment centers can be difficultwhen transfer pricing is involved. A transfer price is the price of a good or service that onesegment of a company charges another segment of the same company. Unlike intercompanytransactions in which prices are determined by supply and demand factors, transfer pricingarrangements are established by a company’s management. Transfer pricing is especiallyimportant for health plans with subsidiaries or health plans that are themselves subsidiaries.

Several methods are used to set transfer prices. The transfer pricing method a company selects iscritical because transfer prices directly influence the profits for which managers of profit orinvestment centers are held responsible. An inappropriate transfer price might provide amisleading picture of a responsibility center’s true performance, and, even worse, might motivatethe responsibility manager to initiate actions that are not in the best interest of the company.Figure 13A-8 summarizes three methods of setting transfer prices: cost, market price, andnegotiated price.

AHM Health Plan Finance and Risk Management: Cost Accounting

Course Goals and Objectives

After completing this lesson you should be able to

Explain the primary uses of cost accounting in health plans Discuss various ways that costs can be accumulated Compare the three methods of analyzing costs: change analysis, functional cost analysis,

and activity-based costing

Nearly every decision that a health plan makes about product benefit design, providerreimbursement, products, and advertising carries a cost. Before a health plan can determine whatproducts it can offer, how many plan members it can serve, and what it can charge for its productsand services, the health plan must know its cost of doing business.

For example, a health plan determines the minimum premium (price) that it can charge for agiven level of healthcare benefits by examining the costs it incurs in developing, distributing, andadministering those benefits now and in the future. Generally, the selling price of a company’sproduct must be at least high enough to cover all of the product's costs and provide a profit for thecompany. The gathering and interpretation of cost information is therefore critical fordetermining an appropriate premium rate.

Cost Accounting

A cost is an expenditure incurred to obtain an economic benefit or to extinguish an obligation.Cost accounting is a system that defines, describes, accumulates, records, and assigns all thecosts incurred by a company. Cost accounting enables a health plan’s managers to planoperations, organize employee work loads, develop provider networks, and evaluate currentfinancial performance so that the health plan is best prepared to make decisions.

Most health plans have an automated cost accounting system. To satisfy unique needs, a costaccounting system may vary among individual health plans, and, sometimes, even betweendifferent divisions of the same health plan. Whether a health plan prepares its financial statementsfor management reporting purposes or to comply with regulatory requirements, the health plancan design its cost accounting system to provide cost information in a variety of different formatsor to allocate expenses to a specified division, segment, product, or plan sponsor. Figure 13B-1lists some of the uses of cost accounting for health plans.

One essential element of an effective cost accounting system is accurate and complete accountingdata. Before a health plan can develop an effective cost accounting system, it must already havein place an accounting system that produces reliable financial data at the appropriate level ofdetail. The information provided by cost accounting is only as reliable as the historical andcurrent data on which the cost accounting system is based.

Another necessary element is the identification of costs by product line, line of business, division,and function. Examples of a health plan’s product line include its HMO, PPO, and POS products.A health plan’s lines of business may include its group and non-group business.

A health plan may also need to analyze costs by department or function, such as marketing, sales,claims, member services, provider relations, and underwriting. Typically, the more specified thecost information, the greater a health plan’s overall effectiveness in analyzing costs. The rest ofthis lesson discusses how a health plan classifies and analyzes its costs.

Cost Classification

A health plan tries to obtain precise, specified descriptions of all costs that it incurs in the courseof conducting business. The process of classifying a health plan’s costs produces usefulinformation for the health plan’s managers to make objective decisions based on cost. Costs canbe classified by description, behavior, and measurement. Note that many costs fit into more thanone classification. Where appropriate, we identify the classification of a cost in more than onecategory.

Costs Classified by Description

The most basic way to classify costs is by their descriptive characteristics. Because many costclassifications have an opposing classification—for example, direct costs and indirect costs—costs classified by description may be thought of in pairs. Figure 13B-2 summarizes the mostcommon classifications for pairing costs by description.

In the context of cost accounting, a cost object is any purpose for which a company measures itscosts. One way to determine whether a cost is a direct cost of a particular cost object is to decideif the cost would disappear if the cost object disappeared. For example, the salary (cost) of ahealth plan’s marketing manager for its managed dental product (cost object) is a direct cost ofthe managed dental product because the salary cost disappears if the health plan no longermarkets that product.

To establish and evaluate distinct responsibility centers, a company must be able to distinguishcontrollable costs from noncontrollable costs and direct costs from indirect costs. For example,the salary of a responsibility center manager is a direct cost of that center. However, depreciationon a health plan’s home office facility is an indirect cost, so this same responsibility managershould not be held accountable for it.

Differential costs and sunk costs usually are a direct result of management decisions. Suppose ahealth plan plans to design and implement a new automated system to track providerreimbursement and utilization of healthcare services. To complete this project, the health planmust add new computer equipment and software to existing equipment and it must hireconsultants to design the system's software and train the health plan’s employees.

In this case, all costs that are incurred as a result of deciding to proceed with this project are bothdirect costs and differential costs. All costs that are already committed costs, but that were notoriginally committed to this project, are direct costs and sunk costs. Thus, the costs of the newcomputer equipment and software and the costs of the consultants are differential costs. The costsassociated with the health plan’s existing equipment will not change as a result of the decision togo ahead with the project, so these costs are sunk costs.

Costs Classified by Behavior

Time and volume are the defining factors when classifying cost by behavior. Some costs changeas the amount of time needed to complete an activity changes. Other costs change as the volumeof an activity changes. Many costs change with both time and volume, and some costs are notaffected by time or volume at all.

Costs that can be defined by behavior are most commonly classified as fixed costs, variable costs,and semi-variable costs. We introduced fixed and variable costs in our discussion of segmentreporting in the previous lesson. Figure 13B-3 lists costs that are classified by behavior.

Costs Classified by Measurement

The third cost classification considers a cost's measurement attributes. These costs are especiallyhelpful for management reports and for cost-volume-profit analysis, which we describe later inthis lesson. Costs classified by measurement include unit costs, marginal costs, and opportunitycosts, which are depicted in Figure 13B-4 and discussed in the following sections.

Unit Costs

Unit costs in health plans are often described on a per member basis. Examples of unit costsinclude the

Cost per policy or contract issued Cost per $100 of broker commissions paid Cost per new plan member Cost per existing plan member Cost per paid claim Cost per account or group Cost per $1,000 of investment income

Knowing the per member unit cost of products sold can guide a health plan’s managers in

Predicting future costs Evaluating the efficiency of personnel, operations, and equipment Setting premium and dividend rates Benchmarking the health plan’s operations with those of other health plans

Fixed costs and variable costs can be expressed in terms of unit costs. Normally, as productionvolume or the amount of activity increases, fixed unit costs decrease. As volume decreases, fixedunit costs increase.

Suppose a health plan had 150,000 existing plan members in 2003 and 160,000 existing planmembers in 2004. Assume that the health plan’s total fixed costs in each year were $2,500,000. In2003, the fixed unit cost per member was $16.67 ($2,500,000 ÷ 150,000). In 1998, the fixed unit

cost per member was $15.63 ($2,500,000 ÷ 160,000). This simple example demonstrates thatfixed unit costs decrease as volume increases.

Unit costs are often used to express standard costs. Recall from the previous lesson that standardcosts are predetermined costs that a health plan expects to incur for particular items duringnormal business operations. Many health plans establish a standard cost for each item againstwhich they later compare the actual cost.

For example, an important standard unit cost for PPOs is the unit cost of processing one claim. APPO establishes a standard unit cost for processing one claim and then conducts varianceanalysis; in other words, the PPO compares that standard cost with the actual unit cost ofprocessing the claim. We discussed variance analysis in Management Accounting.

Marginal Costs

Marginal cost information is essential for making production decisions because it helps managersto determine the monetary effect of a specific action, and, in certain cases, whether an actionshould or should not be taken. Once a certain sales volume has been reached, the decisionwhether to produce or sell additional units involves different cost considerations than the earlierdecision to produce or sell the initial amount. Some of the costs involved in processing the initialamount may not apply to the additional production.

Suppose a health plan receives 50 new individual policy applications per year at a total cost of$40,000. The total cost of processing 51 new individual applications is $40,500. The marginalcost of the 51st policy is $500 ($40,500 - $40,000). A similar marginal cost study could beperformed on the costs of processing the 52nd and 53rd policy application, and so on.

The health plan’s receipt of the 51st application would probably not cost as much as 1/50th of$40,000, because most of the health plan’s total expenses—such as advertising, office supplies,and office space rent—are committed costs or sunk costs. Therefore, these expenses areunaffected by the processing of one additional application.

In other words, the marginal cost of each additional unit is different from the unit cost of theinitial amount produced. To help make production decisions, managers consider the marginalunit cost, which is the increase or decrease in the unit cost as a result of an additional unit of agood or service. As you may have guessed, marginal cost information is useful to managers whendetermining the optimal level of production relative to the resources available.

For example, a health plan often compares sales per member costs by group size. Larger groupstend to be less expensive to sell on a per member basis, in part because it is possible to spread theplan’s fixed costs over a larger number of plan members. In this case, the health plan wouldallocate proportionately more resources to individual or small group product sales than to largegroup sales.

Opportunity Costs

In making decisions about expenditures, a health plan must consider both its out-of-pocket costsand its opportunity costs. Suppose a health plan is considering the introduction of a new POSproduct. The health plan estimates that its out-of-pocket cost of this project will be $1 million for

research, actuarial work, automated systems, marketing, and compliance with statutory reportingrequirements. What are the health plan’s opportunity costs associated with this project?

Instead of introducing the POS product, the health plan could use the $1 million to enhance itscurrent information system. Alternatively, the health plan could use the $1 million to purchaseassets to generate investment income. Efficiencies realized from an improved information systemor from additional investment income may provide the health plan a return that equals or exceedsthe return offered by the new POS product. Note that the health plan could also use the $1 millionfor a variety of other purposes.

The difficulty with considering opportunity costs is that there is no definitive way to capture themin a health plan’s accounting system because there is no transaction involved—no exchange ofmoney or value of service to record. A health plan’s managers should therefore analyze variousbusiness scenarios to determine the cost of making each business decision.

In the above example, before deciding whether to develop the POS product, the health plan wouldconsider not only the out-of-pocket costs of undertaking this project, but also the opportunitycosts associated with

Undertaking the new POS product Enhancing the existing information system Investing in assets to generate additional investment income

When deciding whether to introduce the POS product, the health plan would also consider themarginal unit costs associated with other alternatives.

Cost Perspective

From the above discussion, we may conclude that there are many varieties of costs and that asingle cost can be classified in several different ways. Cost classification depends on the point ofview of the individual analyzing the cost and the point of view of the individual or departmentincurring the cost. For example, the salary of a health plan's vice president of group marketing is

A direct cost of the marketing division as a whole An indirect cost with respect to the individual and small group marketing areas within the

marketing division A fixed cost that remains unchanged regardless of the activity of the division A controllable cost to the health plan’s president and board of directors A committed cost that resulted from a prior management decision regarding the operation

of the health plan A sunk cost that has already been incurred and cannot be avoided

Similar multiple characterizations can be made for virtually every other cost incurred by a healthplan. A function of management accounting is classifying costs in different ways to better analyzecompany operations. Useful cost classification also promotes proper cost accumulation and costallocation, which we discuss in the following sections.

Cost Accumulation

Ideally, a cost accounting system should provide each manager with sufficient information tomake informed decisions about the operations for which he or she is accountable. But theinformation generated from the cost accounting system is only as useful as the informationoriginally input. To be a valuable management tool, the cost accounting system shouldaccumulate costs and allocate costs accurately and fairly.

Cost accumulation is the process of capturing all of a company’s costs and categorizing them inmeaningful ways. Once the company accumulates the total amount of costs, it can allocate themto departments, products, and lines of business relative to management needs. Specifically, ahealth plan’s cost accounting system should ensure that each cost is charged to the area of thehealth plan that is responsible for generating the cost.

Four methods of accumulating cost data are by (1) type of cost, (2) line of business, (3)department or cost center, and (4) function. Many health plans accumulate costs by more than oneof these methods to learn whether the costs associated with one classification, line of business,department, or function are greater or less than expected.

Accumulating Costs by Type

The most basic level of cost accumulation is by type of cost, such as salaries, advertising,marketing, medical services, and so on. On this level, costs are accumulated without regard to thespecified area of the health plan that incurs the expense. For example, all health plan costsrelating to salaries can be accumulated in one "Salaries" classification instead of being associatedwith a particular department, function, product, or service.

Accumulating costs by type enables health plans to satisfy financial reporting requirements forcompiling financial statements and corporate tax returns. Also, accumulating costs by type assistsa health plan’s managers in studying which types of costs are rising and falling over time.However, accumulating costs by type does not explain which areas of the health plan incur eachcost and, therefore, who or what is responsible for changes in cost levels.

When accumulating costs by line of business, all costs that are associated with the sale andadministration of a particular line are charged to that line. A line of business (LOB) is a segmentthat differs from other segments with respect to sales approach or with respect to client ormember service; in the context of cost accounting, a line of business is a segment of products thathas a cost pattern distinct from that of other product segments.

The product segment’s methods of sales and service usually determine its cost patterns. Examplesof a health plan’s lines of business include individual, small group, large group, Medicare, andMedicaid. After entering a cost in the accounting system, such as under "Salaries," the health planalso assigns the cost to an LOB, such as small group.

Accumulating Costs by Line of Business

Cost accumulation by LOB may include all the costs associated with a particular line or withindividual products within a line. This method of cost accumulation helps management to

Make pricing decisions

Analyze the profitability of products and lines of business Comply with financial reporting requirements

Suppose a certain product requires significantly more of a health plan’s resources than the healthplan’s other similar products. When it accumulates costs by line of business, the health plan’smanagement is better able to identify the problem and take appropriate action. Actions that thehealth plan may consider to address this problem include a product rate increase, productredesign, re-engineering of product processes to reduce costs, or, in a worst-case scenario,withdrawal of the product from the market.

Accumulating Costs by Department or Cost Center

The third level of cost accumulation is by department or cost center. A cost center, as we saw inManagement Accounting, is a department or other business segment—for example, accounting,legal, or claims—to which costs can be charged. To provide accurate cost information, costcenters should accumulate their costs according to the various levels of accumulation, such astype and function.

A health plan accumulates costs by cost centers to facilitate the budgeting process and to identifythe total cost of operating various areas. When accumulating costs by cost center, the costs ofdepartments at each level of a health plan can be "rolled into" the cost reports for departments athigher levels in the health plan. This type of accumulation enables management to judge theperformance of individual cost centers.

Accumulating Costs by Function

When costs are accumulated by function, they are directed to the health plan operation thatgenerates the costs. In the context of cost accumulation, a function consists of a series of tasksthat serve a specific purpose. The accumulated costs of the activities involved within a certainfunction, without regard to departmental lines, are known as functional costs. Within eachfunction are the costs of salaries, supplies, equipment, and so on.

For example, a health plan can determine the cost of collecting renewal premiums by gatheringcost data from all departments or areas that are involved in the collection process, not just fromthe cashiers' area that receives and records premiums. Other costs incurred in receiving premiumsinclude printing and postage expense, machine costs for preparing and mailing premium notices,and the indirect costs of other departments involved in premium collection. The costs of all theseoperations are included in a functional cost analysis of the renewal premium collection process.We discuss functional cost analysis later in this lesson.

Accumulating costs by function is more complicated than accumulating costs by type or costcenter. Functional cost accumulation involves identifying and measuring all the activitiesinvolved in a given function. If an activity is involved in more than one function, a health planallots the correct portion of an activity's cost to each function that uses the activity.

Suppose one of a health plan’s functions is to maintain current information on plan members inthe health plan’s information system. In this case, all the costs associated with maintaining theserecords—including costs associated with obtaining plan member information, inputting theinformation into the health plan’s information system, and obtaining and inputting updated planmember information—would be charged to this function.

Assume that the health plan’s employees in the claims department spend 10% of their timeupdating plan member records. In this case, the health plan would allot 10% of total salaries inthe claims department to the function of maintaining current information on plan members.

Cost Perspectives

Again, we can classify a single cost in different ways. For instance, the cost of underwritingapplications for a new individual HMO product could be classified as

A salary cost when accumulated by type An individual product cost when accumulated by line of business An underwriting department cost when accumulated by cost center A plan member record cost when accumulated by function

Cost Allocation

Once a health plan accumulates all costs, it assigns the costs to the department, function, and lineof business that was responsible for generating them. It is usually straightforward to charge directcosts to the appropriate cost object. For example, if the marketing department spends $300 fordedicated telephone lines for its department's fax machines, the cost of the lines is charged to themarketing department.

Assigning indirect costs to the appropriate responsibility center is less straightforward. To addressthe problem of assigning indirect costs, health plans use cost allocation. Cost allocation is theaccounting process of assigning or distributing an indirect cost or expense according to a methodor formula. Examples of indirect costs that can be allocated include service department costs andthe salaries of managers in charge of more than one responsibility center.

Note that cost allocation is arbitrary to some degree. Therefore, a health plan’s managementconsiders whether indirect costs are allocated and by what method they are allocated in evaluatinga responsibility manager. Sometimes responsibility managers believe they are being allocatedcosts that do not apply to their centers. Problems with improper or unfair cost allocation canoccur because of internal influences (company politics), insufficient data to properly allocatecosts, or a flawed cost allocation system.

Suppose a health plan serves markets in several metropolitan areas, with separate profit centersfor each market. Each of these profit centers receives support—such as underwriting, contractissue, and claims processing—from a regional home office. The health plan must determine aneffective way to allocate the expenses for the support services to each profit center.

Assume that Profit Center A’s market consists predominantly of large employer groups and thatProfit Center B sells primarily to individuals. In this case, Profit Center A would expect to payless per plan member for its underwriting, contract issue, and claims processing services thanProfit Center B.

Cost Allocation Bases

To help ensure an equitable allocation of indirect costs, health plans seek an allocation base, ormeasure of use, that exhibits a proportional relationship between the indirect cost and the costcenter being allocated a portion of that cost. Common allocation bases are the amount of square

footage, number of employees, and percentage of direct costs, as described in Figure 13B-5. Inaddition to these allocation bases, health plans also use number of plan members as an allocationbase.

Cost Allocation Methods

Keep in mind that different allocation methods and allocation bases are typically appropriate forvarious types of costs. There are several general methods for allocating a health plan’s indirectsalary costs and non salary expenses. In addition to these methods, health plans that havegovernment business, including Medicare and Medicaid contracts, must comply with regulatoryrequirements concerning cost allocation.

Most health plans allocate indirect salary costs by using time analysis, which determines thepercentage of time a manager spends with different departments or activities. Three commonmethods of time analysis are estimated time, actual time, and standard time. A discussion of thesemethods is beyond the scope of this course.

Indirect expenses other than salaries include rent and utilities, institutional advertising,association dues, medical fees, and data processing services. A decision whether to distribute nonsalary expenses among cost centers depends on a health plan's size, cost control program, and thelevel of information that its management requires. Nevertheless, methods of allocating indirectexpenses other than salaries are somewhat arbitrary and differ from company to company.

Cost Analysis

Originally, most cost accounting systems for insurance companies and health plans wereestablished to meet statutory reporting requirements, rather than the information needs of internalmanagement. In recent years, however, changing factors—including new and complex products,declining profit margins, increased competition, and more knowledgeable and demandingpurchasers—have led to refinements in cost accounting systems.

As a result, health plans have become more aware of the need for accurate cost data and analysis.In the following sections, we describe three methods used to analyze costs for internalmanagement purposes: change analysis, functional costing, and activity-based costing.

Change Analysis

Health plans analyze the way costs change over time to spot trends in costs. Change analysisinvolves the comparison of costs in one period to the same costs in a different period, such ascomparing this month's costs to last month's costs or this month's costs to the same costs sixmonths ago, one year ago, or several years ago. Figure 13B-6 shows an example of a health plan'schange analysis. This example compares operating costs for the current period with the sameperiod in the previous year.

Analyzing cost trends helps management spot fluctuations, peaks, and valleys in the health plan’soperations. It also helps predict future costs. However, change analysis does not indicate whatcauses the fluctuations. For example, if a health plan’s research and development costs increasedby 130% in one year, resources may or may not have changed proportionately. Change analysiswould not consider this alteration in product mix. Thus, change analysis is useful for identifyingwhat costs have changed but not why they changed.

Functional Cost Analysis

We discussed functional costs earlier in this lesson. Functional cost analysis enables a healthplan's top management to analyze costs as they apply to workflow rather than to organizationalstructures. Through functional cost analysis, a health plan’s management can identify inefficientor unnecessary functions within a department and cut costs accordingly, without harming themore efficient, useful functions within the department.

Developing an effective functional cost accounting system with an appropriate level of detailrequires identifying and defining each business function within the health plan—marketing,claims processing, data processing, underwriting, and so on—as well as each line of business or

product offered. These functions, lines, or products may or may not coincide with thedepartmental units of the health plan.

Functional cost analysis is especially helpful when health plans make pricing and staffingdecisions. Using functional cost analysis, a health plan’s management can analyze relativelysmall functions (for example, file maintenance) by product line, all the way up to complexfunctions (for example, total selling costs). Having functional cost data in addition todepartmental data helps a health plan to:

Price products Monitor and control current operational procedures Identify trends that are not recognizable with conventional analyses Project more accurate plans and budgets for future operations Benchmark operations against other health plans

One of the most useful ways to analyze functional costs is through unit costs. A functional unitcost is found by dividing the total functional cost by an appropriate base unit, such as number ofplan members, number of claims, or amount of premiums collected. The ratio of expenses topremiums is an example of unit cost information in which a health plan’s management is keenlyinterested.

The appropriate unit of measure to use in calculating unit costs depends on the function itself andthe line of business being monitored. Units of measure may be monetary or nonmonetary. Bycomparing functional costs on a unit cost basis, a health plan’s management is able to monitor theproductivity and profitability of departments and products.

Suppose the functional unit cost of adding one new member to Green HMO's health plan issignificantly greater than the functional unit cost of adding one new member to Blue HMO'shealth plan. As a result of functional cost analysis, Green HMO might explore several options todecrease its functional unit cost. Possible solutions include updating Green HMO's informationsystem, providing more training, reducing staff, or standardizing plan designs.

Analysis-Based Costing

Activity-based costing (ABC), a type of functional cost accounting, links costs to productsaccording to the activities consumed in producing the products or services. In other words, ABCidentifies units of activity, calculates the costs of performing each unit of activity, and thenassigns the cost of each unit of activity to products or lines of business.

An activity is any procedure that generates work. Activities within a health plan include issuing agroup policy, sending a premium due notice, and investigating a claim. An activity driver is theoutput of an activity being performed. For example, if the activity is the preparation of memberbooklet-certificates, the activity driver would be the mailing of the printed booklet-certificates.

Establishing an ABC system for a health plan is essentially a four-step process:

1. Identify the activity2. Identify the activity drivers3. Match costs to each activity4. Trace activity costs to products or lines of business

Under traditional costing systems, the assumption is that products generate costs. Under ABC, theassumption is that activities generate costs. To provide products and services for its purchasers,payors, and strategic partners, a health plan engages in a variety of activities. These activitiesconsume resources—such as labor, supplies, and computer time—and produce outputs—such aschecks for network providers or contracts for purchasers and payors.

By using ABC, a health plan's managers are able to identify which activities add value to itsproducts and services and which do not. A value-added activity is one that makes a product orservice more valuable to the customer. A non-value-added activity is an activity that does notmake a product or service more valuable to the customer. Generally, non-value-added activitiesare wasteful and should be minimized. Figure 13B-7 presents a simple comparison of costsaccumulated in a traditional way and costs accumulated by activity. Note that the total costsincurred do not change.

Cost-Volume-Profit Analysis

Cost is a major area influencing the pricing of products and services. For each health plan’sproduct, the product's cost sets the lower limit for the product's price. In the long run, no healthplan can expect to survive if it sells products below what it costs to produce and sell them. Thepricing of health plan products is much more complicated than the pricing of most other productsbecause the price has to be established before the costs are known.

A health plan carefully establishes the assumptions on which it bases a product's estimated costs.Understanding the behavior of costs is essential to estimating a product's costs. Some costs maydecrease over time. Other costs may escalate, particularly in times of high inflation. Unmanagedcosts can quickly reduce or even eliminate a health plan’s expected profit on a particular productor service.

Cost accumulation data helps a health plan’s managers to project the costs associated with aproduct as the health plan gains experience in developing, marketing, and servicing the product.The health plan can apply this knowledge when pricing similar new products or when adjustingpricing factors, such as morbidity charges, on current products. One tool that health planmanagers use to help analyze the appropriateness of pricing decisions is cost-volume-profitanalysis.

Three important elements in business decisions are cost, volume, and profit. Analysis of theseelements is a powerful management accounting tool. Cost-volume-profit (CVP) analysis,sometimes called break-even analysis or profit-volume analysis, is the study of the effects ofchanges in product prices, sales volume, fixed costs, variable costs, and the mix of products.

The use of CVP analysis assists managers in budgeting and planning and it helps answer suchquestions as, "Which products and services should we sell?" "What price should we charge?" and"What level of sales should we strive for?" In the following sections, we discuss two keycomponents of CVP analysis: contribution margin and the break-even point.

Contribution Margin

Cost-volume-profit analysis makes use of costs that are classified by behavior—fixed costs,variable costs, and semi-variable costs—and unit costs. Fundamental to CVP analysis is theconcept of contribution margin, which, as we saw in Management Accounting, is the differencebetween a product's selling price and its variable costs. The contribution margin is important toCVP analysis because it indicates the impact of changes in net gain caused by changes in costs,selling price, volume, or a combination of the three.

The term contribution is used because this amount is available to (1) cover fixed costs and (2)contribute to profit. If a product's contribution margin is less than its fixed costs, the health plansuffers a loss on the product. Otherwise, the health plan breaks even or experiences a gain(profit). Two ways to express contribution margin are as a total, and on a per-unit basis. Wecalculate these two variations

Determining unit price figures for health plan products is complicated and outside the scope ofthis text. In this discussion, we assume that the health plan has already calculated its unit pricefigures.

Break-Even Point

The break-even point is the point at which total revenues equal total costs, and fixed costs equalthe contribution margin. If a health plan sells just enough units of a product to experience neithera net gain nor a net loss—in other words, net income equals $0—it will break even. Once itreaches the break-even level of sales, the health plan will begin to experience a net gain equal tothe contribution margin for each additional unit of product sold.

A product’s break-even point could be found by trialand error. However, it is much simpler to use a break-even formula, in which fixed costs are divided by theunit contribution margin:

Figure 13B-8 calculates the break-even point for ahealth plan's product.

Cost-Volume-Profit Graph

A cost-volume-profit (CVP) graph, sometimes called a break-even chart, highlights cost-volume-profit relationships over a wide range of sales levels. A CVP graph gives a health plan’smanagers another way to see the point at which a product’s net gain begins.

Figure 13B-9 shows the CVP graph for the product discussed in our previous example. Note thatthe total cost line and the sales revenue line intersect at the break-even point—that is, when thevolume of sales (enrolled plan members) is 1,000. This is the same break-even point that wecalculated using the break-even formula.

From Figure 13B-9, we see that, at each volume of sales to the right of the break-even point, thevertical distance between the sales revenue line and the total cost line is the amount of net gainrealized at that volume. Likewise, to the left of the break-even point, the vertical distance betweenthe total cost line and the sales revenue line is the amount of net loss realized at that volume.

Uses of Cost-Volume-Profit Information

There are many applications of CVP analysis for management accounting. The use of CVPanalysis enables a health plan’s managers to test scenarios using different cost, volume, and priceassumptions for each product so they can see what different inputs result in net gains for thehealth plan.

Suppose a health plan currently has a membership of 2,000 and its management is looking forways to increase its net gain from operations. One suggestion might be to change the productbenefit design so that more members will enroll each month.

The health plan’s management predicts that a change in benefit design worth an additional $2 inbenefits—in other words, a $2 increase in the variable unit cost on a PMPM basis—will increase

membership by 100. The expectation is that the increase in membership will increase the healthplan’s net gain. Before instituting this change, however, the health plan’s management decides touse CVP analysis to confirm its estimates.

Currently, the unit contribution margin on this product is $40 ($100 unit sales price (PMPM) -$60 variable unit cost). After increasing the variable unit cost by $2, the product’s contributionmargin decreases to $38 ($100 unit sales price (PMPM) - $62 variable unit cost). Given that theincrease in variable cost will increase sales volume from 2,000 to 2,100, the change in totalcontribution margin is found as follows:

As you can see, proceeding with the change in product benefit design would result in a $200decrease in the product’s contribution margin. Because fixed costs remain unchanged, thischange in contribution margin will decrease the health plan’s net gain by $200. The health planshould therefore not institute this new benefit design.

The previous example is one of many possible applications of CVP analysis, in which a healthplan seeks the most profitable combination of fixed cost, variable cost, sales volume, and productprice. A health plan’s managers study changes in any or all of these variables to maximize theperformance of the health plan’s products and product lines. Sometimes, a health plan canimprove its overall net gain by reducing the contribution margin on a product, but only if itreduces its fixed costs by a greater amount. Otherwise, an increase in net gain comes through anincrease in contribution margin.

There are many ways to increase contribution margin, such as reducing selling price to increasesales volume, increasing fixed costs to increase sales volume, or trading off fixed and variablecosts to achieve appropriate changes in volume. The process is more complex when health planssell many products. In that case, improving net gain comes from finding the right mix and rightamount of each product to sell.

AHM Health Plan Finance and Risk Management: The Budgeting Process

Course Goals and Objectives

After completing this lesson you should be able to

Distinguish among top-down budgeting, bottom-up budgeting, and zero-based budgeting

Distinguish among static budgets and flexible budgets, short-term budgets and long-termbudgets, and rolling budgets and period budgets

Itemize the various components of a master budget

Recall from Management Accounting lesson that a budget is a financial plan of action, expressedin monetary terms, that covers a specified period of time, such as one year. A budget can be usedto plan for something as minor as the office supplies the underwriting department will use in agiven month, or as major as the premium income and medical expenses that a health plan expectsfor the entire year. Through budgeting, a health plan affirms its goals and establishes expectedperformance levels for its management team. Once a budget is in place, the health plan uses it tomonitor performance and ensure behavior that is consistent with its goals.

As you read the following sections, keep in mind that a budget is an estimate. It reflectsmanagement's expectations of performance and provides a plan that a health plan uses to guide itinto the future. Although a budget cannot anticipate future conditions precisely, it does provide ahealth plan with a point of reference. By comparing its actual results to its budgeted expectations,a health plan can evaluate and control its overall performance and the performance of individualdepartments and employees. Through such comparisons, a health plan gains insights that help itplan new courses of action.

In this lesson, we present an overview of the budgeting environment for health plans. First, wedescribe the benefits and the drawbacks of budgeting, followed by a discussion of the budgetingprocess. We separate budgeting into operational budgeting, financial budgeting, and capitalbudgeting. (We discuss capital budgeting in the next lesson.) Then we discuss how a health plancombines these individual budgets into a master budget, which becomes the basis for the healthplan’s pro forma financial statements. (Recall that we discussed pro forma financial statements inThe Strategic Planning Process in Health Plans.)

Why Budget?

Through strategic planning, most health plans determine their mission, their long-term objectives,and the broad overall courses of action they will follow to achieve those objectives. To determinewhether or not the health plan is achieving its mission, the health plan develops and appliesmeans of measuring where it stands in relation to its objectives. Budgeting plays a key role in thisprocess.

Through budgeting, a health plan projects financial targets for a defined future period—typicallyone year—and creates a financial plan of action that it believes will help it achieve its goals. Inthe cyclical management functions of planning, organizing, and controlling, budgeting is one ofthe central planning activities, and budgets are an important instrument in the controlling process.

Budgeting assists a health plan in defining the financial costs and benefits of achieving itsobjectives. In defining costs, the budget not only sets goals for management, but also provides amap of the types of expenses that will be incurred in meeting these goals. Thus, the budgetingprocess integrates the costs of the health plan’s business with the benefits.

For this reason, all companies use budgets, however informally. A budget outlines a health plan'splans for the acquisition and allocation of financial and other resources. Further, a budget is oneof many management accounting reports that a health plan uses to make decisions about itsproduct lines, target markets, and future expectations.

Budgets are most often used to:

Monitor and evaluate financial operations Evaluate managerial performance Assist in financial planning Control and reduce expenses Communicate information throughout the various levels of a health plan Motivate personnel

Regardless of its ultimate uses or its sophistication and complexity, a budget's primary objectiveshould be to systematically project for a given department, division, or line of business theanticipated expenses and income for a given period of time. Budgets indicate whether managersare meeting the financial goals set for the health plan.

Managers are evaluated on the basis of their ability to control the costs, revenues, or investmentsthat are under their supervision. For this reason, most managers review computer-generatedreports on a regular basis to compare monthly and year-to-date actual operating expenses andcompare them with the budgeted operating expenses.

If an area's actual expenses vary significantly from its budgeted amounts, then the area's managerwill meet with senior management or with the analysis unit's personnel to discuss the variance.Once the cause of the variance is determined, management uses the findings to develop an actionplan.

Typically, budget variances in which (1) expenses are higher than projected, or (2) revenues arelower than expected result from one or more of the following causes:

Failure to monitor and control expenses Failure to retain or increase business sufficiently to meet revenue objectives Unrealistic budget projections Changes in a health plan’s objectives between the time the budget was developed and the

time the evaluation was made (for example, the health plan decides to enter a newmarket, to withdraw from an existing market, to develop a new product, to withdraw anexisting product, or to increase spending on operating systems or training)

Unanticipated changes in the external environment, such as changes in state lawsregarding mandatory healthcare benefits.

Although the drawbacks of budgeting are not important enough to keep companies from usingbudgets, you should be aware of what those drawbacks are. First, the budgeting process can bevery time-consuming and can involve everyone from entry-level personnel to senior management.

During the budgeting process, a health plan forecasts—by line of business or product—a varietyof items, including the:

Number of new plan sponsors that the health plan anticipates contracting with in thecoming year and the number of existing plan sponsors that the health plan anticipates itwill retain

Total number of new and existing plan members the health plan expects will be enrolledin the coming year

Anticipated cost of providing medical benefits for all plan members covered under non-administrative services only plans

Staffing levels needed to fulfill the health plan’s objectives based on the projectednumber of plan sponsors and members

Amount of money to be spent in salaries, overtime, and benefits for the health plan’semployees

Level of resources the health plan should spend on technology, training, and compliancewith regulatory requirements during the coming year

The time that a health plan takes to make these estimates is time spent away from doing the actualwork that generates the revenues needed to keep the health plan in business. Another drawback isthat if the health plan makes a material change in its plan for the year, or if expected marketconditions change considerably, the health plan has to revise its budget, which may involveconsiderable additional work. However, budgeting is work that must be done, because it imposesdiscipline in controlling costs and because it improves the health plan’s probability of achievingits revenue goals.

Number of new plan sponsors that the health plan anticipates contracting with in thecoming year and the number of existing plan sponsors that the health plan anticipates itwill retain

Total number of new and existing plan members the health plan expects will be enrolledin the coming year

Anticipated cost of providing medical benefits for all plan members covered under non-administrative services only plans

Staffing levels needed to fulfill the health plan’s objectives based on the projectednumber of plan sponsors and members

Amount of money to be spent in salaries, overtime, and benefits for the health plan’semployees

Level of resources the health plan should spend on technology, training, and compliancewith regulatory requirements during the coming year

The extent to which a health plan suffers from these drawbacks reflects the health plan’s owncorporate culture. If the budgeting process is well monitored and if managers are not rewarded forunderestimating revenues or for padding expense budgets, then these behaviors are less likely tooccur. As reflected in Figure 13C-1, which summarizes the benefits and drawbacks associatedwith budgeting, the benefits of budgeting outweigh the drawbacks.

Producing a thorough, accurate budget requires considerable cooperation among companymanagers and other employees. This cooperation between different departments and functionalareas allows a health plan to prepare a comprehensive planning document known as a masterbudget.

The Master Budget

Large companies usually draw up a network of separate budgets and schedules, each reflectingoperating and financial plans for specific segments of the health plan. When integrated, this groupof budgets becomes the master budget, which shows the overall operating and financing plans forthe health plan during a specified period, often one year. Different companies refer to the masterbudget by many different names, such as operating budget, comprehensive budget, corporatebudget, performance plan, or simply the budget. In this text, we use the term master budget.

The master budget begins with a health plan’s revenue forecast, then shows the health plan’sbudgeted expenses, cash flows, and investment activities. The master budget can be thought of asa profit plan, because the achievement of the health plan’s goals outlined in the budget typicallywill result in a profit for the health plan. Most companies compile the master budget annually andupdate it via "re-projections" semiannually.

The master budget culminates in a set of pro forma financial statements. Recall from Assignment11 that pro forma statements project what a health plan's financial condition will be at the end ofa budgeting period, assuming that the health plan achieves all of its budgetary objectives. At theclose of the budget cycle, most health plans draft a pro forma income statement, cash flowstatement, and balance sheet. Figure 13C-2 shows the relationships among the various

components of the master budget, including the pro forma statements for a typical health plan.Notice that supporting budgets interweave to complete the master budget.

At the end of the accounting period, the health plan compares its actual financial statements to itspro forma financial statements to determine whether it has met its goals. Top management and theboard of directors use the variances between the pro forma statements and the actual statements toevaluate the performance of the health plan and its management team.

Approaches to Budgeting

In many health plans, a budget committee formed by top executives and managers from the healthplan’s functional areas oversees the budgeting and financial planning process. The budgetcommittee reviews proposed plans for reasonableness and works toward integrating allsupporting budgets into the master budget. Ultimately, the budget committee provides the overallguidance necessary to coordinate a health plan-wide budgeting process.

Technically speaking, we can identify three distinct approaches to budgeting: (1) top-downbudgeting, (2) bottom-up budgeting, and (3) zero-based budgeting. In practice, most health plansuse a combination of these approaches in a manner that best suits the health plan’s culture andneeds.

Top-Down Budgeting and Bottom-Up Budgeting

As the names imply, top-down budgeting is generated on the corporate level by uppermanagement and is passed down to lower management, while bottom-up budgeting is generatedat the department level by lower management and is presented in the form of recommendations toupper management. In both types of budgeting, a health plan typically uses the previous year'sbudget as a starting point and then makes adjustments for the current year's projections.

The amounts found in top-down budgets are based on a health plan’s strategic vision andobjectives for the coming year and financial data from the health plan’s activities in prior years.The health plan’s top executives typically develop top-down budgets. Bottom-up budgeting, onthe other hand, includes a much larger number of employees from all departments within thehealth plan.

These characteristics give top-down budgeting the advantage of being less time consuming andless labor intensive than bottom-up budgeting. Also, because top-down budgeting is generated atthe corporate level, it is more likely than bottom-up budgeting to reflect top management'sintentions for the health plan. Further, top-down budgeting enables a health plan to incorporatekey changes in regulatory requirements or the health plan’s strategic plan on a timely basis.

On the other hand, because budgets developed from the bottom up usually reflect the input andparticipation of the employees who will be responsible for achieving the budgetary goals, bottom-up budgeting is more likely to reflect the realities of day-to-day operations. In addition, bottom-up budgeting often has more grassroots support among company employees than does top-downbudgeting.

Zero-Based Budgeting

Zero-based budgeting (ZBB) differs from other budgeting approaches in that, for everyaccounting period, each line of business within the health plan must justify its continuedoperation. Zero-based budgeting generally applies only to expense budgets. (Companies canapply top-down and bottom-up budgeting approaches to both income and expense budgets.)Medical expenses generally are the largest expense for health plans.

With zero-based budgeting, a health plan begins with the premise that no resources will beallocated for the following period unless and until each dollar to be spent is justified and is shownto be in accord with departmental plans and corporate goals and objectives. Thus, ZBB treatseach activity as though it is a new project under consideration and does not automatically assumethat the current levels of spending are reasonable starting points for developing next year'sbudget.

Many of the positive results of zero-based budgeting come from the financial analysis andplanning required at all levels of management in carrying out this budgeting process.Management must evaluate every operation in terms of efficiency and need. Lower-levelemployees play a key role in ZBB because they often provide necessary details to accuratelyassess the importance and financial requirements of each activity. Other benefits of ZBB are thebreadth and quality of information contained in the budgets and the training and educationemployees receive as part of their contribution to the process.

The main drawback of ZBB is that it is costly and time consuming. A great deal of the workassociated with ZBB involves collecting and analyzing data to justify each item and preparecontingency budgets. Thus, many companies do not really have pure ZBB, but instead use amodified ZBB. With a modified ZBB approach, either the budgetary approach is only partiallyzero-based, or the zero-based process is performed irregularly and not at each accounting period.Figure 13C-3 summarizes the three approaches to budgeting.

Budget Classifications

Each of these budgeting approaches can be classified in three ways: (1) as a static budget orflexible budget, (2) as a short-term budget or long-term budget, and (3) as a rolling budget orperiod budget.

Static Budgets and Flexible Budgets

When budgets are classified by the degree of variability inherent in them, they are often referredto either as static budgets or flexible budgets. A static budget, also known as a fixed budget or afixed-amount budget, generally does not change unless management has approved the changes.As a result, static budgets are of limited managerial usefulness if projected amounts of revenuesand expenses are uncertain. Static budgets provide no alternative financial predictions whenactual experience differs from the assumptions underlying the budgeted figures.

Static budgets are most useful when a budget's objective is to reduce or limit expenses. Forexample, if a health plan allocates $10,000,000 for expenses for the coming month, the healthplan generally cannot spend more than this fixed amount on existing revenue-generatingactivities. Further, the health plan would probably not pursue new revenue-generating activitiesthat would require it to incur additional expenses. The health plan, of course, could spend lessthan the budgeted amount. Figure 13C-4 presents an example of a monthly static expense budgetfor each functional area of the health plan.

One approach is for the health plan to develop a flexible budget that shows three columns ofpossible first-year selling expenses based on (1) a pessimistic sales figure of $22,000,000, (2) amost likely figure of $25,000,000, and (3) an optimistic figure of $28,000,000, of new premiumincome. In each case, the amount budgeted for selling expenses differs accordingly.

Figure 13C-5 is an example of this health plan’s flexible budget. Recall that we discussedoptimistic, pessimistic, most likely scenario modeling in The Strategic Planning Process in HealthPlans in the context of pro forma financial statements.

Budgets can cover almost any time frame. A short-term budget generally addresses a period ofone year or less and relates mainly to a health plan's operations during that period. Often, thebudget is further divided into quarterly, monthly, or weekly budgets. A long-term budget

addresses periods of more than one year. Many companies produce long-term budgets in theirstrategic financial plans.

Budgets projecting far into the future allow for income and expenses that correspond to a healthplan’s strategic planning objectives. For example, long-term budgets are often used to plan for thelarge capital purchases that will be necessary for the future operations of the health plan.

Long-term budgets have less detail than short-term budgets because budgetary predictions areless accurate over multiple years. The most current year of a health plan’s long-term budget is theshort-term budget for the current accounting period. Thus, a long-term budget incorporates ahealth plan's short-term budgets.

Rolling Budgets and Period Budgets

A rolling budget, also known as a continuous budget, allows a company to continually maintainprojections for a certain time period into the future. For example, a health plan with a six-monthrolling budget updates the budget at the end of each month so that the projections always apply tothe coming six-month period. A rolling budget forces the health plan’s management to constantlyconsider the upcoming six months regardless of the current point in the fiscal year.

In contrast, a period budget covers a specific time frame, such as one month or one year. Thenumbers in a period budget do not change during the time frame covered by the budget. Becauseit is updated regularly based on the results of the most recent period, a rolling budget canmaintain a higher measure of accuracy than a period budget. However, maintaining a rollingbudget generally requires more resources than a period budget.

Suppose a health plan creates a rolling budget for the six-month period from January 1 throughJune 30. If the health plan updates the budget monthly, then it presents a new budget on February1 to reflect the six-month period from February 1 through July 31. The health plan repeats thisprocedure for the six-month period from March 1 through August 31, April 1 through September30, and so on. Each new budget reflects revised projections for the coming six-month period.Figure 13C-6 depicts a rolling sales revenue budget based on this scenario.

Operational Budgets

Companies typically produce three types of budgets: operational budgets, cash budgets, andcapital budgets. In the following sections, we discuss operational budgets. We discuss cashbudgets and capital budgets in Cash Management and Capital Budgeting lesson.

An operational budget sets forth the income and/or expenses that a company expects over adefinite period of time. Operational budgets provide detail for the projections and objectivesfound in a health plan's master budget. Operational budgets can show information by department,line of business, functional area, or any other classification that might accommodatemanagement's decision-making needs. The operational budget reflects the financial steps thehealth plan will take during the coming year to achieve its profitability objectives.

Examples of a health plan’s operational budgets, which are generally classified by subject matter,include the

Revenue budget or sales budget to project first-year and renewal premium income Expense budget to project medical expenses and selling and administrative expenses Investment budget to project the types of investments to be made and the amounts of

expected investment-related income Cash receipts and cash disbursements budget to estimate the cash flows during the period

(discussed in the next lesson)

In the following sections, we discuss two basic types of operational budgets: revenuebudgets and expense budgets.

Revenue Budgets

A revenue budget indicates the amount of income from operations—new business, renewalbusiness, and investments—that a company expects in the coming budget period. The revenuebudget determines the limits of the other budgets and must be prepared before them. Some healthplans divide the revenue budget into the sales budget and the investment budget. A sales budgetprojects premium income from both new business and renewal business. The health plan bases itsestimates on historical data, reviews of the marketplace, and premium rates charged bycompetitors, among other factors.

An investment budget projects the types of investments the health plan will make and theexpected amount of investment-related income for each type. Because cash flow can have asignificant impact on investment strategy, the health plan does not complete the investmentbudget until after it completes its cash budget.

All operational budgets begin with a forecast of sales revenue and investment income because ahealth plan cannot establish appropriate spending levels until it determines the funds it will haveavailable. The sales forecast estimates new business and renewal business premiums for aparticular period. The investment forecast estimates earnings based on the performance of bonds,stocks, mortgages, and other invested assets a health plan owns.

For large health plans, developing sales and investment forecasts is complex and time consuming.Sales forecasts require analysis of all internal and external variables that can affect sales. Internal

variables include changes in the product portfolio, product prices, provider reimbursements,staffing, systems, and advertising outlays. External variables include changes in the economy, theregulatory climate, and the preferences of purchasers and consumers.

Investment forecasts also require analysis of specific types of investment vehicles and analysis ofmarket conditions. Methods of projecting sales and investment performance can range fromrelatively simple estimates based on prior experience to more complex forecasts based oncomputer simulations. A few of the forecasting techniques that health plans use includequalitative methods, trend analysis, and regression analysis.

Qualitative methods rely on the judgment of managers, who use their own experience andunderstanding of current economic conditions to make predictions.

Trend analysis, which we discussed in Financial Statement Analysis in health plans,relies on historical data to reveal sales and investment trends, and then uses these trendsto predict future performance.

Regression analysis relies on the knowledge of how the fluctuations of a known,dependent variable, such as number of plan members, impacts an unknown variable, suchas claims costs.

Some health plans make several different forecasts that reflect different assumptions, such asfluctuations in interest rates, then use the different tentative sales or investment forecasts todevise a single composite forecast. Personnel in a health plan's sales and actuarial areas providemanagement with estimates of the amount of premium income the health plan can expect. Salesmanagers in the home office usually check the sales forecasts for reasonableness. The investmentdepartment estimates the amount of investment income the health plan expects to earn during thenext period.

The sales budget is often broken down by product type (such as individual or non-group, smallgroup, large group, Medicare, and Medicaid). The investments budget is often broken down byinvestment vehicle (such as bonds, mortgage loans, stocks, and so forth).

Suppose a health plan sells an HMO and a managed dental product. Figure 13C-7 shows thehealth plan’s annual revenue budget, divided into its sales and investment components, andbroken down by quarter.

Expense Budgets

Following the revenue budget, the next step in completing the operational budget is preparingexpense budgets. An expense budget is a schedule of expenses expected during the given period.An expense budget helps to (1) control expenses, (2) increase cost awareness among managers,(3) measure management performance, and (4) assign responsibility for expenses.

Three types of health plan expense budgets are:

(1) the medical expense budget, The medical expense budget indicates the amount of money ahealth plan expects to pay for medical benefits during the next period. Actuaries and medicalmanagement personnel are typically responsible for developing the medical expense budget.

(2) the selling expense budget, The selling expense budget is based primarily on the costsincurred in selling health plan coverage. In addition to commission costs, these selling expensesmay include the direct costs associated with advertising, promotion, travel, sales officeoperations, and salaries for sales and marketing personnel. The marketing and sales departmentstypically are responsible for developing the sales expense budget.

(3) the administrative expense budget. The administrative expense budget includes the otherexpenses needed to operate a company. Usually, this budget is the sum of all departmentalexpense budgets. The administrative expense budget also includes such companywide expensesas depreciation on buildings, computer equipment costs, and administrative salaries. Eachfunctional area of the health plan usually prepares its own expense budget. Some health planshave two expense budgets: a medical expense budget and a selling and administrative expensebudget.

Expense budgets can describe variable as well as fixed expenses. Both the medical expensebudget and the selling expense budget describe variable expenses because the amounts budgeteddepend on the figures contained in the sales budget. Typically, the more plan contracts a healthplan sells, the more selling expenses it incurs and the more medical expenses it incurs due toincreased plan membership.

The administrative expense budget contains most of the health plan’s fixed expenses, such ashome office salaries, rent, and depreciation. However, the administrative expense budget alsocontains variable expenses because the services provided by administrative departments are oftenbased on the number of plan members.

Figure 13C-8 shows a health plan’s annual expense budget by quarter. This budget includeselements of the medical expense budget, the selling expense budget, and the administrativeexpense budget.

Having prepared its revenue and expense budgets, a health plan can then draft its pro formaincome statement, which estimates the net income for the entire health plan. If a health plan’smaster budget is for a period of one year, the health plan’s pro forma income statement may showonly the end-of-period data. However, some pro forma income statements can also be dividedinto quarterly or monthly columns to show the end-of-quarter or end-of-month totals.

AHM Health Plan Finance and Risk Management: Cash Management

Course Goals and Objectives

After completing this lesson you should be able to

Discuss the fundamentals of cash inflows and cash outflows for a health plan Analyze a health plan’s cash budget using the health plan’s cash receipts and cash

disbursements

Cash management, also called treasury management or working capital management, is themanagement of a company’s short-term cash needs.1 In the near term, a health plan either hasexcess cash or a cash shortage. Excess cash can easily become idle cash if it is not invested toearn a return. On the other hand, a cash shortage may delay provider payments and otherpayments that must be made to satisfy a health plan’s current obligations. Further, a health planmay incur additional liabilities if it has to borrow short-term funds to meet these obligations. Tomanage its cash effectively, a health plan typically constructs a cash budget.

Recall that a health plan’s working capital is the difference between the health plan’s currentassets and its current liabilities. Although the amount of working capital is typically positive,sometimes a health plan experiences negative working capital. In other words, the health plan’scurrent liabilities may be greater than its current assets.

Negative working capital tends to occur whenever healthcare expenses generated by planmembers exceed the premium income that the health plan receives. This situation can develop inthe short run simply because healthcare expenses generated by plan members vary from month tomonth, but premium income tends to be a more stable cash flow.

Earlier we discussed how health plans manage the volatility in claims payments throughestimating its IBNR claims. In addition, some forms of provider reimbursement—notablycapitation contracts—tend to stabilize a health plan’s expenses, because a provider will be paidthe same PMPM rate every month of the contract period, even if the cost of providing medicalcare to plan members varies.

Developing the Cash Budget

Typical sources of cash for health plans include premium income, investment income,management fee income obtained from administrative services only arrangements, and subsidiaryincome. A health plan uses cash to make many types of payments for healthcare benefits,provider reimbursement, employee salaries and other operating expenses, and so on.

Most health plans plan to have on hand just enough cash to make these payments as they comedue. A shortage of cash means that the health plan could be delinquent on some of its payments,leading to problems with providers, stockholders, or employees. The health plan may also have tosell its investments at an inopportune time and incur a loss or perhaps borrow money at a higherinterest rate to meet its obligations.

But holding too much cash on hand presents another set of problems. Although it provides thehealth plan a sense of security, excess cash is unproductive because it sits idly and earns little or

no return. A large amount of excess cash therefore has a high opportunity cost because the healthplan could, by using that money elsewhere, earn additional income and improve its profitability.

Budgeting for cash helps a health plan avoid cash shortages and cash excesses. Cash budgetinganticipates the flows of cash into and out of a health plan during a given period. A cash budgetshows all expected cash inflows, cash outflows, and ending cash during a period. Many healthplans prepare an annual cash budget that is broken down into quarterly, monthly, weekly, and,sometimes daily budgets to monitor its cash flow more closely.

Through monitoring its cash budget over a long period, a health plan may discover how cyclicalevents and seasonality affect its estimated cash inflows and cash outflows. Suppose a health planlearns that its IBNR claims liabilities typically become cash disbursements within 45 days of theiroccurrence. In this case, the health plan’s cash disbursements budget and cash budget wouldindicate a 45-day payment cycle for IBNR claims.

In another example, a health plan may discover that its provider reimbursement payments peakaround a specified time each year. The underwriting cycle is one example of the impact of acyclical effect on health plans. Recall from The Relationship Between Rating and Underwritingthat the underwriting cycle occurs when a health plan experiences a pattern of three years ofunderwriting profits, followed by three years of underwriting losses.

In conjunction with, and sometimes instead of, a formal cash budget, some health plans have theirinternal accounting function submit a daily cash report to the health plan’s investment function.In turn, the investment function uses the daily cash report to determine the amount of excess cashavailable to invest each day. The daily cash report is used primarily for operational purposes.

Although specific cash inflows and cash outflows are unique to each health plan, some generalassumptions can be made about cash flows in the health plan industry. A health plan forecasts itsexpected cash receipts and cash disbursements using qualitative methods, trend analysis, andregression analysis. We discussed trend analysis in Financial Statement Analysis in Health Plans.A discussion of regression analysis is beyond the scope of this course.

The Cash Receipts Budget

Typical cash receipts (inflows) for a health plan result from premium income and investmentincome. Most group health premiums are due on a quarterly or monthly basis according to duedates specified in each contract. The majority of plan sponsors remit their premiums by the duedate to avoid losing coverage, so a health plan’s cash inflows from premiums are relatively stable.

Somewhat less predictable is a health plan’s investment income. However, even if some of ahealth plan’s investments are volatile by nature, most of a health plans investments are inrelatively low-risk assets that provide a guaranteed, steady income stream. One example of suchan investment is a U.S. Treasury bill that pays semiannual interest. Nevertheless, whenforecasting for investments, health plans must consider the overall economic outlook, statutoryrequirements, tax factors, and the health plan’s investment strategy.

A company plans for its cash inflows through a cash receipts budget, which is a schedule of cashreceipts that the company expects to receive during the period. To predict both the timing and theamount of its cash receipts, a health plan constructs the cash receipts budget using data from itssales forecast and investment forecasts. Many cash inflows are received on or around the first day

of each month because many premiums and investment income payments have due dates at thebeginning of the month.

Figure 14A-1 shows a sample health plan’s annual cash receipts budget broken down by quarter.Note that the sample health plan divides its cash receipts budget into receipts from the sales ofhealth plans and healthcare products and receipts from investments. For simplicity, Figure 14A-1assumes that there is no timing difference between income and cash receipts. In other words, therevenue forecast equals cash.

The Cash Disbursements Budget

A company attempts to estimate the timing and amount of all of its cash disbursements in a cashdisbursements budget. Unlike a health plan’s cash receipts, the health plan's cash disbursementstake a variety of forms. Common disbursements that most health plans make include

Healthcare benefit payments Provider reimbursement payments Employee salary payments Investment purchase payments Stop-loss insurance premium payments Tax payments to government agencies Operating expense payments

Besides the ongoing cash disbursements listed above, a health plan also incurs some nonrecurringcash disbursements, many of which result from its capital budgeting decisions. Also, a health planmust estimate its liability for IBNR claims as accurately as possible to manage cash effectively. Ifan health plan significantly underestimates the IBNR claims liabilities, the amount of these

liabilities will be understated on the health plan’s balance sheet—that is, the dollar amount ofIBNR claims liabilities would be lower than it should be.

The health plan’s income statement would similarly understate the amount of its healthcarebenefit expenses, thereby making the health plan look more profitable than it really is, all otherfactors remaining equal. If a health plan significantly overestimates its IBNR claims liabilitiesduring a period, then the health plan would most likely have little or no excess cash to invest—essentially the health plan would be holding cash to pay for claims that do not exist. A highopportunity cost would result.

Again, a health plan generally experiences heavy cash outflows in the first few working days ofeach month because most monthly payments are due on the first of the month. These paymentsinclude provider reimbursements and utility payments. The cash disbursements for fixed expensessuch as salaries are made with relative ease and accuracy. However, estimating the cashdisbursements for variable expenses such as claims payments and variable providerreimbursement contracts such as FFS contracts is less predictable. The accuracy of thesepredictions depends in large part on the accuracy of a health plan’s sales forecast.

Figure 14A-2 shows a sample health plan cash disbursements budget. This figure shows that asample health plan first divides its cash disbursements budget into two categories: healthcare-related disbursements—such as claims payments and provider reimbursement—and investment-related disbursements.

Note that a sample health plan subdivides its healthcare-related cash disbursements into a fixedcomponent and a variable component and its investment-related cash disbursements into short-term purchases and long-term purchases. Also, note that a sample health plan made a one-timepurchase of computer equipment during the third quarter.

The Cash Budget

Once a health plan has prepared its cash receipts budget and cash disbursements budget, thehealth plan prepares its cash budget. Important pieces of information that are contained in a healthplan’s cash budget include the health plan’s:

Beginning-of-period cash balance (equals end-of-period cash balance from previous period) Available cash for the period (beginning cash plus cash receipts during the period) Minimum cash balance (the amount of cash that a health plan determines is necessary to

pay all obligations in a given budgeting period without needlessly tying up excess cash) Cash needed for the period (cash disbursements during the period plus the minimum cash

balance) Excess cash or cash shortage (cash available for the period minus the cash needed; excess

cash results if this amount is positive; a cash shortage results if this amount is negative) Effects of financing activities (initial borrowing or repayment of borrowed funds) End-of-period cash balance (excess cash or cash shortage plus any financing activity

The minimum cash balance is of great importance in cash budgeting. Determining the amount ofa health plan’s minimum cash balance requires a great deal of research and estimation from ahealth plan's managers. Setting this figure too low raises the risk of running out of cash. Settingthis figure too high carries a high opportunity cost.

A health plan that sets a lower minimum cash balance in an effort to keep as much cash "at work"in the health plan’s productive assets usually arranges for a line of credit from a bank. A line ofcredit, also called a bank line, is a pre-arranged agreement that allows a company to borrowmoney on demand up to a specified amount. This short-term borrowing becomes necessarywhenever a health plan encounters a cash shortage. Some health plans make arrangements withbanks that allow a health plan to keep funds in interest-bearing accounts and the bankautomatically transfers money to the health plan’s checking (or other cash disbursements) accountas needed.

A health plan can use many methods to derive its minimum cash balance. For example, a healthplan may set its minimum balance equal to that of its budgeted cash disbursements for a month.The health plan’s IBNR calculations, as well as planned-for capital improvements, may alsofigure into the determination of an appropriate cash balance for any given period. Moresophisticated techniques involve computer spreadsheet simulations. Regardless of the methodused to determine the minimum cash balance, this decision is a significant one with respect to ahealth plan’s solvency and profitability.

By examining its cash budget, a health plan’s management can estimate the timing and amount ofa cash shortage, which will require additional financing, or excess cash, which will allow forinvestment in relatively liquid assets. Recall that an asset’s liquidity is the ease with which anasset can be converted into cash for an approximation of its true value. Generally, the more liquidan asset, the more easily it can be converted into cash if the need for that cash arises.

Typically, health plans invest excess cash assets in money market mutual funds, governmentsecurities money funds, certificates of deposit (CDs), commercial paper, and U.S. Treasury bills,so that, when necessary, they can retrieve cash quickly. Figure 14A-3 shows health plan XYZ’scash budget. Note that health plan XYZ has set its quarterly minimum cash balance at$3,250,000.

Note also that health plan XYZ anticipates that, by the end of the first quarter, it will encounter acash shortage of $2,021,000. To address the expected cash shortage, health plan XYZ has plannedfor a short-term loan in the amount of $2,500,000. (Alternatively, health plan XYZ could sellsome of its investments to cover the cash shortage.) The health plan also expects to be able to

repay the loan plus interest in the fourth quarter, and the effect of this financing activity is notedin its cash budget.

After completing its cash budget, a health plan then prepares its pro forma financial statements.First, the health plan develops its pro forma income statement. Next, data from a health plan’scash receipts and cash disbursements budgets, the cash budget, and the pro forma incomestatement are transferred to the health plan’s pro forma cash flow statement. Then, the health planprepares its pro forma balance sheet.

Endnotes

1. Susan Conant et al., Managing for Solvency and Profitability in Life and HealthInsurance Companies (Atlanta: LOMA, 1996), 369.

AHM Health Plan Finance and Risk Management: Capital Budgeting

Course Goals and Objectives

After completing this lesson you should be able to

Describe the purpose of capital budgeting Identify the characteristics of the payback method, the discounted payback method, the

net present value method, and the internal rate of return method with respect to a healthplan’s capital budgeting decisions

Describe factors that affect a health plan’s capital budgeting decisions Explain the function of sensitivity analysis in capital budgeting

A health plan’s managers focus on ways to make the health plan grow or otherwise become moreprofitable. In many cases, growth or increased productivity requires investing in new assets,which sometimes means a large outlay of funds. To prepare for such large cash outlays, acompany undertakes capital budgeting, which is the analysis of decisions about investing in long-term assets. The capital expenditures made to obtain a health plan’s long-term assets are expectedto produce income or other benefits for more than one year.

Buildings and computer equipment are examples of long-term assets that a health plan plans tohold for 3 to 20 years or more. Long-term assets are sometimes referred to as long-lived assets,capital assets, plant assets, or fixed assets. For health plans, a new product launch may be a majorcapital project if the new product requires a large amount of up-front capital for development andmarketing.

The Capital Budgeting Process

Because a capital budget is long-term in nature, it is used extensively in a health plan’s strategicplanning. As a result, the health plan’s top management is closely involved in developing thehealth plan’s capital budget. A capital budget is a budget in which a company estimates its needfor capital. Capital budgets generally incorporate new projects, major repairs to or remodeling ofalready-owned long-term assets, acquisitions of other companies, legislatively mandated safetyand environmental improvements, cost reduction projects, and revenue expansion projects.

The capital budgeting process often includes many steps. In this lesson, we identify fourimportant steps: (1) generating capital budgeting ideas, (2) classifying each capital projectproposal, (3) estimating cash flows for each proposal, and (4) evaluating and selecting proposals.

Generating Ideas

All capital projects begin as ideas. For example, a health plan’s marketing function or actuarialfunction may suggest a new product idea for development. The claims administration functionmay recommend upgrading outdated equipment to enable more effective claims processing. Ahealth plan’s investment function may request a new decision support system to generate a higherreturn on the health plan’s investments. Or the health plan’s president may decide that theorganization plan is outgrowing its office space and propose investing in additional space orextensive remodeling.

Classifying Each Proposal

In compiling the master budget, a health plan determines the resources—money, staff time,equipment, and so on—that it can devote to proposed capital projects. Because there are oftenmultiple functional areas requesting capital resources, it is helpful to classify each capital projectproposal so that a health plan’s managers can better analyze each one and gauge its potentialusefulness to the health plan. Although specific classifications vary among health plans, sometypical classifications include

New Projects such as new assets or new uses for existing assets. Examples of thiscategory are new healthcare products or the purchase of another health plan or one ormore of its product lines.

Replacements such as new assets that will be used to replace old or defective assets. Anexample is the replacement of an outdated mainframe computer with a new computersystem.

Cost reduction programs such as assets that reduce the cost of a health plan’soperations. An example is the purchase of a printer to handle in-house print jobs thatpreviously had been outsourced.

Safety and regulatory expenditure programs such as those that address employeesafety concerns or are required by legal regulations. An example is the purchase of a newfire alarm and sprinkler system for a health plan’s home office building.

Estimating Cash Flows

Once a health plan has generated and classified its capital project ideas, the health plan thenestimates the cash flows associated with each project. Estimating each project’s cash flowsquantifies both its benefits and drawbacks and facilitates the evaluation of each project. Capitalprojects have both cash inflows and cash outflows. A health plan’s management should consideronly each project’s incremental cash flows, which are the additional costs or revenues that resultfrom a capital project. We discussed incremental (differential, marginal) costs in ManagementControl.

Suppose a health plan’s salary expenses are $1,000,000 before undertaking a new capital project.The health plan estimates that its salary expenses will be $1,200,000 after undertaking the project.In this case, the incremental cash outflow associated with this project is $200,000. In other words,the health plan would incur the $1,000,000 of salary expenses, all other factors remaining equal,even if it did not undertake this particular project. The new project would result in a $200,000.

Almost all capital projects begin with an initial investment in equipment or other assets. Insubsequent years, some capital projects will require cash outflows for repairs and maintenance.These ongoing cash outflows are referred to as incremental operating costs. The cash inflows of acapital project are usually in the form of incremental revenues or a reduction in costs.

Typically, a health plan would consider accepting a capital project if the health plan expects thatthe project will increase revenues, decrease costs, or both. A project’s cash inflows may bepredictable in amount and timing; that is, the same cash inflow may be expected during each yearof the asset’s useful life. Often a project’s cash inflows are uneven, in which case the amount orthe timing of the inflow varies each year.

For capital budgeting purposes, a reduction in costs is equivalent to an increase in revenuesbecause either results in an increase in a health plan’s net income. In the case of a replacementproposal, such as a computer system, the salvage value of the old computer system is treated as acash inflow. Salvage value is the residual value or selling price of a tangible (physical) asset atthe end of its useful life.

The time value of money concept is critical to capital budgeting decisions because such decisionsrequire a health plan to invest money in the present so it can generate more money in the future.Generally, the value of one dollar earned today differs from that of one dollar earned three yearsago or five years in the future. Calculating the present value or future value associated with eachcapital project is therefore critical to the decision-making process. Although a completediscussion of the time value of money is beyond the scope of this course, Figure 14B-1 provides asummary of this concept.

Estimating Cash Flows

Besides considering the time value of money, a health plan’s managers need to consider theopportunity costs associated with its capital budgeting decisions. In other words, by committingmoney today for a specified capital project, the health plan is giving up the opportunity to investin other capital projects. Before we review a few of the evaluative methods that health plans usein making capital budgeting decisions, we first review the selection of the appropriate discountrate to use in calculating a capital project’s estimated cash flows.

Because of the importance of the time value of money, some capital budgeting methods involvethe calculation of discounted or compounded cash flows. It is therefore vital that the health planchoose an appropriate rate to discount these cash flows to their present value and apply that rateconsistently to each project being evaluated. The discount rate used in capital budgeting usuallyrepresents a health plan’s weighted-average cost of capital (WACC).

A health plan’s cost of capital is the "price" that a health plan pays collectively for its varioussources of financing. One way to determine a health plan’s cost of capital is to find the weighted

average cost of all sources of debt capital (primarily bank loans and bond issues) and equitycapital (common stock, preferred stock, and retained earnings). Each component’s costs aremeasured in terms of interest payments, bond amortizations, stockholder dividend payments, andthe opportunity cost of retained earnings (or surplus). Recall our discussion of the weightedaverage cost of capital (WACC) in The Strategic Planning Process in Health Plans.

A complete analysis of the way a health plan derives its WACC is beyond the scope of this text,but a simple example using the Mainline health plan, a publicly owned company, should helpillustrate the concept. The WACC simply means that Mainline will factor into its calculation theamount of money financed at each discount rate. Suppose that 60% of Mainline’s total capitalcomes from retained earnings and 40% comes from a new issue of common stock. Assume thatthe financial managers of Mainline have calculated the cost of retained earnings to be 13% andthe cost of the common stock issue to be 18%. Mainline’s cost of capital is the weighted averageof these two sources of financing, calculated as shown in Figure 14B-2.

Mainline’s weighted average cost of capital is 15%. Therefore, an appropriate discount rate forMainline to use when applying each capital budgeting method could be 15%.

Evaluating and Selecting Proposals

Remember that the expected cash flows for a capital project are estimates. How a health planevaluates the capital projects that it is considering depends in part on the accuracy of its cash flowestimates. Once the health plan has calculated the relevant cash flows of each proposed capitalinvestment, the health plan evaluates all proposals and decides which, if any, to accept andimplement.

A health plan may use a variety of evaluation methods to quantify the value of each proposedcapital project. Quantifying the value of each capital project in financial terms makes it easier fora health plan’s management to compare proposals with each other or with some predefineddecision-making benchmark. We discuss these methods later in this lesson.

The Cash Disbursements Budget

Remember that the expected cash flows for a capital project are estimates. How a health planevaluates the capital projects that it is considering depends in part on the accuracy of its cash flowestimates. Once the health plan has calculated the relevant cash flows of each proposed capitalinvestment, the health plan evaluates all proposals and decides which, if any, to accept andimplement.

A health plan may use a variety of evaluation methods to quantify the value of each proposedcapital project. Quantifying the value of each capital project in financial terms makes it easier fora health plan’s management to compare proposals with each other or with some predefineddecision-making benchmark. We discuss these methods later in this lesson.

Capital Budgeting Methods

Capital budgeting methods serve as a screening function. That is, a health plan uses them toevaluate proposed capital projects to determine which ones meet a minimum standard of financialacceptability. Four methods of analyzing the worthiness of a capital investment are the (1)payback method, (2) discounted payback method, (3) net present value method, and (4) internalrate of return method.

Admittedly, capital budgeting is imprecise because the process requires an estimation of expectedcash inflows and outflows. Therefore, a health plan often uses more than one capital budgetingmethod to minimize the chance of making incorrect decisions about investment proposals. Ahealth plan’s management applies the health plan-defined decision rules to the results of one ormore of these analyses to decide whether to accept or reject a particular capital project. Instead ofemphasizing the mathematical calculations inherent in these methods, the following sectionshighlight the decision rules that a health plan may use and the way these methods assist indecision making.

The Payback Method

The payback method is a capital budgeting technique that calculates how long it will take a healthplan to recover its investment in a capital project. This recovery time is called the payback period.The payback method compares the initial investment with the additional cash expected to comeinto the health plan as a result of its investment in a project. If the annual revenues or savings areexpected to remain constant each year, the payback method calculation is relatively simple:divide the actual cost of the expenditure under consideration by the annual cash inflow.

To illustrate, assume that the Mainline health plan is considering the purchase of 20 new laserprinters at a cost of $75,000 (a cash outflow). The new printers will enable Mainline to print allits forms in-house. Under the current system, Mainline spends $25,000 a year to have formsprinted by a local printing company. Thus, by purchasing the new printers, Mainline should save$25,000 a year, and this savings is a cash inflow. (In reality, the $25,000 cash inflow amountwould change from year to year as the cost of external printing increases or decreases and as thevolume of printing increases or decreases. For simplicity, this example ignores these factors.)

To compute the payback period, divide an health plan’s initial investment by the annual expectedcash inflow (in our example, $75,000 ÷ $25,000 = 3 year payback period). If Mainline’s decisionrule is to accept all proposed capital projects that have payback periods of four years or less, thenit would accept this proposal. If the decision rule requires a payback period of less than threeyears, then Mainline would reject the proposal.

The main benefit of the payback method is its simplicity. Also, the payback method suggests adegree of risk inherent in a proposed capital project. Generally, a longer payback period indicatesa greater risk because the health plan’s initial investment may not be recovered.

The payback method has several limitations. One drawback of the payback period is that it doesnot measure profitability, so the payback period provides no information about the rate of returnon the health plan’s investment. Also, the payback method ignores the time value of money andignores all cash inflows and cash outflows that occur after the payback period.

In our example, the new printers may reduce Mainline’s expenses by $25,000 for each of the firstthree years (the payback period), but what about cash flows in the fourth year and succeedingyears? Because of these limitations, many health plans supplement the payback method withanother analysis method. Many health plans use the payback method only as an initial screeningdevice, because the payback period alone is not enough justification for undertaking or rejecting aproposed capital project.

The Discounted Payback Method

Similar to the payback method is the discounted payback method, which overcomes onedrawback of the payback method by taking into account the time value of money. The discountedpayback method calculates, in terms of discounted dollars, how long it will take a health plan torecover its initial investment.

Again, let’s assume that the Mainline health plan is considering the purchase of the 20 printers atan initial cost of $75,000, and that the savings (cash inflows) provided by the printers will be$25,000 per year. Assume also that Mainline selects a 15% discount rate based on its weighted-average cost of capital. The cash inflows for each year, discounted to their present value, areshown in Figure 14B-3.

According to the discounted payback method, Mainline recovers only $57,100 of its investmentafter Year 3 and $71,400 after Year 4. Not until Year 5 does Mainline recover its entire $75,000initial investment. Therefore, consideration of only discounted cash flows has increased thepayback period to more than four years (actually 4.29 years).

Mainline would not approve this proposal if it had a decision rule to accept all projects withpayback periods of four years or less. Because it considers the time value of money, thediscounted payback method is superior to the payback method. However, the discounted paybackmethod also fails to measure profitability and ignores cash flows beyond the payback period.

The Net Present Value Method

A third method of evaluating proposed capital projects is the net present value method. The netpresent value (NPV) method evaluates a proposal based on its net present value (NPV), or thedifference between the present value (PV) of a project’s cash inflows —revenues, cost savings,and interest income—and the present value (PV) of its cash outflows—project or investmentcosts and expenses.

Unlike the payback method and the discounted payback method, which both evaluate proposedprojects according to the length of time needed to recoup a project’s initial investment, the NPVmethod states a proposed project’s cash flows in terms of present value for the entire life of theproject.

The Net Present Value Method

The NPV method has an advantage in that this method considers the time value of money. TheNPV calculation involves determining the proposed capital investment’s useful life and selectingan appropriate discount rate. Again, an appropriate discount rate for a health plan may be thehealth plan’s weighted-average cost of capital.

The decision rule for accepting a proposal under the NPV method is that the present value of aproject’s cash inflows must exceed the present value of the project itself. In other words, the netpresent value of a project must be greater than zero for an health plan to accept the project.Usually a health plan establishes additional decision rules. For example, a health plan will select aproject if its NPV is greater than or equal to $1,000, $5,000, or $10,000, depending on the project.

If the proposed printers have a five-year useful life and Mainline’s discount rate is 15%, then theNPV for Mainline’s printer proposal is $8,825, as shown in Figure 14B-4. Assume thatMainline’s decision rule is to accept all capital projects that have an NPV greater than zero. Inthis case, Mainline would accept the printer proposal.

The NPV method considers a health plan’s profitability with respect to a proposed capital project,because a project’s NPV can be thought of as additional wealth to the health plan. The NPVmethod also considers the time value of money, and all cash flows during a capital project’suseful life, including those cash flows that occur after the project’s payback period.

However, to use the NPV method, a health plan must first determine its WACC. Also, a directcomparison of the NPVs of two or more capital project proposals may be misleading unless allproposed projects require an health plan to invest equivalent amounts.

The Internal Rate of Return Method

Another useful evaluation method is the internal rate of return method. The internal rate ofreturn (IRR) method, also called the time-adjusted rate of return method, determines thediscount rate at which the net present value of a capital project equals zero. In other words, theIRR method determines the rate at which a project’s cash inflows must be discounted to recoupthe project’s initial investment. A capital project’s IRR is determined by analyzing the project’syearly cash inflows, then using the appropriate interest factor to calculate the present value ofthose cash inflows.

Let’s return to our example. To find an appropriate IRR for a project, divide the amount of therequired investment by the annual net cash inflows to obtain a present value interest factor of anannuity (PVIFA). In our example, Mainline would divide the project’s required investment of$75,000 by the project’s annual cash inflows of $25,000, to obtain a PVIFA of 3.0. Next,Mainline would find the discount rate, given the appropriate number of periods (five), that isclosest to 3.0. Mainline would use a present value interest factor of an annuity (PVIFA) table tofind the discount rate.

Mainline finds that, on the PVIFA table, the factor that is closest to 3.0, for five periods, isbetween 19% and 20%. Therefore, the IRR of Mainline’s proposed printer is between 19% and20%. Calculating the precise IRR involves the use of PVIFA tables and interpolation, which arebeyond the scope of this course. The interpolated IRR for Mainline’s printer proposal, assuming auseful life of five years, is 19.87%.

The decision rule for the IRR method requires that a health plan compare its WACC to theproposed project’s IRR. If the project’s IRR exceeds the health plan’s WACC, then the project’sbenefits should exceed its costs. Thus, the project would be accepted according to the IRRmethod. Otherwise, the health plan would reject the project. Mainline’s printer project isacceptable because the proposed printer’s IRR of 19.87% exceeds the Mainline’s WACC of 15%.If Mainline must choose among this project and other proposed projects, then Mainline wouldaccept the project that has the highest IRR.

Figure 14B-5 summarizes the four capital budgeting methods we discussed and the evaluationeach one provided for Mainline’s proposed capital project.

Investing Decisions and Financing Decisions

As shown in Figure 14B-5, different capital budgeting methods may yield conflicting evaluationsof the same proposal. In our example, the decision rule for the discounted payback periodindicates that Mainline should reject the proposal, although the other three capital budgetingmethods indicate that Mainline should accept the proposal. Conflicting results often occur when ahealth plan compares the accept-reject decision of several capital budgeting methods. Therefore,health plans also consider other factors when deciding which proposals to accept or reject.

An underlying assumption of capital budgeting is that investing decisions (what to purchase)should be kept separate from financing decisions (how to purchase). Combining the two can leadto inaccurate capital budgeting evaluations. For example, assume that a health plan with a 13%WACC uses the NPV method to evaluate a capital project that will be financed through a long-term bank loan at an interest rate of 10%.

It might seem logical for the health plan to use the 10% interest rate as the discount rate for itscalculation of the project. However, doing so could lead the health plan to accept a proposal thathas a rate of return that is less than the health plan’s WACC, although the project’s return may begreater than the cost of a specific form of financing, such as the 10% bank loan.

Independent Proposals and Mutually Exclusive Proposals

When a health plan considers multiple capital project proposals, it must be aware of whether theproposals are independent or mutually exclusive. Independent proposals have cash flows that areunrelated; that is, the acceptance of one independent proposal does not automatically eliminateany others. Mutually exclusive proposals involve investment choices that perform essentially thesame function, so the acceptance of one proposal automatically eliminates all others fromconsideration.

A health plan may accept any number of independent proposals but only one in a group ofmutually exclusive proposals. For example, if a health plan was deciding whether to move its

home office either to Atlanta or to Miami, the acceptance of one of these mutually exclusivealternatives automatically eliminates the other choice.

Capital Rationing

A health plan may find that it has more acceptable capital proposals than it has availableresources to fund them all. In these circumstances, the health plan would use capital rationing.Capital rationing is the process of allocating limited resources to a health plan’s capital projectproposals. Under capital rationing, a health plan ranks all capital project proposals according toexpected rates of return and accepts only those with the highest rankings. There are several waysto rank all acceptable proposals. If a health plan relies on each project’s IRR to screen capitalproposals, the health plan ranks them by their expected IRR. For example, assume that an healthplan has four acceptable capital proposals with IRRs as follows:

If the health plan has resources to accept only twoproposals, it should choose proposals C and D becausethey have the highest IRRs.

Profitability Index

Recall that, unlike the IRR method, the NPV method does not allow for direct comparisons ofproposed capital projects, unless they require an equal amount of investment. So, if a health planuses the NPV method, the health plan calculates the profitability index to rank proposals forcomparative purposes. The profitability index (PI) is the ratio of the present value of future cashflows expected from a project to the amount of a health plan’s initial investment in the project.

In our example, Mainline calculates the PI of its printer proposal, as follows:

A project that has a PI of 1.0 means that the project’s NPV is zero. The decision rule for using PIinvolves rejecting projects that have a PI of less than 1.0. If a health plan is considering severalprojects, then the health plan will rank the project from highest PI to lowest PI.

Sensitivity Analysis

As you have seen, capital budgeting involves making decisions under the assumption that a healthplan’s management has perfect knowledge of the future. Keep in mind that any number ofassumptions could be wrong. In the Mainline example, suppose the printers actually couldprovide only $15,000, rather than $25,000, of cash inflows per year. Suppose the printers couldbe usable for only four years instead of five. If either or both were to happen, would Mainline stillaccept the printer proposal?

To address these types of circumstances, an health plan’s managers apply sensitivity analysis.Recall from The Strategic Planning Process in Health Plans that sensitivity analysis determines avariety of scenarios by calculating how far reality can vary from estimates without invalidating anhealth plan’s accept/reject screening decision.

For example, sensitivity analysis reveals that Mainline must receive cash inflows of at least$22,375 per year for five years for the proposal to “break even.” To determine the break-evenpoint of the printer proposal’s cash flows, divide Mainline’s cost of the investment by the presentvalue interest factor of an annuity (PVIFA) at 15% and five years: $75,000 ÷ 3.352 = $22,375.

Mainline’s managers also would perform a similar calculation to determine the amount ofcushion in its estimate of the printers’ useful life of five years. In light of the new information,Mainline’s managers would assess the likelihood that the printer proposal will actually meet itsinvestment thresholds.