What is a Self-Insured Health Plan?



A self-insured group health plan (or a 'self-funded' plan as it is also called) is one in which the employer assumes the financial risk for providing health care benefits to its employees. In practical terms, self-insured employers pay for each out of pocket claim as they are incurred instead of paying a fixed premium to an insurance carrier, which is known as a fully-insured plan. Typically, a self-insured employer will set up a special trust fund to earmark money (corporate and employee contributions) to pay incurred claims.

Demographics
According to a 2000 report by the Employee Benefit Research Institute (EBRI), approximately 50 million workers and their dependents receive benefits through self-insured group health plans sponsored by their employers. This represents 33% of the 150 million total participants in private employment-based plans nationwide.

The pricing of group insurance is dependent on many factors the most common factors:



 All the above items are known entities with the exception of the level and frequency of claims.

Differences in pricing amongst insurers result from their assumptions regarding future levels of claims, non-claims costs or retention, reserve requirements, and the method used for calculating renewal rate adjustments.

Group insurance pricing is also influenced by the underwriting method or level of risk taken on by the insurer. Several funding and financial arrangements are available, each resulting in a different level of risk for the insurer and the insured. Shifting the risk from the insurer to the insured reduces the insured's potential liability and therefore affects the pricing. An understanding of the manner in which renewal rates are calculated and the underwriting methods available is important to ensuring that the plan is priced appropriately and at an acceptable level of risk.

Insurance is about risk sharing or financing risk over a period of time. The risk being an unexpected financial loss. The larger the group, the more predictable the loss and therefore the lower the risk. The lower the risk, the less there is a need for insurance. Some Employers take advantage of this risk sharing and enjoy the rewards in the form of lower costs per employee per month or PEPM.

A Self-insured plan by definition

A plan offered by employers who directly assume the major cost of health insurance for their employees. Some self-insured plans bear the entire risk. Other self-insured employers insure against large claims by purchasing stop-loss coverage. Some self-insured employers contract with insurance carriers or third party administrators (TPA'S) for claims processing and other administrative services; other self-insured plans are self administered.

Minimum Premium Plans (MPP) are included in the self-insured health plan category. All types of plans (Conventional Indemnity, PPO, EPO, HMO, POS, and PHOs) can be financed on a self-insured basis. Employers may offer both self-insured and fully insured plans to their employees in any combination.

Advantages of Self funding

There are several reasons why employers choose the self-insurance option. The following are the most common reasons:



Disadvantages of Self Funding

Self-Funding isn't appropriate for every employer. To be effective in attaining the advantages of self-funding, the employer must be willing to exercise discipline over eligibility for benefits, over the actual payment of claims, and in the incurring of expenses. Even then, self-funding may not reduce costs every year - or at all.

Additional potential disadvantages:

  • Risk assumption - The employer assumes the risk between the normally anticipated claim level and the Stop Loss coverage level.
  • Provision of services - The employer must provide the services the insurance carrier normally provides. This is generally accomplished by contracting with a TPA.
  • Asset exposure - The employer's assets are exposed to any liability created by legal action against the self-funded plan.
  • While Specific and Aggregate Stop Loss protection limits maximum employer liability, there is some risk that is not transferred to the stop loss carrier.
  • The employer must be willing to trade the complete security (and associated costs) of a fully insured plan for the possibility that actual cost will exceed what the fully insured plan would have cost.


Stop-Loss (Excess) Insurance

Is a term to describe a product that provides protection against catastrophic or unpredictable losses. It is purchased by employers who have decided to self-fund their employee benefit plans, but do not want to assume 100% of the liability for losses arising from the plans.

Under a stop-loss policy, the insurance company becomes liable for losses that exceed certain limits called deductibles.

A significant difference between stop-loss and conventional employee benefit insurance is that stop-loss insures only the employer. Stop-loss does not insure employees (health plan participants).

Types of Stop-Loss coverage's

Stop-loss comes in two forms: specific and aggregate. Specific Stop-Loss (ISL) is the form of excess risk coverage that provides protection for the employer against a high claim on any one individual. This is protection against abnormal severity of a single claim rather than abnormal frequency of claims in total. Specific stop-loss limits your liability for claim expenses per each covered individual at a predetermined amount. The specific limit is determined prior to the start of the contract year and is based on the size of your employer group and risk retention ability. When a claim reaches the specific limit, you continue to pay the claim; however, the stop-loss carrier will begin to reimburse you for the amounts above the specific limit. Specific stop-loss is also known as individual stop-loss. Other names for Specific Stop loss include: Spec, Individual Stop Loss (ISL), Specific Retention Point as well as Specific Deductible.

Simply put "Specific stop-loss" coverage means that an insurance company is contracted to provide reimbursement to the Plan Sponsor (usually the Employer) for any claim over a certain amount, e.g. $25,000.

An example:

If the Employer Plan purchased "specific stop-loss" coverage, with a "Specific Retention Point" or "Specific Deductible" of $25,000 and a covered employee, the Plan Participant, incurred a hospital bill of $54,500. The employer would "Retain" the first $25,000.the employee would be subject to paying all applicable deductibles and co pays pursuant to the plan documents. The "stop-loss" carrier would then reimburse the employer the difference between the "Retention Point" ($25,000) and the total claim $54,500 or $54,000 - $25,000 = $29,500. In this example, from the Insurance Company's perspective the "stop-loss" policy is nothing more than an extremely high deductible ($25,000) policy.

The higher the Specific Deductible or the more the employer "retains" of the risk, the lower the cost to the employer. There are many different ways of determining "how high" to set your Specific Deductible. The bottom line is that each employer needs to assess their own risk tolerance and rely on their consultant's review of their specific circumstances, demographics, claims experience as well as other factors in determining the best course of action.

From this example you can see that a large claim would not be a significant risk to the employer if the consultant has provided adequate advice and together the employer and consultant have set the specific deductible appropriately. The risk now shifts away from the large claims.

The concern now is that in a given year many of your employees could penetrate or surpass the Specific Deductible. Two examples of this are shown below.



To address the issue in claim exhibit 2.2 a second type of Stop Loss coverage is added.

Aggregate Stop-Loss (ASL)

This type of coverage provides a ceiling on the dollar amount of eligible expenses that an employer would pay, in total, during a contract period. Under Aggregate Stop Loss, the Insurer will reimburse the employer the amount by which aggregate losses exceed the aggregate attachment point during the coverage period. Aggregate losses are the total amount of eligible expenses incurred and paid for all persons covered under the employer's benefit plan, excluding any amounts reimbursed under the ISL.

Aggregate Attachment Factors

Are determined annually based on fixed dollar amounts for single and family units. At the beginning of each month during the coverage period, the attachment point is calculated as follows:

A. The single attachment factor and the family attachment factor are multiplied by the number of single and family units, respectively.

B. The resulting amounts are added together for each month of the coverage period.

Generally, all but the largest employers will want to protect their plan with both specific and aggregate stop-loss coverage. Occasionally, circumstances may be such that specific stop-loss by itself will fulfill the employer's need for protection. A number of variations are available for each of these two products.

Reimbursements

All reimbursements are paid directly to the employer, never to an employee or to a provider of services or supplies. Specific claims are generally submitted and processed as soon as the deductible is met. Aggregate claims are usually processed only after the close of the contract period. Occasionally, there are requests for a "monthly accommodation" on the aggregate. This means the employer wants the year-to-date aggregate claims to be compared to the year-to-date aggregate deductible to determine if any amount is payable.

Money could change hands during the year. The ultimate amount of the claim should remain the same. There is a business risk in this situation rather than an insurance risk; the employer may not pay back an advance if it turns out in a later month that he isn't entitled to it.

Contract types

Stop Loss contracts are generally underwritten for a 12-month period. Incurred and paid date criteria are conditions of the policy. Claims have to meet both the Incurred and Paid criteria in order to be covered.

There are several types of contracts:



These are just a few of the most common types of contracts. Other forms of run-in and run-out coverage are available.

Benefits of Self-Funding

The advantages of self-funding are many. There is tremendous flexibility in the benefit plan design. You can decide what you want to cover and what you don't, whether it's certain vaccinations, chiropractors, injectibles, obesity, or infertility. Another major advantage is portability from one carrier to another. There's no disruption in plan when you shift between reinsurance carriers. You don't have to start all over again with new I.D. cards, booklets and doctors, the way you do with the fully-funded plans.

Also, for employers with more than one office, it is possible to offer the same plan to everyone in every location. This makes it so much more administratively simple. By Self Funding an employer can utilize one national network or multiple local PPO networks with the same benefit plans.

But the bottom line is cost savings. If you have a good expected claims year, that is the best scenario. But even if you don't, there's maximum liability in place. Another advantage of self funding is the ability to class out the executives and provide them with a 100% benefit where, executives and their families pay no co pays, deductibles or coinsurance

Design and consultation

Understanding how to design a self funding plan begins with understanding the underwriting method. Keep in mind proper reserve funding is extremely important in the initial design of a self-funded plan. Underwriting Method

The underwriting method refers to the assessment of risk for the purpose of pricing group insurance. When underwriting a group benefit plan, there are three major considerations:



The most common underwriting methods available are described below.

Fully Pooled

The underwriter, usually an insurance company, takes all the risk and charges a rate per unit of coverage. Under the pooled concept, the renewal rating will not be based on the experience of the plan, but rather in accordance with the overall results obtained by the insurance company in its pool, where several of the company's clients participate for a given type of insurance.

The pooled method of underwriting is used on types of insurance which are characterized by unpredictability, a low incidence of claims and a high claim level compared to the required premium. Benefits such as Group Life, Accidental Death & Dismemberment (AD&D) and Long Term Disability (LTD) have these characteristics and as a result are underwritten on a pooled basis.

Prospectively Experience Rated (Non-Refund)

The underwriter accepts all the risk and uses past claims along with demographics, trend factors and inflation factors to estimate future claims and arrive at a premium.

The medical, dental, and short term disability benefits are generally underwritten on an experience rated approach. As the claims under these benefits are small in dollar amount and are incurred with relatively high frequency, their expected claim patterns are generally more predictable than Life, AD&D and LTD claims. Accordingly, premium rate levels at renewal can be assessed based primarily on a group's past experience.

For small groups, only partial credibility is generally given to the claims experience. In these cases, the rates are in effect partially pooled as they are also based on the insurer's manual rates (average rates for a group of similar demographics within a similar industry).

Retention Accounting (refund accounting)

The underwriter uses past claims along with demographics, trend factors and inflation factors to estimate future claims and arrive at a premium. If at the end of the financial year, premiums exceed costs, then the surplus can be used to boost reserves or refunded to the plan sponsor. If at the end of the policy year, costs exceed premiums, the deficit is collected through a premium increase. The underwriter risks being left with a deficit if the policy is terminated.

In terms of the renewal rating process, there is essentially no difference between a prospectively experience rated group and a retention group. The main difference between the two methods is the financial accounting process. Although a prospectively experience rated group is rated on its own experience, it is still pooled in that it does not share in the plan results. In contrast, a retention accounting group is rated on its own experience and also shares in its experience.

Administrative Services Only (ASO) With an ASO plan, a third party provides claims paying services and charges for services provided. The cost can be budgeted and remitted monthly based on a level amount or according to volume of coverage. Alternately the cost of claims and charges can be billed to the plan sponsor monthly. Some benefits, such as hospital out-of-country and long term disability coverage are generally insured as claims for these benefits can be substantial.

A "stop-loss" policy is also usually purchased to protect against other large health claims. The dental benefit is usually fully self-insured. Expenses for an ASO plan vary considerably, but typically are as follows:



*The 2% premium tax is already taken into account in the target loss ratio of a non-retention plan.

As the health benefit is mainly self-insured and the dental benefit is fully self-insured, the plan sponsor may save with an ASO plan when claims are low. However, the plan sponsor may incur higher expenses if claims are high as the plan sponsor is responsible for funding the payment of all claims (with the exception of those benefits which are insured and those claims that fall within the parameters of the stop-loss insurance). In other words, the plan sponsor is sharing in the risk.

Self-Administered

The plan sponsor performs all administration functions including the payment of claims and accepts all risks associated with the benefit program. There is a potential issue relating to confidentiality under this type of arrangement as a result of the plan sponsor having access to the medical information of plan members. The fluctuation of claims decreases as the size of the group increases. Only very large organizations will even consider self-insuring their long term disability benefit. The risk of out-of-country and large non-recurring medical claims is often managed through pooling limits.

Underwriting Terminology


A fully insured carrier's profit margin can be as high as 52% with your current fully insured health plan. This means if your premium is $1 million, the insurance carriers "Profit" can be as high as $520,000.

Note: Even with a highly profitable employer case a fully insured carrier will have no problem hitting the employer with a "double digit" rate increase. Insurance carriers continually base rate increases upon a concept called "pooling."


Pooling means that if other employers the carrier insures had bad claims experience, which hurt profitability, the fully insured carrier will penalize and raise rates for all employers


In order to reduce the volatility of the claims experience and the liability to a plan sponsor under a self-administered arrangement, certain claim payments may be insured.

The underwriter charges a monthly premium per person or a percentage of claims as a pooling charge. Examples of claims that can be pooled under this type of arrangement include:



The estimate of future claims expense is based upon various factors that create change in medical costs. Also referred to as trend. Trend means increases within the healthcare industry. The fully insured carrier will argue a double digit increase was justified by "trend" on an employer who is running at 50% of claims (highly profitable). Trend is determined by various factors. These factors include:



Trend concern: This means even though a particular employer has excellent claims experience and is not running at "trend" where other companies have bad experience; the carrier will still raise their rates.

Claims Credibility

There are several ways an insurance company values statistical "credibility" of historic loss experience in an experience rating arrangement. The most common method is to use a weighted average of the employer's actual claims experience and the insurance companies standard loss factors for a similar conventional insurance arrangement.

The percentage weighting given to the employer's actual paid claims is called your credibility factor. The greater the statistical credibility of the risk the closer the credibility factor is to 100 % which would imply that the employer's prior loss experience is wholly representative of future loss experience.

The typical credibility factors applied to a medical plan are based on the number of covered participants. Most carriers use this basic formula to some degree, however each carrier can use "credibility" to their own benefit during the renewal process. As an example if your claims experience in a given year is poor, the carrier may use a "higher" factor to adversely affect your renewal rating. Conversely if your claims experience is excellent, the carrier may use a "lower" factor to skew the renewal in their favor.

A seasoned consultant will recognize this "underwriting tactic" instantly and be able to have your plan rated more accurately.

The following table is typical of how a carrier applies credibility factors:



Premium Tax

In most states there is no premium tax for self funded plans. This results in an immediate savings since between 2%-4% of your current fully insured health plans costs are premium taxes. Your consultant will be able to determine if your state has premium taxes.

Improved Cash Flow

Moving from a fully insured plan to a self funded plan usually results in about 3 months of relatively little new claims. During this time, the previous fully insured carrier is still paying claims incurred prior to the new self funded plan year. This claims lag allows your new Self Funded plan the opportunity to build and establish a reserve to pay future claims. Also, reserves for claims are held by the employer and only released if claims materialize, resulting in an improved cash flow for the employer. Remember proper reserve funding is extremely important in the initial design of a self-funded plan.

Control & Flexibility of Plan Design - Benefits

The employer can duplicate its current fully insured benefit plan or it can "redesign" and tailor the benefits to meet the specific needs of the employer. This means the employer can eliminate benefits which result in plan abuses or high utilization. The employer can also create special executive benefits.

Eliminate State Mandated Benefits

Since Self funded plans are governed by ERISA, they follow Federal law, and are not required to cover "State-Mandated" benefits, which can be expensive and unnecessary. By eliminating unnecessary and expensive state mandated benefits employer's can realize an immediate savings. Employer's can also set the limits on certain benefits, where with a fully insured plan there may be state required limits. Since fully insured plans include state mandated benefits the cost of offering these benefits raises the costs of the health plan to the employer.

Control of Reserves - Return of Investment on Reserves

A good portion of your fully insured premium is held by the fully insured carrier as a state required reserve for claims and inflation. Under Self Funding the employer maintains and controls reserves and can invest these or put them in an interest bearing account. The employer retains the reserves when claims do not materialize, and there are no restrictions on reserves with a self funded plan.

Claims Experience - Immediate Realization of Hard Dollar Savings

Under a fully insured program, if an employer's experience is "better than expected," the insurance company gains financially and makes an unexpected profit. The insurance carrier does not refund the excess profit to the employer. Even if an employer had good experience, the insurance company will still pass on a renewal based upon the insurance company's pool of thousands of groups. You are not truly rated based upon your claims experience and can be treated unfairly.

With Self Funding your renewals are based on "YOUR" company's claims experiences, and it is not based on thousands of other companies that have no relation to your company or industry. You, the Employer, not the insurance company enjoy the advantage of favorable claims experience. You, the Employer, keep the savings.

OTHER IMPORTANT ADVANTAGES

Improved Employee Satisfaction- Personalized Employee Service

Third Party Administrators or TPA's specialize in one thing, Customer Service. Their sole purpose is to provide the best quality service possible, and to personalize that service to members. This includes dedicated account representatives who know not only the employer's account but the individual employees of each company. Employees and HR get on a first name basis with claims examiners, and are not transferred to a random person that does not know anything of the employee or the employer. TPA's also implement unique programs such as hospital bill auditing, case management, pre-certification review, lab programs, etc to keep costs down.

Lower Costs of Operation

Third Party Administrators have lower overhead and expenses than a fully insured plan, which result in an immediate direct savings for the employer, when switching to Self Funding.

Claim Utilization and Cost Controls

Third Party Administrators work directly with consultants to review utilization of the plan and benefits and see where the employer's claims and costs are. This allows the employer along with the consultant, to make informed decisions as to plan benefits, costs, and any adjustments that need to be made.

National or regional companies & Provider Networks

The fully insured, insurance company's inflexibility to deal with national or regional employers means a multi-location employer cannot offer the same benefits or insurance carrier options to all of its employees. Some mutli-location employer's have to use multiple fully insured carriers with varying benefit plan designs. This results in far higher plan management costs, and extra administrative work for human resources. With a self-funded plan, a multi-location employer can choose from one network to dozens of networks, offering a single standard benefit plan design across several states with significant savings on plan management expenses. This saves your human resource department from dealing with multiple confusing health plan designs and multiple insurance carriers.

Prescription Drugs

With rising prescription drug costs it can be unnerving that an average employer's prescription drug plan can be the cause of almost 25% of the cost of the company's group health plan.

Fully Insured carriers pass along minimal prescription drug discounts to employers and keep any pharmaceutical rebates. The result is larger Rx costs and claims experience, which then result in higher rate increases.

With a Self Funded Plan, Employers will actually receive substantial rebates ($ money back each quarter from pharmaceutical managers). Company's will also receive the strongest prescription drug discounts (depends on the TPA) in the country, reducing the employers' prescription drug costs, and hence resulting in lower costs for the group health plan.

Questions & Answers about Self Funding

Q. What types of benefits are self-insured?

A. Usually the group medical or health plan is the focus of a self-funded program. Other benefits that are often self funded are dental, prescription drugs, vision and short term disability. Life Insurance, Accidental Death and Dismemberment and long term disability are not suitable for self-insurance. However there has been an increasing desire of larger employers to also self-fund these benefits. Your consultant can provide crucial information to assist you in this decision.

Q. Is self-insurance the best option for every employer?

A. No. Since a self-insured employer assumes the risk for paying the health care claim costs for its employees, it must have the financial resources (cash flow) to meet this obligation, which can be unpredictable. Therefore, small employers and other employers with poor cash flow may find that self-insurance is not a viable option. It should be noted, however, that there are companies with as few as 25 employees that do maintain viable self-insured health plans.

Q. Can self-insured employers protect themselves against unpredicted or catastrophic claims?

A. Yes. While the largest employers have sufficient financial reserves to cover virtually any amount of health care costs, most self-insured employers purchase what is known as stop-loss insurance to reimburse them for claims above a specified dollar level. This is an insurance contract between the stop-loss carrier and the employer, and is not deemed to be a health insurance policy covering individual plan participants.

Q. Who administers claims for self-insured group health plans?

A. Self-insured employers can either administer the claims in-house, or subcontract this service to a third party administrator (TPA). TPAs can also help employers set up their self-insured group health plans and coordinate stop-loss insurance coverage, provider network contracts and utilization review services.

Q. What about payroll deductions?

A. Any payments made by employees for their coverage are still handled through the employer's payroll department. However, instead of being sent to an insurance company for premiums, the contributions are held by the employer until such time as claims become due and payable; or, if being used as reserves, put in a tax-free trust that is controlled by the employer.

Q. With what laws must self-insured group health plans comply?

A. Self-insured group health plans come under all applicable federal laws, including the Employee Retirement Income Security Act (ERISA), Health Insurance Portability and Accountability Act (HIPAA), Consolidated Omnibus Budget Reconciliation Act (COBRA), the Americans with Disabilities Act (ADA), the Pregnancy Discrimination Act, the Age Discrimination in Employment Act, the Civil Rights Act, and various budget reconciliation acts such as Tax Equity and Fiscal Responsibility Act (TEFRA), Deficit Reduction Act (DEFRA), and Economic Recovery Tax Act (ERTA).

Q. How and when are claims paid?

A. Most Stop-Loss insurance is provided on a reimbursement basis. In some cases immediate reimbursement provisions can be added to eliminate potential cash flow hardships. This is an area where your consultant will spend considerable time in helping you to determine if this option would benefit your plan. Without an immediate reimbursement option the employer is responsible for payment of all losses under a self-funded plan as they occur. With the purchase of Stop-Loss coverage, the employer is still responsible for all losses including those that exceed the deductible. After the losses have been paid, the employer will be reimbursed for the amount of the loss that exceeds the deductible.

Q. What happens when employee leaves the self-funded plan

A. Many employers offer conversion privileges to qualified members leaving the group. This pressure is being reduced to a noticeable extent by the COBRA requirement to extend coverage. Sometimes two complementary products are offered: Medical Conversion and Temporary Medical. Neither plan requires proof of good health, but the approach to coverage varies.

Medical Conversion is similar to a classic insured plan's medical conversion. The rates are high and the benefits are limited, but usually all existing medical problems are covered.

Temporary Medical is for the self-perceived healthy person leaving the group. The rates are lower and the benefits are more generous, but no pre-existing conditions are covered. This product is also offered only for a limited coverage period.

Q. What is the Underwriting cycle?

A. The underwriting cycle is a thing of the past for most health insurance companies. There were six primary factors that caused the six-year pattern of the underwriting cycle for 1965 - 1991. These factors were claims payment cycle time, renewal dates and process, growth versus profit objectives, role of the actuary, rate regulation, and reimbursement methods. Most companies have made major changes to influence these factors, which will prevent a recurrence of the underwriting cycles of the past.

The phenomenon of the underwriting cycle has been well documented. The health insurance underwriting cycle demonstrated amazing regularity during 1965 - 1991 - a six-year cycle of three years of gains followed by three years of losses. The years since 1991 have shown a different pattern, however, which has led some observers to question whether the underwriting cycle will continue into the future. Based on my experience in the industry, the underwriting cycle will continue into the future for some insurers but not for most. This is attributable to the actions taken by insurers, both profit and not-for-profit, that will help them avoid the swings of the underwriting cycle in the future. Even for those companies that do experience underwriting cycles, the swings will not be as severe as they have been in the past.

Six Contributors to the Underwriting Cycle

There are six causes of past underwriting cycles that explain the cycle itself as well as the six-year pattern. These factors work in concert with each other. In this brief comment I outline these factors and what lies ahead for the health insurance industry. Claims payment cycle time.

Before the recent improvements in electronic claims submission, auto-adjudication, and other technological advances, cycle time as measured from service date to payment date of a claim was often 90 - 120 days. This implied that at any point in time, the three or four most recent months of experience used in financial or pricing calculations were based primarily on projections of past claims data, generally per member per month claims projected forward with a trend assumption. This straight-line type of projection for the most recent months often led to a delay in recognizing that trend was turning upward or downward, causing pricing errors and earnings swings. Renewal dates and process.

The majority of renewals for group health insurance occur on January 1; in the past, these rates were guaranteed for twelve months. For the customer, this ties in nicely with fiscal periods and with calendar-year deductibles. Renewals on any date are subject to a gap in time between the prior experience and the future projection period. For example, for a January 1st renewal, the underwriter needs to release the renewal to the salesperson by October 1st, and the salesperson needs to release the renewal to the account by November 1st For larger accounts, this might occur several months earlier. Therefore, the underwriter would be using paid claim experience through the end of August and projecting this experience forward.

Health care actuaries often refer to the "midpoint to midpoint" rule for trend, which means that a past twelvemonth period (in this case, the twelve-month period from September 1st in year x through August 31st in year x+1) is being projected with sixteen months of trend to the renewal twelve-month period (in this case, January 1 in year x+2 to December 31 in year x+2).

If one now combines this with the claims projection process mentioned above, the projection period increases from sixteen months to nineteen months, since the last three months of incurred claims are themselves based on a projection. That is a long period of projection for health care costs. If a 12 percent trend rate was used, and the trend rate should have been 15 percent, the difference on a compounded basis for nineteen months is worth 5.1 percent.

That is a huge difference for an industry that usually runs pretax net gains of 3 - 7 percent. If most of the business renewed on January 1, then that 5 percent miss would apply to the majority of the business for a full twelve months.

Growth versus profit objectives

In the early years of for-profit managed care, investors rewarded growth over profitability. At the point of greatest gain in the cycle, management was faced with the daunting question of growth versus profitability. If enrollment had slowed down and if management was comfortable with surplus levels, there was an attempt to lower trend rates or to take other pricing actions to improve the competitive position. This started the cycle in the opposite direction.

Role of the actuary

The underwriting cycle has been studied primarily for Blue Cross and Blue Shield (BCBS) plans, since the data have been available through the Blue Cross and Blue Shield Association. Many Blues plans did not have actuaries on staff until fairly recently.

An article published in the May 1996 issue of the Actuary reported that the number of actuaries at BCBS plans increased from 15 in 1970 to 245 in 1995.1 When health maintenance organizations (HMOs) relied on capitation, many companies did not think that actuaries were needed. As a member of the actuarial profession, I can easily point to the lack of actuaries as one of the causal agents of swings in the underwriting cycle.

Actuaries are trained in using data to analyze trends and in building financial models. However, the most difficult part of a health care actuary's job is predicting when trend rates are changing direction - either up or down; a delay in recognizing that inflection point is often the key driver of the underwriting cycle.

Rate regulation

In states where rates for individuals, small groups, or seniors required approval from regulators, it was easier to get approval for higher rates when the plan's surplus position was low than when it was high. It was also difficult to convince regulators that trend was accelerating when this could not be statistically demonstrated from prior experience.

Depending on the size of these blocs of business, this might compound the effect, so that when the surplus position is at its highest and the plan starts trying to raise enrollment in response to competitive pressures, it is also not getting sufficient rate increase approvals from regulators; this drives earnings toward the downward part of the cycle.

The rate approval process also introduces an even larger time gap between the experience period and the rate projection period, because of the time needed for regulatory review.

Reimbursement methods

BCBS plans have historically used network models, even before the rise of managed care. However, if the reimbursement mechanism was a discount from billed charges, the projection of future trend rates was just as uncertain as a projection of fee-for-service trend rates. For commercial carriers, payments were generally made on a "usual and customary" fee basis, so once again they were inherently uncertain. This resulted in misses on setting trend rates in pricing, which caused the earnings swings.

How the Six Factors Work Together

If a carrier has a majority of renewals on January 1st, and the trend factor used for pricing is too high or too low, pricing itself will be too high or too low, causing the underwriting cycle. The six years can be characterized as follows:

(1) Year 1: Trend starts to increase above the projection. Because of the nineteen-month lag for renewal rating, this inflection point is missed, and actuaries hold the trend constant. There is a minor loss, or earnings are close to break-even for the year.

(2) Year 2: The Company has missed the trend for January renewals on the low side. The majority of cases have been under priced for a full twelve months, leading to heavy losses. The error would normally be corrected by the middle of the year.

(3) Year 3: Trend is correct for the January renewals, but there are still some inadequacies in the early months, because of under priced renewals from the months of year 2 prior to the correction (such as under priced results for January, since the correction cannot be made until the February renewal). Financial results are closer to break-even.

(4) Year 4: Trend and pricing are correct for all renewal months, and the profitability picture improves, and is better than break-even.

(5) Year 5: Rates are correct for all renewal months, and trend may have started to decrease. The gains are highest. Market pressure starts to build, and discounts are built into rates.

(6) Year 6: Rates have been discounted too much, so the gains are lower than they were in year 5, but there are still gains.

The pattern described above is not entirely consistent. This is because the six-year timing may affect companies at different times, so that when one looks at the entire system of Blues plans, the pattern is not exactly as described above. However, it does follow three years of underwriting margin losses followed by three years of gains.

Companies within the BCBS system as well as HMOs and commercial carriers will continue to experience the underwriting cycle. However, since many companies have taken steps to avoid the downward part of the cycle, since 1991 the pattern has been different than the earlier pattern; the cycle has evolved from a pattern of gains and losses to a pattern of greater and lesser gains.

Steps Insurers Have Taken To Avoid the Cycle

The steps that most health insurers have taken to avoid the down side of the underwriting cycle fall into the six categories described above.

Claims payment cycle time

Through technology enhancements, more claims are now received electronically (some carriers have even given computers to providers to assist in this goal). Many companies have decreased cycle times to fifty to sixty days on a dollar-weighted basis. They also have invested in data warehouses that allow actuaries to retrieve claims data shortly after month's end, so that actuaries are always working with current data.

Renewal dates and process

Companies have diversified the customer segments they serve. Large-group business is heavily January-dominated; small-group business is less so; individual business is not at all. Government programs generally have July 1 or October 1 renewal dates. Large-group business can be written on a self-funded basis. Ancillary lines of business not subject to medical price trends can help moderate the financial impact of the renewal distribution. Some companies have changed their contracts to allow off-anniversary rate actions and will take this step if there has been a big miss in pricing. Also, some companies may have blocs of business, such as individual or small-group, for which focal renewals are done-meaning that all of the business in a bloc is given a rate increase on the same date, instead of having each piece of business renewed on an anniversary date.

Growth versus profit objectives

Some companies view this as an "and," not an "or," and have set goals that use words such as "profitable membership growth." These companies have also developed pricing discipline and will not discount adequate rates to the point of inadequacy, in spite of market pressures. Companies have also learned the importance of focusing on value instead of cost. The value comes from network quality, information, pricing stability, financial stability, product innovation, disease management and other medical management programs, and customer service. Many companies realize that this is not an industry in which discounting works, with pretax margins of 3 - 7 percent, not a 30 percent margin business in which a company would be satisfied with a 20 percent margin.

Role of the actuary

In companies that have taken steps to avoid the cycle, not only are there an adequate number of professional actuaries, but the actuaries hold positions at the executive team level. Actuaries are integrated into the entire operation of the company - not just valuation and pricing, but underwriting, network contracting, medical management, and product design.

Rate regulation Some companies can obtain adequate rates in spite of rate regulation. They have developed good working relationships with their regulators and have assisted in efforts to lower the number of uninsured people in key markets, participated in high-risk rating pools, and worked to keep claims costs and administrative expenses as low as possible.

Reimbursement methods Many companies have developed provider reimbursement mechanisms that do not make them dependent on changes to billed charges. Actuaries at these companies have developed models that allow them to predict contractual rates for future periods fairly accurately. These companies also review utilization patterns and look for ways to improve quality by eliminating inappropriate use of health care services.

In my opinion, the underwriting cycle pattern seen from 1965 to 1991 is a thing of the past. However, it will probably continue for some companies and still swing earnings up and down slightly for others. As companies continue to make the changes described previously, the swings will continue to moderate. It is in the consumers' best interest for the underwriting cycle pattern to mitigate, since the result will be more stable premiums.

For a more information regarding Self-Funded Health Plans and how they may benefit you and your company, please contact Almond Valley Insurance Services, Inc. or visit the Health Care Financing Administration online.


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