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 plans financial information Identify the internal users and external users of a health plans 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 of healthcare through health plans such as those offered by health plans. Recall from Healthcare Management: An Introduction that a health plan is an entity that utilizes certain concepts or techniques 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 of healthcare benefits. Because finance is closely tied to delivery systems and costs, all health plans rely heavily on financial information. In the context of this course, finance is the effective and efficient management of money to achieve a health plans strategic goals and objectives. A primary strategic goal of a health plan is to offer one or more health plans that meet the healthcare needs of employers and other purchasers or payors. Many health plans offer one or more products. Although in some contexts the term health plan refers to healthcare benefits provided through an employer or other group, in the context of this course, a health plan is the delivery and financing system of healthcare benefits, rather than the benefits themselves. Health plans expect to receive regular premium payments in exchange for assuming 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 be able to interpret financial information. Financial information includes any numerical data compiled for and from a companys records. Health plans analyze financial information as part of the decision-making process involved in generating enough funds to conduct ongoing business and to expand operations. Examples of a health plans financial information are listed in Figure 1A-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 plans employees must be able to interpret financial information to attain the health plans goals. Key characteristics of useful financial information include timeliness, quality, accuracy, and clarity of that information. Also, financial information must be appropriate. In other words, financial information is appropriate when it serves the needs of those who use the information. We discuss the impact of these characteristics on a health plans strategic planning process in The Strategic Planning Process in Health Plans. A health plans accountants, actuaries, underwriters, financial analysts, investment analysts, sales forecasters, and other staff members have a decision support role in developing and providing the plans managers and executives with appropriate financial information. Compilers of a health plans financial information also serve in a decision support role for regulators, investors, and others outside the plan who make decisions about the plan from their interpretation of the plans financial information. In addition, financial information developed for health plan managers and executives must be "actionable". That is, it must provide what is necessary for a health plans managers to make decisions about the plans direction, growth, and ongoing survival.

Users of Financial Information 1 Many organizations and people rely on the financial information contained in a companys accounting records and reports. These interested parties generally consist of two groups: internal users and external users of financial information. Internal Users Internal users of a health plans financial information are those individuals within the health plan who make decisions that affect plan operations. These individuals include the health plans directors, officers, managers, and others involved in planning, controlling, monitoring, and evaluating the financial implications of their decisions. Figure 1A-2 lists several key positions typically found in a health plan and the general responsibilities of these positions within the plans financial functions. Note that actual health plans may have different internal corporate structures than those presented. For example, one health plan may outsource its actuarial and underwriting functions; another health plan may have one or more actuaries on staff and an underwriting department.

External Users External users of a health plans financial information include those individuals and organizations outside 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 of financial 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 health plan. External Users: Direct Financial Interest Any external user who stands to gain or lose money as a result of a health plans financial performance is said to have a direct financial interest in that plan. Health plan members, providers, outside agents and brokers, creditors, stockholders, and potential investors are examples of external users with a direct financial interest in the financial performance of a health plan. Figure 1A-3 summarizes typical interested parties with a direct financial interest in a health plans financial performance. Plan members have a general interest in a health plans reliability in paying claims. Providers are interested in a health plans financial condition because they want to be 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, external auditors, independent financial analysts, rating agencies, economists, attorneys, consumer groups, financial publications, and the health plans competitors. Figure 1A-4 summarizes the primary activities or scope of interest associated with external users that have an indirect financial interest in a health plans financial condition or performance.

Users of Financial Information Different users of financial information often have different needs and uses for a health plans financial information. Financial information is often used to make key decisions related to a health plans long-term and short-term business objectives. Figure 1A-5 summarizes several questions that internal and external users hope to answer by reviewing a health plans financial information. We discuss these concerns, including how a health plans financial information can be analyzed and interpreted, later in this course.

Legal Forms of Organization That Affect Health Plan Finance 13 Recall from Healthcare Management: An Introduction that there is a wide variety of health plan structures and arrangements. In addition to having many options for their structure, health plans also have several options related to their legal form of organization. These options may affect sources 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 common types of health plans. A health plan can be established on either a for-profit basis or a not-for-profit basis. Profit is the excess of a health plans 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 to generate profits in order to fund ongoing operations and future growth. The choice of for-profit or not-for profit status determines to a great extent the way a health plan approaches critical financial 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 a satisfactory return on their equity investment in the health plan. An equity investment typically consists of shares of stock that a health plan sells to owners or investors. If shares of stock are offered to the general public, then the health plan is a publicly traded corporation, also called a stock company. A publicly traded corporations shares of stock are traded in the financial markets. If shares of stock are not offered to the public, then the health plan is called a privately held corporation. A privately held corporation has the option of "going public" if it decides that this would be in its best interest. For example, a privately held corporation may need to generate funds quickly for expansion into new markets or to improve its information management capabilities 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, cannot distribute its profits to individuals for personal gain, but must instead use its profits for the benefit of the health plan and its purposes. The distinguishing characteristic of a not-for-profit health plan is that it has no owner investors, as does a for-profit health plan. Not-for-profit health plans sometimes 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 health plans qualify under the Internal Revenue Code for tax-exempt status. Tax-exempt organizations do not pay federal, state, or local taxes on earnings, although some of them may be required to pay certain other taxes such as premium taxes. The criteria for qualifying for tax-exempt status under 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 plans ability to generate profit instills confidence in potential investors and lenders who provide access to additional funds. If a health plan is unable to convince investors and lenders of its ability to operate profitably, then the health plan is likely to lose access to outside funds that are often critical to its ongoing operations. In the health plan industry, for-profit health plans and not-for-profit health plans compete in the same marketplace for funding sources. A critical success factor for any health plan is its ability to access funds needed to establish, maintain, and expand operations. Typically, health plans acquire funds 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-profit companies 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 funds from 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 options available 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 a complete discussion of the advantages and disadvantages and the legal structures associated with each 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 key factor that distinguishes the various types of health plans is the type and amount of risk that a health plan assumes with respect to the delivery and financing of healthcare benefits. In the context of this course, risk-bearing health plans, including HMOs, PPOs, and PSOs, assume the financial 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 risks associated with the financing and delivery of healthcare benefits. We discuss the concept of risk in Risk Management in Health Plans. Through its wide variety of structures and organization types, health plans seek to align the often differing 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, and regulatory agencies. Financial information plays a vital role in this process, because most types of financial information either measure performance toward goals, or predict the effect of choosing one 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 of the participants in health plans and how financial factorssuch as the cost of services, provider reimbursement, return on assets, and return on investmentaffect the goals they are seeking to achieve through health plans:
Health plan members- Health plan members and their dependents would like to receive

the 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 cost of receiving care in the event of a serious illness or injury would be financially devastating. Also, plan members typically want to pay the lowest possible premium. Employers-Employers and other group plan sponsors would like to enable group plan members to access the highest quality healthcare at the lowest possible cost. They also prefer simplified record keeping and minimal complaints from plan members about access, quality, service, or cost. Healthcare Providers- Healthcare providersincluding physicians, hospitals, and ancillary service providers (for example: laboratory, diagnostic, pharmacy, physical therapy, and mental health services) want to use their specific expertise and skills to provide healthcare services as efficiently as possible. Also, providers want access to plan members in order to maintain or increase their market share, and providers want to be rewarded financially for offering healthcare services. Owners of a health plan - Owners of a health plan, whether they are individual or institutional stockholders or another corporation, want the health plan to be solvent, profitable, and poised for future growth. In return, owners and investors seek to be rewarded financially for their investment in the health plan. Regulatory Agencies- Regulatory agencies ensure that health plans adhere to the law and remain 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 highest possible 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 major medical procedure. By providing healthcare for a large number of healthy people, a health plan is able to both take advantage of economies of scale and spread out the financial risk that any one plan member will suffer an illness or injury. Plan members want to avoid financial risk, and health 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 of balancing 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 not obviously complementary, but many of the features of or practices employed by health plans help align the goals of the various participants. Lets look at two examples of how health plan goals integrate 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 plans goals is to manage costs, this particular health plan has a copayment feature. Recall from Healthcare Management: An Introduction that copayment is a specified charge that a plan member must pay out-of-pocket for a service at the time the service is rendered. For example, each time the member visits physician, the member may have to pay $10 copayment. In the short run, copayments might appear to interfere with the plan members goal of receiving healthcare 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 of healthcare benefits. Also, in the long run, the copayment feature lowers the cost of healthcare because copayments give plan members a reason to help control the number of unnecessary visits to the doctor a copayment feature helps to lower the health plans costs. Thus the goals of the plan member are aligned with the goals of the employer and the health plans owners. At the

same time, the plan member receives quality healthcare and avoids the risk that illness will cause financial hardship. In another example, suppose a physician owns her own practice. She finds that, although she enjoys helping plan members by practicing medicine, she spends much of her time on the administrative aspects of her practice. Administrative tasks include payroll, accounting, purchasing supplies, and other business functions. A PPM company provides physicians with administrative support services, which the PPM company can more efficiently perform, leaving the physician more time to practice medicine and thereby better serve plan members. By using financial information to calculate the expenses and projected income involved in offering such services to providers, a health plan may ultimately take advantage of economies of scale by offering administrative services to a large number of physicians. Economies of scale result in a decrease in the cost per plan member of administering healthcare. In turn, the health plans owners may receive a higher return on their investment. Also, through the health plan, both plan members and physicians benefit: the plan members benefit because their access to the physician has been improved, and the physicians benefit because they are able to see more plan members than before. Perhaps the best example of aligned incentives is a risk-sharing arrangement in which a health plan and its providers share the risks and rewards of higher- or lower- than expected medical expenses. We discuss risk management in Risk Management in Health Plans and provider reimbursement arrangements in Provider Reimbursement Arrangements and Capitation and Plan Risk . Course Overview Health Plan Financial Information introduced the functions that comprise health plan finance and described some types, users, and uses of a health plans financial information. Throughout the remainder of this course, we discuss various financial aspects of health plans and their impact on planning 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 Financial Reporting in Life and Health Insurance Companies (Atlanta: LOMA, 1997), 6-9. Used with permission; all rights reserved. 2. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life and Health 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), 2-9-216. 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 Management 22. 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 the various participants in health plans face. Generally speaking, risk has a direct association with costthat is, in the long run the greater the exposure to risk, the greater the costs that follow from that risk. In the following sections, we explain the concept of risk and explore the methods that health 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 experience two kinds of riskspeculative risk and pure risk. Speculative Risk Speculative risk involves three possible outcomes: loss, gain, or no change. For example, after an investor purchases stock in a publicly traded health plan, the stock price will either rise, fall, or stay the same. The investors financial returns on that stock will follow the stock price plus whatever dividends the health plan issues. Thus, the owner of the stock faces speculative risk to the extent that the future returns on the stock are uncertain. Likewise, when a health plan purchases a new information system, the health plans owners hope that the initial investment in the system will result in an increase in operational efficiency and in the level of customer servicefactors that will help the health plan earn a profit (if the health plan is for-profit) or a higher level of retained earnings (if the health plan is not-for-profit). Furthermore, the health plans owners hope that the total benefits that derive from the health plans investment in the information systembenefits such as increased income and market shareexceed the benefits the health plan or its owners could have received by investing the same amount of money in a different information system. Again, uncertainty and risk are present in this investment decision because there is a possibility that this particular information system will not work as hoped, and that the health plan will incur greater expenses and fewer benefits than anticipated from the system, thereby losing money on its investment. There is also a possibility that the investment will neither lose nor gain a significant amount of moneythat is, the benefits of the system as measured by increased revenue are essentially 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 plans owners or stakeholders are in a position similar to owners of other investments such as stocks or bonds: owners invest their money and accept 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 risk is the possibility that you may contract a serious illness. Such unforeseen illnesses will result in economic 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 by fire, or that the health plan will be a victim of fraud, or that an employee will act in a negligent manner and in so doing expose the health plan to financial liability. Notice that like speculative risk, pure risk contains an element of uncertainty, but unlike speculative risk, pure risk contains no possibility of gain. The possibility of economic loss without the possibility of gainpure riskis the only kind of risk that healthcare coverage is designed to help plan members avoid. The purpose of healthcare coverage is to compensate, in part or in full, a plan member, either directly or indirectly, for financial losses resulting from unintentional illness or injury. The coverage is not designed to provide an opportunity for the plan member to obtain a financial gain from his or her healthcare needs. In other words, healthcare coverage is not designed to be a means of engaging in speculative risk for plan members. Instead, plan members transfer to the health plan the pure risk of medical costs arising from plan members unforeseen illnesses or injuries. Notice that healthcare coverage does not necessarily prevent events that are associated with pure risk: many plans include wellness programs to reduce the frequency of illnesses, but neither participation 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 to another partyfor example, the health plan. The health plan itself, by charging actuarially derived premiums for accepting this risk, engages in speculative risk, because it may either experience a gain or a loss from its business, depending on the rate at which plan members utilize services and the health plans administrative and other business costs. Risk Management Individuals and businesses are surrounded by risks. Accepting risk is a key business function of health plans, and a vital part of a health plans 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 the organization survives, operates efficiently, sustains growth and effectiveness, and, in the case of publicly owned for-profit health plans, increases shareholder value. Health plan finance is concerned not only with pure risk, but with a specific type of speculative risk called financial risk. Financial risk is the possibility of economic or monetary lossor gainin undertaking or neglecting to undertake a certain action. Figure 2A-1 asks you to consider the risks in a typical health plan situation.

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

Risk Management However, in order to achieve a return on financial resources, a health plan must accept the financial risk of engaging in business activities. Similarly, an investor typically accepts some risk in order to achieve a return in, for example, the stock market. For businesses and investors, risk and return are therefore closely related. Another way to look at the risk-return relationship is that the greater the risk associated with an investment or business activity, the greater the potential return must be in order to offset the risk the investor is taking. This direct relationship between the amount of risk and the amount of the potential return required to make the risk financially acceptable is known as the risk-return tradeoff . The risk-return trade-off is a basic consideration in decisions concerning many core business activities health plans undertake. For example, where regulations allow, an HMO will charge higher premiums to a high-risk group of enrollees than to a low-risk group of enrollees, because as the risk-return trade-off suggests, the HMO will only accept greater risk in exchange for greater potential returns.3

In this lesson and many that follow, we will discuss ways in which health plans manage the risks that they face. First, however, we continue with an overview of the specific types of risk generated by a health plans business, and the relationship between those risks and the health plans solvency. Risk Categories Faced by Health Plans In the most general sense, any activity undertaken by a business entails some risk, and ultimately every risk has the potential to impact the business financially. Health plans, for example, face risks when entering a new market, exiting a market, or deciding to continue to operate in a given market. The health plan faces other risks in plan design activities, benefit coverage decisions, pricing products, choosing an information system, hiring employees, reacting to the regulatory environment, or developing provider reimbursement contracts. To manage and understand risk, managers have divided risk into different categories. The first categories 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 bearing on both cash flow and solvency. Solvency is generally defined as a business organizations ability to meet its financial obligations on time. To continue operations, for example, a health plan must be 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 plans ability to stay solvent, and the ability of a health plan to stay solvent is a minimum requirement for the health plans continued operation. In accounting terms, solvency in a health plan is closely related to the amount of capital and surplus (also called owners equity) that the health plan has on hand. Capital and surplus is, at the most basic level, the difference between a health plans 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 converted into cash. Money market funds and checking accounts are examples of liquid assets, but an office building is not a liquid asset. For health plans, solvency also refers to the legal minimum standard of capital and surplus that every health insurance company must maintain. The issue of health plan solvency is extremely important from a regulatory point of view, because the ability of health plans to pay the covered medical benefits of enrollees is a public policy priority. We will discuss regulatory standards for solvency in the next lesson. There are four C-risks. Each measures aspects of a health plans financial and management operations that can influence its solvency. Although C-risks were developed to apply to the life and 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 a brief 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, including

investments in stocks, bonds, mortgages, and real estate.

C-2, or pricing risk, is the risk that the health plans experience with morbidity or

expenses will differ from the assumptions that were used in pricing the health plans products. For health plans, this risk is typically the most important factor in determining whether or not a plan is solvent. C-3, or interest-rate risk, is the risk that interest rates will shift, causing the health plans invested assets to lose value. C-4, or general management risk, is the risk that financial losses will result from business management decisions. Businesses that have significant assets face these C-risks to varying degrees, but the relative importance of each C-risk varies from business to business. For example, a typical health plan faces much different levels of exposure to asset and interest-rate risks than do life insurers or banks. Life insurers usually collect premiums on a life insurance policy for many years before paying a claim on that policy. Thus, life insurers typically maintain a significant portion of their assets in long-term investments, which causes both asset and interest-rate risks to be very important factors in their profitability. In contrast, a health plan will begin paying for medical costs relatively soon after first receiving premiums from, for example, a group health policy. Because the health plans medical payments come much sooner and more frequently than a life insurers payment of a claim on a life insurance policy, a larger portion of a health plans assets will flow into and out of short-term, liquid investments. Because these assets are liquid, they can be sold for cash more easily than many long-term investments, which, generally speaking, makes liquid assets less subject to asset risk than long-term investments. Thus, the health plan faces relatively smaller asset risk than businesses 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, provider reimbursement, enrollee information, customer service, and medical costs. Tracking data is a crucial part of an health plans ability to manage costs and risk exposure. Additionally, many types 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 asset risk. Although health plans face relatively less exposure to interest-rate risk and asset risk than do banks or life insurance companies, health plans face considerable pricing risk under almost all health plan contracts. For most health plans, pricing risk is the most important risk the organization faces. Pricing risk is so important because a sizable portion of the total expenses and liabilities faced by a health plan come from contractual obligations to pay for future medical costs, 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 yearly basis. The health plan will set a price (premium) in advance for the expenses it expects to incur in delivering healthcare services to the groups plan members. Although medical costs will be paid throughout 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 that assumptions made in pricing the plan benefits at the beginning of the contract will not necessarily match the actual medical costs. In any market where health plans face constraints in pricing their services, these health plans also face 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 markets health plans will compete with each other for market share partly by attempting to keep their prices (premium rates) low. Additionally, government activities also place constraints on pricing in some markets. For example, as we discuss later in another lesson, the federal government develops payment schedules 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 they receive for the healthcare coverage they provide. At the same time, health plans in many markets are subject to mandated benefit laws. These laws add to the expenses health plans incur while operating in the market because such laws require health plans to cover healthcare expenses for certain treatments or benefits. Thus, health plans may be constrained in both setting the payments they receive and in the methods they have for reducing expenses. Both conditions can serve to increase the pricing risk health plans face. Finally, general management risk is also an important issue for health plans, because management decisions are critical to a health plans financial outcomes. Decisions related to controlling costs, improving customer service, designing plan benefits, and structuring provider reimbursement contracts are all critical management decisions. Management risk also includes the risk that actual expenses will exceed the amounts budgeted for those expenses. Accurate estimates of future expenses and liabilities allow health plans to retain sufficient liquid assets to meet obligations. Beyond solvency concerns, accurate budgets also allow management to use resources efficiently so that the assets generate the greatest possible return. If the management of a health plan underestimates expenses for an upcoming financial period, the health plan may either fail to retain sufficient assets to cover current obligations, or be forced to sell long-term assets at a loss to meet those obligations, or take other financially costly steps to stay solvent. Management risk is always present in a business, because management constantly faces choices concerning how to allocate financial resources to achieve the best financial outcomes. For example, after satisfying regulatory requirements for solvency, an HMOs management must decide the specific level of capital and surplus the HMO will maintain. If management fails to retain a sufficiently high level of surplus, then the HMO may not be able to absorb losses incurred from other financial risks. On the other hand, holding excessive amounts of surplus is not risk-free, because this excess is not 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 and external conditions change. Consequently, management risk is present at any level of surplus. Some of the variables that management must take into consideration when making financial decisions are wholly or partly within the health plans control. For example, a health plans management has considerable control over whether or not to contract with a given provider, and

whether or not to include that provider on the health plans list of primary care providers. However, the health plan has only partial control over the reimbursement rate it pays the providers 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 in the economy, and the general rate of increase in medical costs, are often beyond the health plans control. Thus, the risk that a management decision will result in unfavorable financial outcomes increases 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 varying degrees of control over internal business decisions and external business conditions. For the health plan industry, a very important source of external risk is regulatory risk. Regulatory risk is the risk that changes in regulations or laws may adversely affect the financial condition of a health plan. We will discuss some of the laws that carry regulatory risk in Risk Management in Health Plans and Provider Reimbursement and Plan Risk, but for now you should know that there 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 or mandated benefit laws. Rate caps, which are most common in markets such as Medicare where the government itself is the payor, limit a health plans ability to increase revenue in response to rising 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 of increasing expenses for a health plan operating in that jurisdiction. Although regulatory risks such as premium caps and mandated benefits are particularly important to health plans risk management function, health plans also face regulatory risks that are not unique to the healthcare industry. Tax laws, regulations and laws governing employment, building and safety codes, and other laws have a tendency to change over time, and the possibility of regulatory change carries with it regulatory risk. In a health plan environment, antiselection is the tendency of people who have a greater-thanaverage likelihood of loss to seek healthcare coverage to a greater extent than individuals who have an average or less-than-average likelihood of loss. Antiselection risk for health plans is the possibility that a higher-than-anticipated percentage of people who need greater-than average healthcare benefits will sign up with a healthcare plan. Antiselection can occur because individuals often know much more about their health than a health plan can know. People who know they are ill or believe that they are likely to become ill tend to more actively seek health coverageparticularly coverage with enhanced benefitsthan do healthy people who believe they will not become ill. If an health plan has designed its health plan and premium rates assuming a utilization rate based on an average population, but attracts enrollees who are less healthy than average, the health plan faces higher-than-expected utilization rates because of antiselection. Antiselection also occurs when people choose between competing plans. For example, suppose a large employer offers two health plans to its employees. Both plans cover the same range of medical treatments, but Plan A has relatively high deductibles and relatively low monthly enrollee 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 who anticipate little need for medical treatment will be more likely to sign up for a plan with low monthly 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 financial impact 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 own solvency. In addition, health plans are interested in the general financial condition of the healthcare industry for at least two reasons. First, all health plans are better off if the public has faith and confidence that health plans are financially stable and reliable. Second, health plans recognize that regulators and elected officials see financial stability and reliability in the healthcare industry as a public policy goal. In pursuit of this goal, lawmakers and regulators have established legal solvency standards that directly impact how health plans manage risks. However, solvency standards themselves vary widely depending on the type of health plan being regulated. HMOs, for example, are typically regulated as insurers, and as such must comply with state insurance laws. On the other hand, federal law exempts self-funded employer-sponsored health plans from state insurance laws and regulations. Recall from Healthcare Management: An Introduction that under self-funded plans an employer or other group sponsor, rather than a health plan 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 more concerned with defining the fiduciary duties of those who exercise control over the plan, rather than concern with setting solvency standards for the plan sponsor. We will discuss self-funding in more detail in Fully Funded and Self-Funded Health Plans. In the next sections of this lesson, we examine two solvency standards regulators use to set financial requirements with respect to risk for health plans. The first standard is from the HMO Model Act as developed by the National Association of Insurance Commissioners (NAIC). The second standard is known as risk-based capital (RBC). HMO Model Act and Solvency 5 The HMO Model Act is a model law, developed by the National Association of Insurance Commissioners (NAIC), that is designed to aid state governments in regulating the licensure and operations of HMOs. More than half of the states have adopted the HMO Model Act or substantial portions of this model law. 6 Under the HMO Model Act and most state laws, an entity that wishes to operate as an HMO must obtain a certificate of authority, often called a license. A certificate of authority (COA) is a certificate issued by the state authority that regulates HMOs; the COA certifies that all requirements have been met for the establishment of an HMO in accordance with the states HMO laws. Generally, the purpose of licensing is to ensure that an HMO is a solid, dependable organization, 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 any control over plan assets, or renders investment advice for a fee7 Among other requirements, the HMO Model Act sets financial requirements for HMOs seeking to obtain COAs. An HMO must have an initial net worth of $1.5 million and thereafter maintain the minimum net worth described in Figure 2A-2. In this context, net worth is an organizations total admitted assets minus its total liabilities (its debts and obligations, including obligations to pay for in-network and out-of-network care for its providers). An admitted asset is an asset that state HMO or insurance laws permit on the Assets page of a companys Annual Statement. We discuss financial statements in more detail in Accounting and Financial Reporting, but you should recall from Healthcare Management:An Introduction that the Annual Statement is a financial 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 listed in Figure 2A-2 contain some important elements. First, the net worth requirements set a minimum fixed level of capital and surplus for all HMOs.

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

than other HMOs must have a higher net worth, and each HMOs net worth requirement increases as the HMO grows larger. Third, an HMO must be able to accurately track and report the financial results of a number of its operations. These results include, but are not limited to, premium revenues, uncovered healthcare expenditures, 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 risk exposure for health plans: The larger the number of enrollees in the plan, the greater the health plans net worth requirement should be, assuming coverage levels remain the same. The higher net worth requirement makes sense intuitively, because in the long run a large group of enrollees will generate more healthcare costs than a small group will generate. Therefore, an HMO providing coverage for the large group must have greater surplus to pay those expenses as they come due. A second principle reflected in the HMO Model Act is that the larger the number of enrollees covered by an HMO, the more predictable the morbidity experience of the covered group should be. For HMOs with a large number of enrollees, predictable morbidity experience tends to result in more predictable claim expenses. This increase in predictability decreases the chance that expenses will be so unexpectedly high in any one period that the HMO will experience insolvency, assuming that the premiums are set on an actuarially sound basis. The HMO Model Act therefore requires that plans meeting the net worth requirement through the percent-ofpremium method must maintain 2% of premium revenues for the first $150 million in premium revenues, 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 of approach mandates a minimum level of capital and surplus for any health plan that falls under a law based on this model act. One drawback to this type of solvency regulation is that other than adjusting for the size of the HMOs premiums and expenditures, this approach mandates the same solvency requirement for all organizations that must comply with the regulation. In other words, the size of an HMOs premiums and expenditures is assumed to reflect accurately the level of risk the HMO faces. Our discussion of C-risks, however, suggests that two health plans that receive the same premium income may be exposed to very different levels of financial risk depending on their approaches to pricing their products, investing their assets, and managing their utilization costs. Furthermore, the HMO Model Act is retrospective in its assessment of risk. That is, it uses past expenditures 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 have stable enrollment figures. Another problem exists in terms of the assumption that the amount of premiums an HMO charges always directly corresponds to the level of the risk an HMO faces. In some cases involving plans that 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 its net worth requirements through the 2-percent-of-premium method. Under the HMO Model Act,

this HMOs net worth requirement would fall slightly as a result of the HMOs lowering its premium revenue (that is, as a result of the HMOs decreasing its rates to policyholders). However, lowering rates without decreasing the benefit coverage actually increases the HMOs exposure to risk. Thus, under these circumstances, the model acts method of determining net worth would not necessarily require an HMO that increased its risk of future insolvency to increase its net worth requirement. Typically, HMOs are prudently managed, and will not lower premium rates so much that insolvency occurs. However, in cases where insolvency has occurred, extremely competitive pricing in the HMOs market is often a key contributing factor in the insolvency. Retrospective net worth methods, such as the HMO Model Act method, can under some circumstances fail to anticipate 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 by different 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 that this 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 and insurance statutes may not apply to some provider organizations or certain other risk-bearing entities. Recognizing the limitations of relying upon a single minimum fixed level of capital and surplus requirements, the NAIC then began a process to create a separate RBC formula for all health insurers and health plans that accept risk. The RBC formula for health plans (health plan-RBC) is a set of calculations, based on information in the health plans annual financial report, that yields a target capital requirement for the organization. The RBC formula applies to health plans in states that have adopted legislation to implement RBC requirements. The Centers for Medicare and Medicaid Services (CMS), the federal agency that oversees the Medicare program, requires PSOs to be state licensed, and has therefore become interested in RBC requirements as a secondary regulator. The RBC formula assesses the specific level of risk faced by each health plan. Under RBC requirements, a health plans target surplus is not simply a function of the premiums it receives or the costs it has incurred in the recent past, but also reflects the underlying risks the health plan faces and how the health plan manages those risks. For example, as we will see in Provider Reimbursement Arrangements and Capitation and Plan Risk , health plans can use provider payment methods to transfer some utilization risk from themselves to the providers who make treatment decisions. In a healthcare context, utilization risk is the possibility that the rate of use of medical services by a given enrolled population will exceed the predicted rate. Higher-thanexpected rates of utilization tend to result in higher-than-expected costs for the entity at risk for utilization. For health plans, utilization risk is a critical factor in the financial outcome of the health plans business, because a large portion of an health plans total expenditures involve medical expenses. Higher-than-expected rates of utilization can occur simply because a given populations legitimate need for medical services is greater than the actuarially predicted need. However, utilization risk is increased in situations where overutilization occurs. Overutilization is the use of medical services or procedures that are not medically necessary. Because providers make many treatment decisions, one of the central financial strategies in health plans is the use of provider reimbursement systems that motivate providers to avoid treatment decisions that result

in overutilization. Consequently, the RBC requirement is adjusted for any provider payment methods the health plan has in place that reduce the health plans risk. The Development of Risk-Based Capital Requirements The health plan-RBC formula takes into account five different kinds of risk:
Affiliate riskthe risk that the financial condition of an affiliated entity causes an

adverse change in capital

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

claims Credit riskthe risk that providers and plan intermediaries paid through reimbursement methods that require them to accept utilization risk will not be able to provide the services contracted for, and the risk associated with recoverability of the amounts due from reinsurers Business riskthe general risk of conducting business, including the risk that actual expenses will exceed amounts budgeted You should notice that many of these RBC risk categories parallel the C-risks we discussed earlier. The system of C-risks was developed before RBC, and formed the basis for the development of RBC risk categories and the RBC formula. For this reason, the C-4 (general management risk) is related to the RBCs business risk category. Both systems also include a category for asset risk. Finally, the C-2, or pricing risk, is paralleled by the RBCs underwriting risk. However, RBC also contains differences that reflect the nature of the health plan industry. For example, as we have mentioned, interest-rate risk for health plans is relatively small, so the RBC does not have a separate interest-risk category. Also, the RBC categories reflect the fact that the level of risk faced by health plans is significantly impacted by provider reimbursement methods that shift utilization risk to providers. We will discuss provider reimbursement methods in later lessons, but for now you should know that such reimbursement methods, in which providers assume 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 to higher-than-expected levels of utilization. By decreasing this utilization risk, the health plan is decreasing its underwriting risk. Consequently, a health plans underwriting risk can be significantly reduced when the health plans use these reimbursement methods. Underwriting risk is the greatest risk component of a typical health plans RBC formula, and often largely determines the health plans net worth requirement. The structure of provider reimbursement methods used by health plans therefore becomes a key strategy for risk management in health plans. The RBC formula explicitly recognizes this. The strategy of using provider contracts to manage risk is also valid for health plans that are not subject to RBC requirements, because the underlying utilization risk is important to all health plans, no matter what method is used to determine their minimum net worth requirements. The second influence of provider reimbursement contracts on a health plans RBC formula is reflected in the credit-risk category. The credit-risk category recognizes that transferring utilization risk to providers does not eliminate the health plans responsibility to arrange for

medical services covered by its health plan. If these providers accept too much risk and become insolvent, the health plan will incur a number of expenses, including those associated with having to develop new provider contracts, or even new provider networks. Even if providers do not become insolvent, but simply refuse to renew contracts at old reimbursement rates, then the health plans cost of paying these providers would increase if the health plan wished to continue contracting with the providers. The greater the amount of risk the health plan transfers to providers, the larger the credit-risk factor becomes in the health plans RBC formula. Thus, transferring risk to providers through reimbursement contracts decreases the health plans underwriting risk, but increases the health plans credit risk. However, because the underwriting risk is by far the largest risk in the RBC formula for health plans, the net effect of using provider reimbursement contracts to transfer risk is that the health plans net worth requirement will decrease. Health plans also use several other strategies to transfer certain risks. Transferring risk using these strategies can also increase a health plans credit risk. For example, health plans can purchase various types of insurance to protect themselves against losses that would result if an unexpectedly large number of plan members incur catastrophic medical expenses. Credit risk captures the risk that the entities selling insurance to the health plan will be unable to make the agreed-upon payments should the insured-against event occur. We discuss these forms of insurance 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 arranged in a formula that generates the total amount of risk faced by the health plan. The mathematical modeling used to develop this formula is beyond the scope of this text, but there are two characteristics of this formula that you should understand. First, numerical values for all the risks are eventually added together, because RBC attempts to capture the total risk of financial failure faced by the health plan. Second, the formula performs mathematical operations on the separate risks before adding the risks together. The result of these operations is that if one of the risks is greater than the others, the influence of that large risk on the health plans financial strength is emphasized. Because underwriting risk is typically the most important risk faced by health plans, the underwriting risks influence on the health plans financial strength is often much greater than any of the other risks, and the RBC formula reflects this relative importance. Strategies for Controlling Risk The categories of risk that we have discussed so far can be used by managers and regulators to analyze the ways in which a health plans operations influence the health plans financial strength. In this portion of the lesson, we will examine three general strategies for controlling various 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 to those risks. A basic, but important, economic principleopportunity costapplies to any financial decision that a health plan makes in choosing among the three risk control strategies, as well as in choosing among specific courses of action once a strategy is selected. Opportunity cost is 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 risk management 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 limit exposure to the risk. Many businesses avoid financial risks by choosing either not to enter certain markets or to exit markets in which risk is increasing. Suppose, for example, that a health plan believes that changes in federal regulation increase the risk that payment rates in a certain Medicare market will cause that market to become unprofitable. A health plan may choose to avoid the risk of operating in that market by either withdrawing from or not entering that Medicare market. An important point here is that health plans do not simply avoid all risks, because their core business involves accepting financial or business risks of one type or another in exchange for premiums or other payments. In other words, avoiding risk is a useful management technique in reducing expenses and risk exposure, but in cases of speculative risks, avoiding risk also results in decreased chance of potential financial gains. In our example, a decision to avoid the risk of entering a new market would allow an health plan to avoid the start-up costs of developing that market and the operational costs of doing business in that market, but would also mean that the health plan would give up the potential income it would receive from operations in that market. In situations involving speculative risk, opportunity costs are 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 two analyses: first, an analysis of the savings that can be had by avoiding the risk, and second, an analysis of the amount of revenue or other financial gain that that could be had by accepting and managing the risk. Generally speaking, the smaller the likely benefits of accepting a risk, and the lower the costs of avoiding that risk, the greater the likelihood that a health plan will elect to avoid the risk. If a risk is a pure risk from the point of view of the health plan, then there will be no possibility of gain 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 some resources in attempting to avoid being subject to fraud. The decision to avoid or accept any given risk, however, often varies not only according to the activity that generates the risk, but also the qualities of the specific health plan that is contemplating the risk. For example, beginning operations in a new market always involves risk for 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 as whether or not the health plan already operates in the markets geographical location, whether or not the health plan has experience operating profitably in similar markets, and whether or not the health 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 a risk from one party to another. As the concept of risk-return trade-off suggests, the party that agrees to accept the financial risk usually does so in exchange for some type of financial incentive. A common form of risk transfer for both individuals and businesses is insurance. Under an insurance contract, the insurer agrees to pay a specified amount of money if certain events occur in exchange for receiving a payment (usually called a premium) from the party seeking the insurance. For example, most physicians purchase malpractice insurance. A physician purchasing malpractice insurance pays a premium to an insurer that agrees to pay a specified amount of money (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 property insurance to insurance that provides financial protection against catastrophic and unexpected claims rates. In general, health plans can use this last type of insurance to reduce the health plans exposure to the risk of having to pay larger-than-expected medical expenses, and in doing so, the health plan reduces its underwriting risk. We discuss the forms of insurance important to health plans in more detail later. As important as insurance is as a means of transferring risk, health plans almost always use other types of contractual, non-insurance risk transfer as well. For example, suppose a large employer is willing to self-fund the healthcare coverage it offers to its employees. Recall from Healthcare Management: An Introduction that under a self-funded plan, an employer, rather than a health plan or insurance company, remains financially responsible for paying plan expenses, including claims made by enrollees. In this case, the employer also decides to contract with a health plan to provide 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 employees that sign up for the healthcare coverage, then the employer is transferring to the health plan some of the business risk of operating complex administrative functions. In exchange for payment, the health plan accepts the risk that administering the plan will be more expensive than anticipated. In this case, although there has been a transfer of risk, the health plan is not functioning as an insurer because the employer is retaining the responsibility to pay for the medical costs of the plan under its employee benefit program, and no insurance contract has been made. Another important area in which health plans use contracting rather than insurance to transfer risk is the area of provider reimbursement. As we will see in the next few lessons, hospitals and individual physicians can be compensated in ways that transfer some of the risk of unexpectedly high rates of utilization from the health plans to the providers. For example, a health plan retains utilization risk if it pays physicians on a per-treatment basis, because the more treatments a physician provides to plan members, the greater the medical expense liabilities the health plan faces. However, if the health plan pays the physician a rate that is based on the number of plan enrollees that choose the physician as their primary care doctor (rather than the number of treatments the physician supplies to those patients), then the physician assumes some or all of the utilization risk. The greatest risks faced by health plans involve utilization rates. The premium payments a health plan 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 providing healthcare coverage to plan members will exceed the revenue the health plans receive from premiums or other payments. Health plans almost always transfer some of this risk to other parties through a number of plan design elements and provider reimbursement methods. For example, deductibles and copayments are common elements in health plans. By including these elements, the plan transfers a small portion of the utilization risk from the health plan to the plan member. This transfer of financial risk is important to health plans primarily because it motivates plan members to avoid seeking unnecessary medical treatments, and thus makes the plan member a partner with the health plan in controlling utilization rates. Similarly, some types of provider reimbursement contracts contain elements that financially motivate providers to avoid supplying medically unnecessary treatments. We discuss these reimbursement contracts in the next few lessons. Accepting the Risk The final general strategy for controlling risk that businesses as well as individuals use is to accept the risk . To accept the risk means to assume financial responsibility for the risk. In a health 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 plan that provides a healthcare plan to a group often accepts some or all of the utilization risk within the terms of that group contract. In this case, the group seeking coverage is transferring risk, but the health plan is accepting risk. By definition, accepting risk exposes an health plan to the possibility of losses. The financial outcome of accepting risk in exchange for premiums or other payments largely depends on how well the health plan is able to predict the costs associated with the risk, and how well the health plan is able to manage those costs. In the next few lessons, we discuss the means by which health plans adjust the total amount of risk they are exposed to and some of the methods health plans use to manage the costs of those risks. We also discuss how health plans predict the costs of the risks they 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 involve assuring 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 risk managers seek to achieve each of these goals, they must also balance the actions of the organization 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 in controlling costs at all operating levels, but will not cut expenses that are vital to the health plans continued survival. For example, a health plan will bear the expense of verifying that the healthcare providers with which it contracts have proper credentials, because for regulatory and liability-exposure reasons a health plan would not survive if it negligently contracted with unqualified providers. Similarly, a for-profit health plan will retain sufficient liquid assets to remain solvent rather than distribute all earnings to shareholders, because remaining solvent is a necessary condition of the health plans survival. In general, the acceptance of risk by an health plan implies that the health plan is prepared to manage that risk. Risk management is a process in the sense that, for many risks, the health plans management 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), 34. 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 Health Insurance Companies (Atlanta: LOMA, 1996), 35. 4. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMAs Glossary of Insurance Terms, 3rd ed. (Atlanta: LOMA, 1997). 5. Adapted from Academy for Healthcare Management, Health Plans: Governance and Regulation (Washington, D.C.: Academy for Healthcare Management, 1999), 5-2520. 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 Objectives After completing this lesson, you should be able to List some of the factors that may give rise to the assumption of an agency relationship between health plans and their providers Discuss some measures a health plan might take to limit the liability associated with credentialing its providers Explain some of the ways a risk manager can reduce or eliminate risk exposures related to utilization review List some of the actions that a risk manager can take in managing the process of providing healthcare in a health plan environment Risk management has been in a period of evolution almost since it first became an important function in the healthcare setting. In the mid-1970s, the healthcare risk management profession emerged 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 insurance industry, over the past two decades the discipline of healthcare risk management has taken on many important characteristics and unique functions. Although there are clear risks associated with benefits administration, contracting, and other activities, the bulk of risks in health plans is associated 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 the purchase of commercial insurance or the financing of risk through the establishment of a selfinsured trust or investment fund to a profession where education, proactive risk control and risk modification, and risk financing and risk transfer are merged into a partnership. The overall goals of the partnership enable the organization to be responsive to the needs and demands of the healthcare industry and to provide safe and effective care to patients. The organizational goals of ensuring financial stability in the event of an adverse outcome are still consistent with the goals of the healthcare risk manager, but risk managers also find that their work takes them out of the finance department and into those clinical and operational areas where the risks are created. Specific objectives in risk management programs relate to the organizations desire to ensure survival, maximize efficiency, and sustain growth and effectiveness. This is accomplished through the identification, control, management, elimination, transfer, or financing of risk. Achievement of these objectives is accomplished by interacting with internal and external customers of the organization that demand low-risk, high-quality, cost-effective service. Management may have different priorities in seeking efficiency and growth, particularly as health plans continue to dominate the marketplace. The primary targets or strategies of management could relate to gaining market share, increasing the overall number of relationships and contracts with payers, increasing sales or service volume, ensuring continuity of performance, maintaining the quantity of controlled resources, or other items 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 adopting those strategies. The goals identified to achieve market success may not be the most efficient or effective strategies from a risk management perspective. To achieve favorable results from both a risk management and an organizational perspective, the risk manager must recognize how the internal and external changes in healthcare created by managed care influence or enhance risk. The risk manager should begin to plan a strategy by first identifying how the organization is influenced from a risk perspective due to managed care (Figure 2B-1 and Figure 2B-2). After this assessment, the risk manager should work with administration to determine critical success factors 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 to protect the organization and help it progress. The risk managers role and the challenges posed by that role will not differ significantly if the risk manager is employed by a health plan, a hospital that seeks to be the hub of an integrated delivery system, or a network that forms to be able to compete under health plans. Thus this lesson has been written to focus on the key risk management issues created by health plans as opposed to a specific job that a risk manager might assume given potentially differing structures. Many of the legal and risk management challenges created by managed care will exist regardless of the employer. The customers of the risk manager will include not only those in administration and finance but also physicians, nurses, and external customers. As health plans become more prevalent, risk managers must develop new knowledge and utilize existing and new skills and techniques to identify the new risks created, design creative strategies for managing those new risks, and provide education and information to an ever 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 actual management of medical care by providing the patient with the appropriate level of care in the appropriate 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 decision making of providers of healthcare services by interjecting a complex system of financial incentives, penalties, and administrative procedures into the doctor-patient relationship. Managed care often attempt to redefine what is best for the patient and how to achieve it most economically."2 This statement implies altering and directing care to gain a cost advantage, which is risky if it is at 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 law associated with managed care, particularly how quality or access is limited by strict utilization or financial restrictions and how that limitation can pose a significant financial risk to the organization. Learning how to identify proactively these and other potential new exposures associated with managed care and how to control or eliminate them will be a challenge and will be at the core of the risk managers responsibility. This statement implies altering and directing care to gain a cost advantage, which is risky if it is at 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 law associated with managed care, particularly how quality or access is limited by strict utilization or financial restrictions and how that limitation can pose a significant financial risk to the organization. Learning how to identify proactively these and other potential new exposures associated with managed care and how to control or eliminate them will be a challenge and will be at the core of the risk managers responsibility. Historically, health plans have faced minimal professional liability exposure, especially compared with other healthcare organizations. In large part, this is the result of the broad and wellpublicized protection provided by the Employee Retirement Income Security Act of 1974 (ERISA).3 That protection includes barring jury trials and punitive damage awards, limiting compensation to medical expenses, and preempting actions against a health plan for the "administration" of an ERISA-qualified employee benefit plan. 4 The Federal Employee Health Benefits Act can also afford some protection for federal employee benefit plans. 5 These statutory protections have their limits, however, and the risk manager must develop a clear understanding of the new risks that may be created under managed care and are not afforded statutory protection and must develop strategies to manage them. The changes in the organization relative to health plans created new operational and clinical risks and opportunities for risk management. No longer are the risks contained within the walls of a provider organization; rather, the risks now follow the patients to whom the health plan has agreed to provide services. This may result in making the environment more difficult to control for 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 primary care and prevention. This group of professionals may include physicians but may also include nurse practitioners, physician assistants or extenders, social workers, and other healthcare professionals. Credentialing, reappointment, privilege delineation, and definition of the scope of service for an enhanced range of caregivers will be essential components of the risk managers job.

Operational Risks Under Managed Care Operational risks are enhanced under managed care. For example, a provider organization becomes more complex as it attempts to compete by becoming part of an integrated delivery system. New business risks can create corporate liability, both direct and indirect (vicarious). A risk manager whose responsibility is to manage the risks of the health plan must be mindful of the business and clinical risks created. Health plans can pose the following risk concerns that will be new challenges for the organizations risk manager:
Coordinating the appropriate amount and level of care, by appropriate providers, through Negotiating arrangements with selective providers with proven skills and competence to

utilization management activities.

provide comprehensive services identified in the contracts.

Ensuring that the financial incentives provided by the contract are sufficient to sustain the

organization and that the potential for catastrophic financial risk is understood and appropriately funded for or transferred. (Relative to financial risk management, the risk manager should also be cognizant of the potential double-edged sword created by the use of financial incentives to providers. In a positive sense, these types of incentive structures can help support the provision of efficient, effective, and appropriate service. They can also, however, be seen as a reward system that inappropriately incents physicians to deny needed care to patients in exchange for increased compensation.) Understanding the nature of the new clinical risks created and proactively designing systems or structures to eliminate or control them. Figure 2B-4 illustrates the relative risk for health plan structures based upon the degree of influence and relationships that the health plan maintains with its providers. 6 It is only through an analysis of the health plans business and an understanding of the relative risk associated with that business that one can develop a comprehensive risk management plan to ensure that all risks created 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 a legal duty to protect the patient from harm. This responsibility can be deemed to be abrogated when 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 staff members and to follow those procedures is an important risk management function in this new environment and should be carefully monitored to verify adherence. Under the doctrine of corporate negligence, a health plan and its physician administrators may be held directly liable to patients or providers for failing to investigate adequately the competence of healthcare providers whom it employs or with whom it contracts, particularly where the health plan actually provides healthcare services or restricts the patients/enrollees choice of physician. Health plans and their physician administrators may be held liable for bodily injury to patients/enrollees resulting from improper credentialing of physicians or for economic or compensatory damages to providers as a result of credentialing activities (e.g., unlawful exclusion from provider networks or staff decertification). The doctrine of corporate negligence may also apply to other health plan activities besides credentialing, such as performance of utilization review. Under the theory of negligent or improper design or administration of cost control systems, a health plan and its physician administrators may be held liable when they design or administer cost control systems in a manner that interferes with the rendering of quality medical care or corrupts medical judgment. To date, most litigation involving allegations of negligent administration 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 for violations of federal and state laws, which generally prohibit the unlawful restraint of trade, monopolies, price fixing and discrimination, group boycotts, illegal tying arrangements, exclusive dealing, and other arrangements that are anticompetitive. Antitrust problems may arise when entities engage in collective actions that reduce competition in a given market. Antitrust problems can arise early in a market where health plans encourage the combining of the services of former competitors to facilitate service delivery. A balancing test must be performed to ensure that the benefits gained by combining outweigh the danger posed by limiting competition of those entities outside the agreement. Health plan networks are also likely to face an increased number of antitrust lawsuits from providers and competitors as they gain increased market share. The larger a health plan becomes in a particular area, the fewer opportunities available to the provider who is not part of the network. In addition, health plans and their physician administrators face corporate exposure to direct liability for various forms of discrimination, for example discrimination in benefit design, underwriting, claims adjudication, credentialing, treatment, employment, and contracting. The following 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 of privacy of providers for improper dissemination of information regarding credentials or competence to the National Practitioner Data Bank or other third parties or of patients/enrollees for improper dissemination of their records or information pertaining to their health. They may also be sued by providers, patients, or employees for defamation, particularly in connection with their peer review activities. In such an event, however, they may be entitled to qualified immunity under the Health Care Quality Improvement Act of 1986 (HCQIA). Vicarious Liability Under the theory of vicarious liability or ostensible agency, hospitals have been held vicariously liable for the acts, errors, and omissions of their independent contractors. By definition, a provider is an independent contractor in independent practice associations and direct contract models. Therefore, the health plan should not be responsible for negligent acts unless the health plan has given the impression that these providers are acting as agents of the health plan. The decisions of the courts to uphold claims based on ostensible agency depend on many factors, applicable state statutes, the ability of the plaintiffs attorney to demonstrate the apparent agency relationship, 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 agency argument, it might be wise for the risk manager to consider some of the circumstances that might lead the public to assume that an agency relationship exists and to make the necessary arrangements to control these potential exposures. Factors that may give rise to the presumption of the existence of an agency relationship include:
Supplying the provider with office space Keeping the providers medical records Employing other healthcare professionals, such as nurses, laboratory technicians, and Developing promotional or marketing materials that allow a relationship to be inferred

therapists, to support the physician provider

The risk manager may wish to review documents provided to patients to ensure that the physician is described as an independent practitioner and that there is a clear distinction between those services 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 risk manager. This activity continues to be important, but there have been changes in its complexity under health plans. Specific risks that require control and relate to the provision of clinical care include 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 to externally imposed standards of care. Credentialing Credentialing is a risk management function that considers who the healthcare provider is in the health plan and what the provider can do.7 In an effort to facilitate the credentialing process and reduce administrative burdens and costs, some entities may choose to participate in a joint credentialing 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 have appropriate releases signed by the professional being credentialed so that there can be no subsequent claims for breach of confidentiality. In general, a credentialing process must be developed that allows for the successful selection and retention of high-quality providers who understand and support the mission and vision of the organization or network with which they work. Credentialing Measures that might be instituted to prevent or limit liability associated with credentialing include establishing 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 tying quality to the economic credentialing process. 8 The following is a checklist for risk managers to keep in mind when setting up a credentialing process:9 Review Credentialing Policies and Procedures- Review credentialing criteria for compliance with state statutes, standards for health plans, Joint Commission on Accreditation of Healthcare Organizations standards, Medicare conditions of participation, National Committee for Quality Assurance, and court decisions. Review Application Forms Review application forms for compliance with standards and local, state, and federal regulations. Review Protocols Review protocols for investigating and verifying an applicants credentials. Do these protocols minimize the risk of inadequately screening and verifying the credentials of practitioners? Observe Methods Observe the methods by which these protocols are applied in reviewing individual applicants. Are protocols applied equally to all applicants whether they are well known or not? Evaluate Organizational Structure Evaluate the organizational structure of the credentialing process. Are checks in place to minimize the involvement of direct economic competitors in the credentialing process? Does the structure minimize the risk of creating antitrust liability? Review Due Process Provisions Review due process provisions to ensure that practitioners who are denied medical staff membership or have had privileges restricted are afforded a fair hearing in accordance with federal and state laws and standards. Require Practitioners To Report Require all practitioners to report claims, disciplinary proceedings, or adverse actions taken against them at other facilities or hospitals. Ensure risk management access to these records. Ensure HCQIA Compliance Ensure that HCQIA regulations are complied with and that information from the National Practitioner Data Bank is used appropriately in credentialing 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 and procedures of other hospitals, facilities, and credentialing services whose credentialing decisions 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 system whereby care is predicated on a persons ability to pay or upon an externally imposed system of values that dictates which medical conditions are appropriate for specific types of intervention. In general, when these issues and concerns are voiced they relate to the denial of interventions deemed to be extraordinary or experimental to patients with terminal conditions or conditions where the treatment may not result in a cure but may only serve to delay inevitable furtherance of the 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 should be avoided. Risk managers can assist in limiting these types of risks by determining that policies are in place that clearly indicate that care decisions are not predicated on the ability of the patient to pay or the willingness of the payer to reimburse but rather are based on sound medical judgment that is rendered consistent with appropriate professional standards of care. Many of these decisions also are linked to an area of well-developed case law in health plans, that law related to utilization review activities. Utilization Management Issues Controlling the parameters of care through a well-detailed utilization review process is an important component of cost controls associated with health plans. Court cases have demonstrated that a plans utilization review process is an operational exposure with the potential for considerable financial risk. A well-structured utilization review program is designed to limit the potential risks associated with attempts to structure care around predetermined criteria. The program should allow for retrospective, concurrent, and prospective review of care provided under the health plan. It should be remembered that underutilization presents real threats to quality 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 inappropriate utilization criteria is Wickline v. State of California.10 This case addressed the legal implications of preadmission certification of treatment and length of stay authorization. In this case, suit was brought against the state of California alleging that its agency for administering the medical assistance program was negligent when it only approved a 4-day extension of the plaintiffs hospitalization when an 8-day extension was requested by the physician. Plaintiffs attorney alleged that the discharge was premature, resulting in the ultimate amputation of the plaintiffs leg. 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 plaintiffs favor on the grounds that the plaintiff had suffered harm as a result of the negligent administration of the states cost control system. The trial courts decision was reversed by the appellate court, which found that the state had not been negligent and therefore was not liable. The court held that the state was not responsible for the physicians discharge decision and that a physician who complies without protest with limitations imposed by third party payers when the physicians medical judgment dictates otherwise cannot avoid ultimate responsibility for the patients care. The court did acknowledge, however, that an entity could be found liable for injuries resulting from arbitrary or unreasonable decisions that disapprove requests for medical care. The court emphasized that a patient who requires treatment and 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, when appropriate, healthcare payers. The court went on to say that third party payers can be held legally accountable when medically inappropriate decisions result from defects in the design or implementation of cost containment mechanisms. The court concluded from the facts at issue in this case that the California cost containment program did not corrupt medical judgment and therefore 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 sons suicide was directly caused by the utilization review firms refusal to authorize additional days of inpatient treatment.11 The patient had been admitted for inpatient psychiatric care for depression, drug dependency, and anorexia. His physician recommended 3 to 4 weeks of inpatient care, but the utilization review firm only approved 10 days. The patient was discharged and committed suicide less than 3 weeks later by taking a drug overdose. The trial court granted summary judgment in favor of the defendants. The appellate court reversed this decision, concluding that the insurer could be held liable for the patients wrongful death if any negligent conduct was a substantial factor in bringing about harm. Testimony of the treating physician indicated that, had the decedent completed his planned hospitalization, there was a reasonable medical probability that he would not have committed suicide. The court concluded that whether the conduct of the utilization review contractors employee was a substantial factor in the patients suicide was a question of fact precluding summary judgment and remanded the case for further review. On retrial, the jury entered a verdict in favor of the defendants. Litigation for utilization review decisions may also be brought under theories of bad faith and breach of contract based on the contractual nature of the relationship between the health plan and its patient members Reducing Utilization Management Exposure The risk manager attempting to work with providers in the organization can provide the following advice to assist physicians in the reduction or elimination of exposures related to utilization review: Devise a comprehensive utilization management program. Devise a comprehensive utilization management program that integrates with quality and risk management. Individuals performing utilization management functions should utilize patient outcome indicators as a means of identifying quality of care or risk problems. Physicians must exercise independent medical judgment that meets with the standard of care. Physicians must exercise independent medical judgment that meets with the standard of care. Utilization management decisions should not influence the physicians clinical decisions in any way that the physician would consider truly harmful to the patient. Providers must advise the health plan of their medical judgment. Providers must advise the health plan of their medical judgment. The physician needs to be aware of each plans utilization review process and to advise the plan of his or her medical judgment in clear terms. If a disagreement arises, the physician may need to support the validity of the clinical recommendations with documentation as to the medical necessity. Including diagnostic test results and providing an opinion as to the possible adverse outcomes should the request be denied will also be helpful. Develop a "fast-track" second opinion program. Develop a "fast-track" second opinion 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 and training are commensurate with those of the provider whose judgment is being questioned. The patient should be informed of any issues that are being disputed. The patient should be informed of any issues that are being disputed relative to the physicians recommended treatment plan and the health plans coverage decision. Alternative approaches and the potential cost and outcome of those approaches should be discussed with the patient. Also, the patient should be informed that, if the plan continues to deny coverage, the patient may be responsible for payment. The patient should continue to be informed throughout the appeal process. Exhaust the appeals process. Exhaust the appeals process. In the event that the treating physician firmly believes that the health plan has made an incorrect decision, then the best defense in cases of treatment denials is staunch patient advocacy. The physician should request to speak to the medical director in charge of the utilization decision and explain the rationale behind the intended treatment. If a plan continues to deny coverage for a service that the physician feels is necessary, the process that allows for a second opinion fails to support treatment, and the physician continues to believe that the denial of coverage is in error, then the decision should be appealed aggressively. All avenues of appeal should be exhausted. If unsuccessful, the physician should inform the patient of treatment opinions without regard to coverage. The patient must ultimately decide whether to continue treatment at his or her cost. If the patient should wish to proceed at his or her own expense, the physician should have the patient sign an informed consent signifying 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 seek to define appropriate services that should be provided to a patient given a specific condition. In some 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 that best practice determinations are predicated on an evaluation of effectiveness, some providers believe that under health plans best practice really means lowest cost. To avoid the risks that are likely to be associated with the use of guidelines, clinicians should be assured that the existence of a guideline does not in and of itself create a standard of care and that guidelines, although they may be instructive, do not set standards of care (although well-developed guidelines should articulate agreed-upon standards of care). Risk managers should advise clinicians that, despite the existence of a guideline, their skill and judgment based on a careful assessment of the patients condition 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 network agreements makes it essential that the risk manager create tools that can empower staff at these sites to understand and manage their own risks. Risk management will increasingly become a responsibility of all staff who will rely on the risk manager for support and advice but will ultimately 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 healthcare professionals working in a particular area to identify issues unique to their area that may give rise to risk and to modify those risks in a manner that will allow for a safer environment with staff increasingly aware of the risks inherent in providing care in a specific area or setting. Tools that contain specific questions about an area can be developed and are useful for assisting manager and clinicians in recognizing and managing their own risks. Capitation Health plan contracts create both opportunity and risk for healthcare organizations. Under many contracts the reimbursement from payers is capitated, with the healthcare organization receiving a fixed 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 risks or transferring them to a third party require many of the same skills that the risk manager uses to manage the clinical risks that are part of all healthcare organizations. Once the total risk being assumed is quantified, the risk manager, working with the chief financial officer or health plan administrator, 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 effective healthcare. An incentive system is meant to encourage providers to render only care that is necessary and appropriate. Financial incentives can take a variety of forms, and depending on the outcome 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 an incentive structure that predicates payment for services based on utilization of services make treatment decisions based more on their financial reward than on the well-being of the patient. It is imperative that financial incentives be structured in such a way that they do not have the appearance of encouraging this type of behavior. Whether the cost control program of the health plan creates a financial incentive for physicians to provide inadequate treatment was raised in a recent legal opinion. 12 The case involved a delay in the diagnosis of cervical cancer due to the failure of the primary care physician to order a Pap smear. In this case, a health plan participant brought suit against the health plan alleging that the contractual agreements between the health plan and its providers encouraged physicians not to refer patients to specialists. The court found that the plaintiff had offered evidence establishing that the cost control system contributed to the delay in diagnosis and treatment. A formal opinion on this issue was never rendered, however, because the case was settled during trial for an undisclosed amount. In another well-publicized case, Fox v. HealthNet, a California jury awarded nearly $90 million to the estate of a breast cancer patient arising from the refusal of the health plan to pay for a bone marrow transplant: $77 million was awarded as punitive damages.13 The health plan considered this procedure experimental and would not pay for any experimental treatment until it was proven effective. According to reports in the press, testimony at trial included that of two women for whom the health plan had approved identical treatments as proof that the treatment might have worked.14 Furthermore, it was shown that the physician executive who denied payment for the bone 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 its subscriber, and intentionally inflicted emotional distress. This case represents a good example of how denial of access to treatment can expose a health plan to liability. It also demonstrates how the emotional impact and negative publicity associated with the denial of treatment, even if the treatment has not been proven effective, can influence the ultimate decision and the damage award. In a health plan environment, the primary care physician, in conjunction with the health plan, acts as a gatekeeper in determining what hospital or specialty physician services should be provided. The failure to meet the applicable standard of care in making these decisions can expose the primary care physician and the health plan to liability. In the Fox case, the treating physician recommended the treatment with the support of the two other health plan physicians who had used it for the two witnesses in the case, and the health plan, as gatekeeper, refused to pay for it. These cases reveal that courts are willing to impose liability on health plans when inappropriate medical decisions result from defects in the design or implementation of the cost containment programs, breach of contract, or bad faith in the denial of payment. The impact of a health plans financial incentives to contain costs has also been tested. If financial incentives result in inadequate treatment being rendered, the health plan could be held liable. These cases indicate that members will seek redress if harmed as a result of the administration of cost control programs which deny them access to care, which delay care, or which deny payment for necessary care. Avoiding Liability Associated with Cost Control Programs The design and administration of cost control programs should promote efficient care but must not corrupt the medical judgment of the physician. If a health plan overrides the medical judgment of the physician, it could be held liable for the consequences of the treatment or discharge decision. To avoid liability in this regard, a health plan needs to ensure that its financial incentive 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 the appropriateness of care Maintain policies and procedures that ensure that operations do not interfere with the physician-patient relationship regarding the duration and level of medical care Carefully document procedures used to deny certification of care (coverage restrictions need to be adequately described in materials given to health plan members, especially with respect to experimental or investigational treatments) Devise a mechanism for communication of programs to members, especially financial incentive programs Risk Financing The professional liability and business risks that are associated with health plans have fairly consistently been insurable under standard insurance contracts. Many creative products and

concepts are being developed for the control or minimization of the financial risks that are inherent in capitated contracts or for the balance sheets fluctuations that are possible during a period of time when there is considerable volatility in the financing of healthcare services. The concepts underlying the financing of all these risks are the same and are consistent with the risk financing 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 (which include the identification of risk, the elimination of risk whenever possible, and the control or management of risk when it cannot be entirely eliminated) and loss transfer (techniques which include determining the economic risk associated with various types of loss and selection of the best methods either to finance risk internally or to transfer those risks to a third party, generally through the purchase of insurance). These processes can be successful in managing the emerging risks that are created by a managed healthcare system. Obviously, the techniques will need to be tailored to the specific needs of each organization, particularly as health plans become increasingly 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 effective communication links with those parts of the organization that are responsible for the strategic growth 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 created by the new delivery model will be capable of being controlled. Educating all staff, including administration and healthcare providers, about the emerging risks that are associated either with the delivery system created by health plans or with the clinical delivery system that is more decentralized because of health plans will be an important function for the risk manager. The risk manager may achieve the greatest success by developing tools that can be used by others to assess and manage their own risk. Making each member of the healthcare team responsible for managing the risks created by this complicated new healthcare delivery model will be the only way to ensure success. Conclusion Risk managers must continually monitor emerging risks and design comprehensive strategies for managing them. Unlike the traditional role of the risk manager in a hospital, where a single person or a designated risk management staff is central to the risk management effort, in a health plan or integrated delivery system everyone will have to become engaged in the process of proactively identifying and managing risks. A brief checklist follows that will assist the risk manager in managing the process of providing healthcare in a health plan environment:
Design department-, unit-, or function-specific assessment tools that can be used easily

by managers and clinicians to assess risks associated with specific environments or activities. Make risk management everyones responsibility! Continually monitor case law and developing trends in health plans and design a system to provide information about new developments to all staff working in the health plan or network. Never underestimate the importance of a rigorous credentialing process that allows for the careful screening of all healthcare providersphysicians and advanced practitioners.

Make certain that this process is in compliance with state and federal law and that it measures 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, not primarily the financial interest of the provider or the health plan. Develop a system that allows risk managers to be involved in the assessment of potential new business opportunities or entities before their becoming part of the organization or network. This will allow for a clear understanding of the risks to be assumed and for the development of a plan to control, eliminate, or transfer those risks. Develop the risk management role as one of a consultant whose advice and expertise are sought 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 and Solutions (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): 37. 9. S. Hagg-Rickert, Medical Staff Credentialing and Privileging Determinations: The Emerging Role of the Risk Manager, Perspectives in Healthcare Risk Management 11 (1991): 24. 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, 741 P.2d 613, 239 Cal. Rptr. 805 (1987). 11. Wilson v. Blue Cross of California, 271 Cal. Rptr. 876 (Cal. Ct. App. 1990), review denied, 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 Objectives After 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 the healthcare environment Explain the financial effects that mandated benefit laws and regulations have on health plans Our discussion of provider reimbursement and plan risk begins with a review of the overall regulatory environment in which health plans operate. Next, we discuss specific federal 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 the United States are numerous and complex. Many general business laws and regulations governing labor, taxes, and contracts apply to health plans much as they apply to other businesses. In addition, healthcare in general, and health plans in particular, are subject to a vast array of industry-specific laws and regulations. Broadly speaking, there are three main drivers of complexity in the healthcare regulatory environment. 1. The number of agencies that are sources of regulations or that have regulatory authority over health plans. Agencies in both the federal and state governments regulate various aspects of healthcare in the United States, and in each level of government, multiple agencies have at least some regulatory authority. State departments of health and departments of insurance typically share responsibility for regulating many aspects of healthcare. The division of this responsibility between the two agencies, however, varies from state to state. Various agencies typically administer federal programs that affect health plans. For instance, the Department of Health and Human Services, through the Centers for Medicare and Medicaid Services (CMS), administers Medicare and Medicaid. A comprehensive list of government agencies that regulate health plans on all levels would be extremely long, because health plans are subject to tax, labor, and other general laws just as any business is. Generally, the larger the number of agencies that have regulatory authority over an industry, the more complex the industrys regulatory environment. The more complex the regulatory environment, the more expensive a businesss compliance operations, all other factors being equal. 2. The relative complexity of both the practice of medicine and the management of health plans. 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, health plans provide health plans that bridge the gap between providers, payors, and members. In doing so, health plans must consider the regulations that affect each of these groups and the goals that these 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 influences health plans by determining the medical options available to the health plans providers. In some markets, laws mandate that specific benefits be covered by health plans in those markets. Health plans that are subject to those laws must cover the cost of the mandated benefits, and these mandates must be reflected in provider contracts. Furthermore, health plans operating in more than one state must comply with the regulatory and licensing requirements of each state in which they operate. 3. The importance of healthcare to the public. The public has an interest in healthcare and the contracts that provide it. Legislative and regulatory bodies reflect these public concerns about healthcare. Generally, the greater the public interest in an industry, the more likely it is that legislative bodies will design and pass laws to regulate that industry. The Regulatory Environment Ideally, healthcare laws and regulations serve the public interest by performing two broad functions. First, they provide protection to consumers of healthcare. Individuals seeking healthcare are often not in a strong position to judge the financial stability of a health plan, and sometimes lack the information necessary to compare the various health plans available. Many regulations are designed to protect consumers from these disadvantages. For example, as we saw in Risk Management in Health Plans, solvency regulations are designed to help assure that health plans are sufficiently financed to meet their obligations to plan members. Second, laws and regulations that are both well designed and consistently applied set standards of conduct for the parties involved in the business of healthcare, and these standards foster a competitive, but fair, marketplace environment. From a financial standpoint, however, the laws and regulations that achieve these ideal goals generate costs. For example, licensing requirements for providers and health plans protect consumers and foster public confidence in the healthcare professions. Part of the cost of this protection is that health plans face licensing requirementsand licensing costsin every state in which they enroll plan members. Complex regulatory environments also generate multiple markets, and therefore multiple healthcare delivery systems. For example, in a given geographical area, Medicare, Medicaid, commercial, large group, small group, and individual markets will be influenced, and in some cases created, by government laws and regulations. Changes in laws and regulations in such areas can cause healthcare resources to shift in and out of health plans or shift from less attractive health plan markets to more attractive markets. Beyond generating administrative and compliance costs for health plans, laws and regulations also 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 risk associated with that illness from the individual plan member to one or more other parties involved in the healthcare contract.

Generally, the distribution of risk among the health plan, the plan sponsor, and the providers is one of the central processes of risk management in health plans. The method that a health plan uses to reimburse its providers is a key factor in determining the amount of financial risk that a provider assumes and the amount by which the health plan reduces its underwriting risk. In this sense, provider contracting is closely tied to risk and to risk management tools, such as those we discussed in previous lessons. The concept of the risk-return trade-off causes health plans financial risk managers to seek an appropriate balance between achieving returns that meet its owners (or stockholders) expectations and maintaining appropriate levels of solvency. Healthcare providers and health plans both face financial risk in the course of conducting business. As businesses, health plans invest financial capital with the expectation of achieving a return. Similarly, providers invest their labor, and often some capital of their own in the course of providing care, and in return expect to be financially rewarded. The various types of provider reimbursement methods therefore indicate not only how the provider will be paid for providing services, but also who will bear the risk that providing these services will be more expensive than anticipated, and who will benefit if expenses are lower than anticipated. There are almost as many provider reimbursement methods as there are provider contracts, but reimbursement methods do fall into general categories. We discuss these categories in this assignment and a future lesson. Keep in mind that what often distinguishes these provider reimbursement methods from each other is how risk is divided among the parties to the health plan contract. Regulations addressing the delivery of healthcare services mandate many of the elements that must be included in contracts between health plans and providers and, in doing so, often serve to assign the risks associated with providing these services. In the following sections, we present an overview of the sources of health plan regulation and some of the mandates imposed by regulations. Sources of Laws and Regulations1 Laws and regulations applying to health plans come from both the federal government and state governments. At both the federal and the state level, legislatures enact statutes, governmental agencies develop regulations, and courts interpret laws and establish case law, all of which affect health plans. Federal Government At least four federal agencies establish rules and requirements that affect health plans: 1. 2. 3. 4. the Department of Health and Human Services, the Department of Labor, the Office of Personnel Management, and 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 a purchaser and regulator of healthcare. In addition, CMS is responsible for administering the

Medicare program and the federal governments role in the Medicaid program. We discuss Medicare and Medicaid in more detail in future lessons. The Department of Health and Human Services is also responsible for issuing regulations pertaining to the Health Insurance Portability and Accountability Act (HIPAA) of 1996. These regulations directly affect health plans that offer insured products to employer group health plans and individuals. Recall from Healthcare Management: An Introduction that HIPAA standardizes an approach to the continuation of healthcare benefits for individuals and members of small group health plans and establishes parity between the benefits extended to these individuals and those benefits offered to employees in large group plans. This act also contains provisions designed to ensure that prospective or current enrollees in a group health plan are not discriminated against on the basis of health status. The Department of Labor (DOL) The DOL is the federal agency with primary responsibility for administering the Employee Retirement Income Security Act (ERISA) of 1974, including recent amendments made by HIPAA. Although ERISA set the standards for the health benefit plans that many employers and some unions establish for their employees or members, ERISA does not directly regulate health plans. Because employer group plans often contract with health plans to provide health benefits to the plans enrollees, health plans that sell to this market must design health plan benefits that meet ERISA requirements. Under ERISA, various documentation, appeals, reporting, and disclosure requirements are imposed on employer group health plans. For example, every employer group health benefit plan that is subject to ERISA must have a written plan document that describes in detail the benefits covered by the plan as well as the rules governing eligibility and the procedures by which the plan 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 descriptions are often at the heart of disputes over whether a health plan is obligated to cover a particular service or course of treatment. For this reason, the plan documents of a health plan may have important legal and financial consequences for the plan. The Office of Personnel Management (OPM) The OPM administers the Federal Employees Health Benefits Program (FEHBP), which provides voluntary health insurance coverage to federal employees, retirees, and dependents. The FEHBP is the largest employer-sponsored health plan in the United States. The OPM sets threshold standards 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 descriptions are often at the heart of disputes over whether a health plan is obligated to cover a particular service or course of treatment. For this reason, the plan documents of a health plan may have important legal and financial consequences for the plan.

The Department of Defense (DOD) The DOD administers the Military Health Services System (MHSS), which provides medical care to 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 HMOs and PPOs because of the structure of its health plan contracting initiatives and the limited number of contractors involved in its programs. State Governments As we mentioned earlier, health plans are often regulated by more than one agency in a given state. Typically, a department of insurance oversees the financial aspects of health plan operations for those health plans that do not fall under the ERISA preemption. In some states, the state department of health regulates the healthcare delivery system, including oversight of access to and quality of care. Other state agencies also may be involved in setting standards for some health plans, because states are also purchasers of healthcare for their own employees and for lowincome state residents through Medicaid contracts. The National Association of Insurance Commissioners (NAIC) is a non-governmental organization that consists of the commissioners or superintendents of the various state insurance departments.2 The NAIC assists states in their attempts to achieve some uniformity of laws and regulations applying to health plans and health insurance. The NAIC does this through the development of model acts. The model acts themselves do not carry the force of law, but state legislatures 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, and health plans operating in more than one state must design their plans and provider contracts to comply 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 regulatory environment 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 certain conditions or treatments have an impact on the health plan-provider contracts. The costs of complying with such laws and regulations affect provider contracts at least indirectly in a competitive market, because resources used to meet compliance costs are no longer available as potential surplus for either providers or health plans. In addition, many laws more directly affect provider contracts by mandating elements within those contracts. The large number of legislatures and agencies involved in passing and enforcing these laws make a full discussion of them beyond the scope of this text. However, the following sections 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 choice of 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 use reasonable care in credentialing providers. Recall from Healthcare Management: An Introduction that credentialing is a review process conducted to determine the current clinical competence of providers and to ensure that providers meet the organizations criteria. Various organizations, including the National Committee for Quality Assurance (NCQA), URAC and the American Association of Preferred Provider Organizations (AAPPO), have adopted standards for conducting provider credentialing. These standards are not mandatory for health plans, but courts sometimes find that health plans have satisfied their duty to use reasonable care in their credentialing activities if they comply with these standards. The NCQA standards list the kinds of information health plans should obtain about providers during the initial credentialing process and suggest that health plans recredential all providers every two years. The NCQA has also established standards for health plans that contract with third parties to credential or verify the credentials of providers. In addition, some states have enacted laws that specify the criteria health plans should consider in making credentialing decisions. Compliance with these laws may help an health plan show that it has satisfied its standard of care. Fair Procedure Laws Fair procedure laws, also called due process laws, are laws that require health plans to disclose the criteria they use in 1. selecting or deselecting the providers with which they contract, and 2. explaining to rejected or deselected providers why they were not selected, and the process by which a provider can challenge the health plans decision. Direct Access Laws Several states have passed direct access laws, which are laws that allow health plan members to see 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 without referral. As of 1997, 14 states had direct access laws, and 9 of those states specified obstetricians/gynecologists. Other direct access laws allow visits to dermatologists (Florida and Georgia) and chiropractors (New York). 4 Even in jurisdictions where there are no direct access laws, some plans allow enrollees to see certain specialists without referral. However, in the absence of direct access laws, plans can require such referrals. In such cases, primary care provider contracts can require the primary care provider to manage some portion of the plan members utilization of such specialists. Direct access 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 laws than they might otherwise have, direct access laws can influence the content of contracts between the health plan and providers.

Any Willing Provider Laws About half of the states have passed any willing provider (AWP) laws, which require that health plans allow any provider to supply services to plan members, so long as the provider is willing to meet the same terms and conditions that apply to the providers that are in the health plans network. In other words, AWP laws mandate that an health plan allow providers to become part of its network or reimburse those providers at the health plans negotiated-contract rate, so long as 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 choose any provider, whether the provider is in the health plans network or not. Several AWP laws require that a health plan send contract proposals to all providers in the health plans service area. Other AWP laws confine themselves to relatively narrow categories of providerspharmacies, 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 a high percentage of the healthcare market in local areas may put providers who do not contract with them at a competitive disadvantage, and may further reduce competition by reducing the number of providers in the market. In contrast, health plans are opposed to AWP laws because such laws tend to remove any motivation a provider may have to contract with the health plan. A health plan can significantly reduce healthcare costs in a health plans population by contracting with providers who agree to provide services to the health plans plan members at reduced rates. In exchange, the health plan effectively makes available to the provider a larger volume of patients than the provider would otherwise have. Fair Procedure Laws Particularly in the case of hospitals, which have high fixed costs, and in the case of physicians who are in individual practice and may not have marketing expertise, a dependably large volume of patients can be a valuable benefit. The greater the perceived benefit of patient volume, the more motivated providers will be to agree to reduce their fees, and the greater the cost reductions the 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 plans utilization management philosophy and who provide excellent care. By allowing all providers access to the health plans patient base, AWP laws remove providers incentive to contract with the health plan at reduced rates and make more difficult the health plans attempt to build a provider panel that includes only the top-quality providers in a given market. As a result, health plans have challenged AWP laws in court. Usually the legal basis for these challenges is that an applicable federal law, such as ERISA or the HMO Act, pre-empts state statutes. Insight 3A-1 highlights the recent finding of the US Supreme Court regarding the applicability of ERISA to AWP challenges. Insight 3A-1 In Kentucky Association of Health Plans v. Miller, the issue the Supreme Court decided is whether Kentuckys 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 that health plans need to use limited provider networks to deliver quality health care at a reasonable cost. The state argued that the Kentucky law is a legitimate consumer protection measure that gives consumers access to providers of their choice. On April 2, 2003, the US Supreme Court, in a unanimous decision, affirmed the Sixth Circuit decision that found that Kentuckys any willing provider" laws are saved from ERISA preemption by the ERISA saving clause because the laws regulate insurance. In the decision, the Supreme Court held that for a state law to be deemed a law which regulates insurance, and thus be saved from ERISA preemption, it must satisfy two requirements: 1) it must be specifically directed toward entities engaged in insurance; and 2) it must be substantially affect the risk pooling arrangement between the insurer and the insured. Mandated Benefits Mandated benefit laws are state or federal laws that require health plans to arrange for the financing and delivery of particular benefits, such as coverage for a stay in a hospital for a specific length of time. In some cases, such as laws that require health plans to supply chiropractic services, mandated benefit laws also have the effect of requiring health plans to contract with specific types of providers. In recent years, the number of state laws mandating coverage has increased significantly. The types of illnesses or procedures covered, and the degree to which they are covered, vary from state 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 mandated benefit 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 the following ways:
They increase the cost of a health plans health plan to the extent that the plan must cover

mandated benefits that would not have been included in the plan in the absence of the law or regulation that mandates the benefits. Health plans must contract with providers, including specialists, to provide the required level of mandated benefits. To the extent the mandated benefits change the benefit structure of the health plans health plan, the health plans may have to contract with providers 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 plan is complying with the law. The health plan must also gather and analyze cost data to be able to adequately price the increased benefits. To the extent that this data tracking and analysis represents an increased load on the health plans information and management systems, costs will increase. Mandated benefit laws may have the effect of causing a higher degree of uniformity among the health plans of competing health plans in a given market. Individual health plans that seek to differentiate their products from those of their competitors in competitive 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 paying premium increases in other healthcare plans that are subject to state mandates. In other markets, 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 least temporarily influence the structure of the market balance between self-funded and other types of plans. A full discussion of all the mandated benefit laws that states have passed is beyond the scope of this 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 illnesses motivated lawmakers to enact a mental health parity requirement that subsequently was incorporated into HIPAA. The federal mental healthcare coverage requirements bar group health plans from having more restrictive annual and lifetime limits or caps on mental illness coverage than for physical illness coverage if the health plan has annual payment limits or aggregate dollar lifetime caps. The federal mental healthcare coverage law does not mandate coverage for mental illness; it seeks to ensure thatif a health plan covers mental illnessthe caps and limits are comparable to caps and limits for physical coverage. More than 15 states have enacted their own mental healthcare coverage laws. These laws, similar to HIPAA, vary from mandating coverage of treatment for severe disorders or biologically based illnesses such as schizophrenia, manic-depression, or bipolar disorder to mandating parity for coverage of mental illnesses comparable to caps and limits for physical illnesses.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 for coverage 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 mental illness any disorder listed in the International Classification of Diseases Manual (ICDM), requires coverage 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 and physical illnesses. 7 Generally, health plans must ensure that they comply with the mental health parity requirements of the federal law as well as any more stringent requirements imposed by the states in which they operate. Length of Stay Laws8 Some state mental health parity laws exclude substance abuse treatment from their mandates for coverage 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 mental illness any disorder listed in the International Classification of Diseases Manual (ICDM), requires coverage 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 and physical illnesses. 7 Generally, health plans must ensure that they comply with the mental health parity requirements of the federal law as well as any more stringent requirements imposed by the states in which they operate.

The Texas State Liability Law In addition to laws that increase health plans costs by imposing administrative or compliance requirements, some laws expose the health plan to financial liability for its actions or the actions of its providers. Providers and health plans may be liable for damages if they fail to perform duties imposed upon them by these laws. A tort is a violation of a legal duty to another person imposed by law, rather than contract, causing harm to the other person and for which the law provides a remedy. The business of healthcare is sufficiently complex that health plans face a certain level of risk from tort actions. Although it would be impossible to list all laws that could subject a health plan to tort action, one state law recently passed by Texas has the potential to significantly increase financial risks faced by health plans through tort actions, and in doing so, increase health plans costs of doing business 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 care treatment decisions made by the health plans employees or agents. In other words, if a physician providing care to a health plans plan member harms the plan member through medical malpractice or other negligence, the health plan, as well as the provider, is liable. Medical malpractice is a type of negligence that occurs when a patient is harmed because a provider failed to exercise reasonable care in providing medical treatment. Traditionally, health plans have not been liable in cases of physician malpractice, particularly when the physician was not a full-time employee of the health plan. The reasoning behind not holding the health plan responsible is that, in the United States, corporations are not allowed to engage 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 for which only individual providers were liable. Thus, in provider contracts with health plans, the risk of malpractice was borne by the providers (or the insurance companies supplying the physicians with malpractice insurance), and not the health plans. Under the Texas law, a health plan 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 the health plan and whether or not health plans are liable for the actions of these agents are significant financial issues for health plans. Currently the Texas law is being challenged in court, in part on the same basis as any willing provider lawsthat is, that federal laws such as ERISA pre-empt state laws. Endnotes 1. Adapted from American Association of Health Plans, The Regulation of Health Plans: A Report from the American Association of Health Plans, Washington, D.C., February 3, 1998, 12. 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 and Regulation (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 and Regulation (Washington, D.C.: Academy for Healthcare Management, 1999), 5-32533. Used with permission; all rights reserved. 5. Adapted from Academy for HealthcareManagement, Health Plans:Governance and Regulation (Washington, D.C.: Academy for Healthcare Management, 1999), 5-25526. 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), 5-26527. Used with permission; all rights reserved. 9. State Wrap-Up 1997: Health Plan Targeted for Restrictions, Mandates,Business Insurance (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, and discounted 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 in health plans, laws and regulations are by no means the only influence on these contracts. Provider contracts in managed care have also evolved over time in response to market forces. Market forces include the presence of competitors in the market, the level of demand for healthcare services, and the availability (or level of supply) of those services. Market forces, in turn, are driven 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 the delivery 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 of balancing 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 and sponsors. Not all sponsors and plan members demand the same level of comprehensiveness; consequently, different groups of consumers will find different plans attractive. All other factors being equal, however, plan sponsors and members prefer to pay the lowest possible price for the healthcare benefits they receive, and the market will tend to reward health plans and providers who 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-term goals of the participants with this long-term goal of cost efficiency. When the short-term financial goals of the participants are in conflict with this long term goal, health plans face various inefficiencies that can ultimately lead to higher costs and lower quality care. Because different healthcare consumers have different needs, however, there is no one reimbursement system that works most efficiently for all providers and types of health plans in all health plans. Each reimbursement system has strengths and weaknesses. Health plans arose as a system for aligning the financial goals of the participants, with each type of reimbursement method implicitly addressing the weaknesses of other methods. This lesson describes common types of provider reimbursement methods in health plans and outlines the advantages and disadvantages of each type.

Provider Reimbursement Methods The rapid growth and dynamic market conditions within the health plan industry have caused the development of a large number of provider reimbursement methods. New variations on these methods are developed (or mandated by regulatory bodies) each year. Generally, physician reimbursement 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 Percent-of-premium schedule (the health plan pays providers a percentage of all the

member during a defined period)

premiums received in exchange for covering plan members, and providers agree to provide all necessary medical treatment for those plan members) In this lesson, we discuss a number of health plan reimbursement methods both in terms of these categories, and in terms of how these methods divide financial and utilization risks between providers and health plans. We begin by outlining how physicians and hospitals were traditionally paid before managed care, because the weaknesses of traditional physician reimbursement led to rising 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 medicines financial structures, including physician reimbursement. Traditional Provider Reimbursement Before health plans became widely established, provider reimbursement typically involved an individual 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 claim to the insurer. If the insurer denied the claim, the responsibility for paying for the care remained with the patient. Although this traditional method of payment allowed individuals who sought healthcare considerable freedom of choice in physicians and treatment options, it also presented several financial disadvantages. Financial Disadvantages of Traditional Physician Reimbursement From a financial point of view, traditional physician reimbursement is subject to three types of disadvantages. First, this reimbursement method concentrates, rather than spreads, the financial risk for a patient and that patients physician when the patient faces a serious illness, particularly in cases where the patient either has no insurance or is underinsured. By concentrating risk, this method, in effect, concentrates the costs of healthcare. In other words, an underinsured individual who had a serious illness often faced a choice of either receiving inadequate care or suffering severe financial hardship in paying for treatment. Providers themselves risked not getting paid for their services. Providers under this reimbursement system also faced a potential ethical and financial dilemma. These physicians had to decide either to provide (1) different levels of treatment, based not on the seriousness of the illness, but on the wealth of the patients with the illnesses, or (2) the same level of treatment to all patients, 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 contain healthcare 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 can afford 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 expertise to judge the benefit of a treatment in relation to the cost of the treatment, so patients who can afford extra services are motivated to purchase the services to be on the safe side. In the long run, 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 within the healthcare system as a whole to be allocated inefficiently. Third, traditional provider reimbursement often involves operational inefficiencies. To provide the best possible care, a physician must stay current with professional advances in medicine. At the same time, a physician would have to perform or manage all administrative and marketing functions of the practice. Few physicians do all of these things equally well, so the practices of even skilled physicians are subject to administrative inefficiencies that can result in either increased costs to patients or decreased profit for the physicians. Physicians who practice alone or in small clinics also may have difficulty achieving economies of scale in their administrative and fixed 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. The structure of provider reimbursement methods in health plans involves a large number of complex details, particularly with respect to determining a fair rate of reimbursement, given that the exact level 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 method addresses 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 the short-term financial goals of those involved in the healthcare system. In most cases, managed care achieves at least part of the realignment of participants goals through the use of strategies that redistribute risk among the participants in healthcare plans. Salary Reimbursement Method Under a salary reimbursement method, or budget method, providers are paid an agreed-upon salary in exchange for providing healthcare services. Such a system requires an administrative entity to pay the salaries. Staff model HMOs, many government healthcare facilities, and some hospitals use salaries as a way of paying physicians. Compared to traditional physician reimbursement, the salary system automatically carries with it several potential benefits. First, it separates some of the administrative functions of healthcare from the practice of medicine, at least to the extent that the physicians and other providers do not have to perform all of the business functions necessary in private practice. These administrative functions can be done efficiently for a large number of providers at once, thus lowering the administrative cost per plan member and achieving economies of scale.

Also, salaries eliminate much of the financial incentive providers might otherwise have to perform services that are not medically necessary. In other words, because the physician is not being paid on a per-treatment basis, simply performing more services will not financially benefit the physician. In addition, because provider reimbursement is a sizable portion of a health plans total costs, salaries help to stabilize expenses for the health plan or other entity employing the providers, 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 pays providers at a predetermined rate in advance of the providers supplying treatments or services. A salary is a prospective reimbursement method, as are many of the health plan reimbursement methods we will discuss. Traditional provider reimbursement and other forms of paying providers per treatment are not prospective. Many prospective reimbursement methods tend to give providers incentives to avoid overutilization, because under these types of prospective reimbursement providers are typically not paid more simply for providing more services. A salary system also has some disadvantages. Although cost stabilization prevents unexpectedly high reimbursement costs, it may also hinder cost reduction. Unless the salary system is augmented with another type of incentive plan, providers who work efficiently and effectively are not necessarily paid more than those who do not. Some providers under a salary system may feel motivated to do less work, because the incentive system itself provides no motivation to work harder. Therefore, positive levels of quality, productivity, and resource utilization have to be encouraged in other ways. One method of doing so is to create a salary range for providers, so that all provider-employees are paid at least a minimum amount, and can earn up to a maximum amount by being more productive or efficient. Similarly, providers or groups of providers can be given a bonus in addition to their salaries after a profitable period. In this way the providers employer encourages high productivity and efficient practices by returning some of the income and cost savings to the providers who are successful in achieving desirable results. Such incentive methods can also be administratively complex. They must be designed carefully so that providers are not simply paid more to do more, but are paid more to work more effectively. For example, an incentive program that measures the level of a physicians workload by counting the number of diagnostic tests the physician orders is encouraging the physician to order diagnostic tests, which may or may not indicate that the physician is practicing more effective medicine. Both salary and nonsalary reimbursement systems can share this problem. Often, the problem is addressed in part by having physician review panels analyze the effectiveness of treatments rendered by individual physicians. Under a straight salary system, providers accept some service risk. Service risk is the risk that plan members will demand more services from the physician than had been anticipated when the salary 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 and financial risks they would face as independent practitioners. Furthermore, they avoid the risk that unexpectedly high utilization rates will drive costs above the income generated by the health plans premiums. The providers employer, whether a health plan, a governmental entity, or a hospital, in effect accepts the risk that, in the short term, costs will exceed cash flows. Like any other 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 or membership levels fall below the plans targets, the health plan or other employer must, at least in the 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 many jurisdictions: as employees, the physicians are the agents of the health plan. Because an employer is typically seen as having greater control over the actions of its employees than it would have over the actions of independent contractors, a health plan that employs physicians may face greater 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 service that they provide. After providing a given service or treatment, the provider bills the plan for that treatment. Typically, FFS payment agreements contain a no-balance-billing clause. No balance billing means that the physician agrees to accept the payment made by the health plan as full payment for the service and will not bill the plan member for that service. No balance billing is also often used in combination with reimbursement systems other than FFS. No balance billing is attractive to plan members and plan sponsors because it reduces the possibility they will face unexpected 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 in markets where health plan penetration is low. Using FFS can allow an health plan to acquire a large panel of providers, which allows plan members considerable freedom to choose their personal physicians or other providers. This freedom is highly valued by a sizable portion of the population. Especially in markets where a health plan is attempting to establish itself, the health plan will appear more attractive to potential plan members if becoming a member does not require 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 was to determine what the usual, customary, and reasonable (UCR) fees were for each type of treatment, then negotiate with providers to pay a discount on the UCR fee. Although UCRs were developed by indemnity insurers, a discount on standard fees is also used by health plans. In discounted fee-for-service (discounted FFS) reimbursement methods, the health plan reimburses the provider on a per-treatment basis at a level below the providers 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 are discounted. The discounted FFS concept can also be coupled with a fee schedule. Under fee schedules, the health plan determines a maximum value for each procedure or treatment, and pays the provider the lesser of the providers requested fee or the maximum value. Fee schedules offer the advantage of allowing the health plan to develop uniform fees for the same service delivered by different providers. Providers are willing to accept a discounted or negotiated fee that is less than their usual fee because doing so allows them access to the health plan membersthat 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, thus removing any motivation the provider might have to provide too few services. From the health plans point of view, the main disadvantage with FFS reimbursement methods is that, while physicians are financially rewarded for providing more services, there is no guarantee that more services necessarily translate into better plan member care in all cases. Although the number of physicians or other providers who engage in fraud by supplying excessive services is relatively small, physicians or other providers who are rewarded for supplying more services will tend to supply them. For this reason, an FFS reimbursement system will encourage providers to bill more services, leading to greater healthcare costs. Both FFS and discounted FFS systems may fail to prevent excessive servicesand therefore excessive costswhen those excessive services take one of three forms: churning, upcoding, and unbundling. Churning involves a physician or other providers either seeing a plan member more often than is necessary, or providing more treatments and tests than are necessary. Churning ultimately adds to the costs of the plan and therefore increases the cost of healthcare coverage to the plan member and the employer (or other payor). A plan member therefore has motivation to avoid churning, but may not have the knowledge necessary to tell whether or not a treatment or return office visit is necessary. Thus, churning almost always has to be prevented by the health plans management practices. Health plans often do so by tracking claims frequency by treatment code and by individual providers. When some treatments appear to be billed at greater-thanexpected rates, the cause can be investigated. Upcoding is the practice of a providers billing for a procedure that pays more than the procedure actually performed by the provider.1 The tendency to upcode can result in code creep, which is the condition of frequently billing for more lucrative services than those actually performed. If upcoding becomes common within an health plans health plan, the health plans costs can rise significantly. Unbundling is the practice of a providers billing for multiple components of a service that were previously included in a single fee, when the total reimbursement for the multiple component services would be higher than the single fee. Many health plans use claims software that can recognize unbundling and will automatically rebundle the component services. Like churning, upcoding and unbundling are essentially impossible for the plan member to detect and may be difficult for employers or other payors to detect as well. Therefore, health plans seek to prevent practices such as churning, upcoding, and unbundling through quality control and cost control management functions. Another motivating factor in some cases of overutilization involves the risk of malpractice liability that physicians face. The risk of being found guilty of malpractice is a pure risk for a physicianit is a loss without possibility of gain. The presence of pure risk motivates those who face it to try to avoid that risk. Some providers will be motivated by malpractice liability risk to practice defensive medicine. Defensive medicine is an attempt to minimize malpractice risk by supplying extra services, such as multiple diagnostic tests, even if those services are not likely to benefit the plan member. As payment methods, neither FFS nor discounted FFS guard against the practice of defensive medicine. Discounted FFS and FFS reimbursement methods also are subject to another disadvantage that we discussed under traditional reimbursement methods. Providers who are compensated under

these systems and who attempt to control costs may find themselves paid less than physicians who make little effort to control costs. Thus, the health plan can in some cases find itself compensating 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 to develop uniform fees to reimburse all providers who perform the same service. An important method 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 medical procedure or service performed by a provider based on the cost and intensity of that service. Each type of procedure is given a code number. For example, an appendectomy would have a different code from a tonsillectomy, and an appendectomy without complications of a peritonitis infection would have a different code from an appendectomy performed on a plan member with severe peritonitis. Usually, RVS code numbers are based on the current procedural terminology (CPT) codes, which were developed by and 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 of the code is multiplied by a money multiplier. In practice, RVS codes have tended to reward procedural services, such as surgical procedures, more than cognitive services, such as office visits or research done by a physician on a plan members 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 all resources 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 use of 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 an FFS reimbursement system. Because physicians using these systems bill for their services according to precise codes, tracking treatment rates is much easier and more exact for the health plans quality and cost management functions. The use of RBRVS also provides a coherent starting point for fair compensation to various providers who may be providing different types of services. Therefore, RBRVS can be useful to a health plan that is developing reimbursement schedules for various types of providers in a comprehensive health plan. One disadvantage that RBRVS shares with other FFS systems is that RBRVS rewards providers for rendering more services, but does not put them at financial risk for overutilization. The health plan retains overutilization risk under a reimbursement system that uses RBRVS in the absence of any other incentive system. Consequently, the health plan must manage the risk of overutilization either through a separate incentive system that motivates providers to control costs, or through administrative measures, such as clinical practice guidelines, that seek to manage provider behavior. The health plan must also establish safeguards to minimize upcoding under RBRVS systems.

Global Fees Another method of provider reimbursement uses global fees. A global fee is a single fee that the provider is given for all services associated with an entire course of treatment given to a plan member. For example, global fees are common in obstetrics. The global fee would be payment for prenatal visits, the delivery itself, and a defined period of post-delivery care. Global fees also can be set up for non-emergency surgical procedures, or certain types of office visits where the service or treatment is well defined. Thus, the provider or providers (for example, a hospital in the case of surgeries) must manage the costs of the components of a plan members course of treatment, 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 to the providers. In doing so, a global fee rewards providers who deliver cost effective care. Global fee systems do not completely eliminate all motivation a provider may have to engage in churning, because the provider is still being paid according to the number of treatments performed. However, global fees do eliminate unbundling and upcoding within specific treatments, because the single global fee covers the entire course of treatment. Global fees can be more administratively complicated to develop initially than straightforward FFS systems, particularly when global fees provide compensation to more than one provider. For example, if a global fee is paid for an appendectomy, then a fair method must be devised for dividing that fee among the surgeon, anesthesiologist, and other providers involved in that treatment. Global fees for physician services or for individual providers, however, are similar to bundling. To operate efficiently, global fees require that a health plan have a claims system that recognizes the component services contained within the global fee, so that the health plan will not pay both the global fee and make individual payments for the same component services billed under individual codes. The global fees themselves must reflect how difficult and time-consuming each course of treatment is relative to other courses of treatment. The health plan and the provider, as parties to the reimbursement contract, will have fewer conflicts if the global fee for a given treatment is fair that is, neither excessively high nor too low to cover the costs the provider incurs in providing the treatment. Ideally, the global fee system balances the reimbursement for each treatment with the relative reimbursement for other treatments. This balance is important in terms of managing utilization, because if the global fee for one procedure is financially more attractive than 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 may exceed the global fee. Under such conditions, a provider may be reluctant to provide additional services. Consequently, a system must be in place to assure that plan members receive appropriate care. Two commonly used systems are quality management on the part of the health plan, and various forms of insurance or contractual elements that protect the provider against financial losses in cases that require exceptionally expensive treatment. We discuss these forms of insurance 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 if it 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 providing excellent care. Some characteristics of provider reimbursement systems that help achieve these alignments 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 by making a portion of their reimbursement dependent on how well the providers and the health plan manage costs. In all three methods, an assumed or budgeted cost is developed, and a portion of the providers income is subject to enhancement (or loss), depending on whether costs are held below the budgeted amount during a specific period. Withholds 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 exceed the budgeted costs for care during that period are charged against the withheld funds, and after such claims are paid, the remaining money in the withhold is distributed to the providers. If providers hold costs below the amount budgeted for that period, then the entire amount of money in the withhold is usually distributed to them. If the cost overruns exceed the withhold, then the deficits are usually the responsibility of the health plan. Withholds usually range from 10% to 20% of total provider reimbursement for the 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 the period, 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 the beginning of the contract period. Bonus Arrangements Bonus arrangements , which pay providers over and above their usual reimbursement at the end of a financial period, are based on the performance of the health plan as a whole, a group of providers within the plan, or an individual provider. Bonuses provide financial incentives to providers to minimize unnecessary costs. Bonuses may be based on a percentage of a providers reimbursement or a percentage of the savings experienced by the health plan. Bonuses based on savings achieved by the plan as a whole have the advantage of being somewhat easier to administer, but, in such cases, the achievement of savings and the bonus for each provider will be based partly on events outside the providers control. Under a bonus reimbursement arrangement, the providers are not at financial risk to make up any deficit experienced by the plan. Beyond the possibility of losing their bonus, providers are not at risk when the plan faces deficits. As we noted previously, providers in a risk pool arrangement are usually responsible for sharing a plan deficit even if the deficit is greater than the funded risk pool. The central motivation for forming risk pools, withholds, and bonus arrangements is to transfer some of the financial risk associated with overutilization to providers, who at least partly control utilization rates. In this way, providers are motivated to control utilization by managing it themselves.

Hospital Reimbursement Methods Hospitals are an important player in provider reimbursement systems. Often a health plan will reimburse hospitals using one reimbursement method, and the providers associated with the hospital will be paid using a different method. Also, a single hospital may be reimbursed under several different payment systems, which will vary from health plan to health plan, and from private plans to government plans such as Medicare and Medicaid. Before continuing our discussion of hospital reimbursement methods, refer to Figure 3B-2, which provides definitions for some key terms used in hospital reimbursement. Straight Charges The simplest (albeit least desirable) payment mechanism in healthcare is straight charges, under which a hospital submits its claim in full to a health plan and the plan pays the bill. It is also obviously the most expensive, after the option of no contract at all. This is a fallback position to be 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 of reserve requirements and licensure. Straight Discount on Charges Another possible arrangement with hospitals is a straight discount on charges, under which a hospital submits its claim to a health plan in full, and the plan discounts it by the agreed-to percentage and then pays the claim. The hospital accepts this payment as payment in full. The amount of discount that can be obtained will depend on the factors discussed above. This type of arrangement is not infrequent in markets with low levels of health plan penetration but is uncommon 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 but some level of competitiveness among hospitals. Under a sliding scale discount on charges, the percentage discount on a hospitals bill is reflective of the hospitals total volume of admissions and outpatient procedures. Deciding whether to combine these two categories or deal with them separately is not as important as making sure that the parties deal with them both. With the rapidly climbing cost of outpatient procedures, savings from reduction of inpatient utilization could 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 year with incremental increases in the discount up to a maximum percentage. An interim percentage discount is usually negotiated, and the parties reconcile at the end of the year based on the final total volume. How a health plan tracks the discount is also negotiable. A health plan may vary the discount on a month-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 should be 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 hospital will demand a clause in the contract spelling out the health plans requirement to process claims

in a timely manner, usually 30 days or sooner. In some cases a health plan may negotiate a sliding scale, or a modifier to the main sliding scale, that applies a further reduction based on the plans ability to turn a clean claim around quickly. For example, the health plan may negotiate an additional 4% discount for paying a clean claim within 14 days of receipt. Conversely, the hospital 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 the hospital, regardless of any actual charges or costs incurred. In this most common type of arrangement, a health plan negotiates a per-diem rate with the hospital and pays that rate without adjustments. For example, the plan will pay $800 for each day regardless of the actual cost of the service. Hospital administrators are sometimes reluctant to add days in the intensive care unit or obstetrics to the base per diem unless there is a sufficient volume of regular medical-surgical cases to make the ultimate cost predictable. In a small health plan, or in one that is not limiting the number of participating hospitals, the hospital administrator is concerned that the hospital will be used for expensive 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 typefor example, medical-surgical, obstetrics, intensive care, neonatal intensive care, rehabilitation, and so forthor 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 can accurately 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 paid even if the billed charges are less than the per diem rate. For example, if the health plan has a perdiem 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-day admission are $3,300, the hospital is reimbursed $4,000 for the admission ($800 per day 5 days). This is acceptable as long as the average per diem represents an acceptable discount, but it has been anecdotally reported that some large, self-insured accounts have demanded the lesser of the charges or the per diems for each casethat is, laying off the upper end of the risk but harvesting the reward. Such demands are to be avoided because they corrupt the integrity of the perdiem calculation. A health plan may also negotiate to reimburse the hospital for expensive surgical implants provided at the hospitals actual cost of the implant. Such reimbursement would be limited to a defined list of implants, such as cochlear implants, where the cost to the hospital for the implant is 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 is also based on total volume. Under sliding scale per-diem charges , a health plan negotiates an interim per diem that it will pay for each day in the hospital; depending on the total number of bed days in the year, the plan will either pay a lump sum settlement at the end of the year or withhold an amount from the final payment for the year to adjust for an additional reduction in the per diem from an increase in total bed days. It may be preferable to make an arrangement whereby on a quarterly or semiannual basis the plan will adjust the interim per diem so as to reduce 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 hospitalizations are more expensive on the first day. For example, the first day for surgical cases includes operating suite costs and operating surgical team costs. This type of reimbursement method is generally 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 pointsthat is, the cost or length of stay that causes the DRG payment to be supplemented or supplanted by another payment mechanismto enable a health plan to negotiate a payment mechanism for DRGs based on Medicare rates or, in some cases, state regulated rates. First, though, the plan needs to assess whether it will be to its benefit. If it is the plans intention to reduce unnecessary utilization, there will not necessarily be concomitant 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 health plan is prepared to perform careful audits of the hospitals DRG coding, it may experience code creep. On the other hand, DRGs do serve to share risk with the hospital, thus making the hospital an 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 manage utilization. Insight 3A-2 explains a Medicare demonstration program, combining DRG payment with incentive, or bonus payments for quality. Insight 3A-2 THE PREMIER HOSPITAL QUALITY INCENTIVE DEMONSTRATION: REWARDING SUPERIOR QUALITY CARE Overview The Premier Hospital Quality Incentive Demonstration is part of the CMS Hospital Quality Initiative, originally launched in 2003 by the Centers for Medicare & Medicaid Services (CMS) and the Department of Health and Human Services (HHS). The Premier Hospital Quality Incentive Demonstration, a three-year project launched with Premier Inc., a nationwide

organization of not-for-profit hospitals, will recognize and provide financial rewards to hospitals that 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 information available about quality of care and through direct incentives to reward the delivery of superior quality care. Through the Premier Hospital Quality Incentive Demonstration, CMS aims to see a significant improvement in the quality of inpatient care by awarding bonus payments to hospitals for high quality in several clinical areas, and by reporting extensive quality data on the CMS web site. Quality of Care Measures Under the demonstration, top performing hospitals will receive bonuses based on their performance on evidence-based quality measures for inpatients with: heart attack, heart failure, pneumonia, coronary artery bypass graft, and hip and knee replacements. The quality measures proposed for the demonstration have an extensive record of validation through research, and are based on work by the Quality Improvement Organizations (QIOs), the Joint Commission on Accreditation of Healthcare Organizations (JCAHO), the Agency for Healthcare Research and Quality (AHRQ), the National Quality Forum (NQF), the Premier system and other CMS collaborators. Hospital Scores Hospitals will be scored on the quality measures related to each condition measured in the demonstration. Composite quality scores will be calculated annually for each demonstration hospital by rolling-up individual measures into an overall quality score for each clinical condition. CMS will categorize the distribution of hospital quality scores into deciles to identify top performers for each condition. Financial Awards CMS will identify hospitals in the demonstration with the highest clinical quality performance for each of the five clinical areas. Hospitals in the top 20% of quality for those clinical areas will be given a financial payment as a reward for the quality of their care. Hospitals in the top decile of hospitals for a given diagnosis will be provided a 2% bonus of their Medicare payments for the measured condition, while hospitals in the second decile will be paid a 1% bonus. The cost of the bonuses to Medicare will be about $7 million a year, or $21 million over three years. Improvement Over Baseline In year three, hospitals that do not achieve performance improvements above demonstration baseline will have adjusted payments. The demonstration baseline will be clinical thresholds set at the year one cut-off scores for the lower 9th and 10th decile hospitals. Hospitals will receive 1% lower DRG payment for clinical conditions that score below the 9th decile baseline level and 2% less if they score below the 10th decile baseline level. Adapted from: Premier Hospital Quality Incentive Demonstration, Fact Sheet. Centers for Medicare & Medicaid Services, Washington, DC February, 2004. Service-Related Case Rates Similar to DRGs, service-related case rates are a cruder reimbursement mechanism. Under service-related case rates, various service types are defined and the hospital receives a flat per admission reimbursement for whatever type of service to which the patient is admittedfor example, all surgical admissions cost $6,100. Service types include medicine, surgery, intensive

care, neonatal intensive care, psychiatry, and obstetrics. If services are mixed, a prorated payment, 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 certain categories of procedures and negotiate special rates. Case rates are rates that are established on a case by case basis. The most common of these is obstetrics. It is common to negotiate a flat rate for a normal vaginal delivery and a flat rate for a Caesarean section or a blended rate for both. In the case of blended case rates, the expected reimbursement for each type of delivery is multiplied by 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, then the 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 case rates, regardless of either length of stay or Caesarean section versus vaginal delivery, are clearly the preferred method of reimbursement, other than capitation. Although common, case rates are certainly not necessary if the per diem is all-inclusive, but a health plan will want to use them if it has negotiated a discount on charges. This is because the delivery suite or operating room is substantially more costly to operate than a regular hospital room. For example, a health plan may negotiate a flat rate of $2,100 per delivery. The downside of this arrangement is that the health plan achieves no added savings from decreased length of stay. 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 at tertiary hospitals for medical procedures such as coronary artery bypass surgery or heart transplants. These procedures, although relatively infrequent, are tremendously costly. A broader variation is package pricing or bundled case rates. Package pricing or bundled case rate refers to an all-inclusive rate paid for both institutional and professional services. A health plan negotiates a flat rate for a procedure, such as coronary artery bypass surgery, and that rate is used to pay all parties who provide services connected with that procedure, including preadmission and post-discharge care. Bundled case rates are not uncommon in teaching facilities where there is a facility 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 than traditional medicine is through economies of scale. For health plans, this typically involves developing a network of providers, including individual physicians and hospitals. health plans seeking to provide comprehensive health plans must also contract with a variety of providers for ancillary services. Ancillary services is an umbrella term for a variety of healthcare services outside of surgery, primary care, and most hospital treatment, and typically these services are provided by non-physicians. Many ancillary services are diagnostic: laboratory tests, radiology, and magnetic resonance imaging are all examples of services often considered ancillary by health plans. Similarly, many kinds of physical and behavior therapy, dialysis, home health care, and even pharmacy services are considered ancillary services.

One characteristic of most ancillary services that has important contractual and financial implications for a health plan is that few plan members seek these services without first being referred to the ancillary provider by a physician. For this reason, the utilization rates for ancillary services are partly controlled by physician behavior. Consequently, utilization rates and the costs that a health plan experiences for ancillary providers depend on the type of network the health plan 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 develop significant data over time concerning quality outcomes by type and intensity of treatments, including ancillary services. Thus, these health plans are able to provide physicians with indicators 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 care by consulting with physicians and ancillary providers at the beginning of a case to determine the appropriate frequency and intensity of use of ancillary services. Reimbursement methods for ancillary service providers tend to fall into the same general categories 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 controls mentioned above, these reimbursement systems distribute utilization risk between the contracting parties much as the same reimbursement methods distribute risk between physicians and health plans. Reimbursement methods for ancillary services may also be influenced by the structure of the health 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 open panel 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 a number 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 responsible for controlling utilization risk and who is responsible for controlling a significant source of financial costs that a health plan incurs. Capitation, which is already an important reimbursement method for many physicians and hospitals, is becoming more common in ancillary service provider contracts. We discuss capitation in the next lesson. Endnotes 1. Peter R. Kongstvedt, M.D., Compensation of Primary Care Physicians in Open Panel Plans, 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), 2-182-19.

 Portions of this section are adapted from Peter R. Kongstvedt, M.D., Negotiating and

Contracting with Hospitals and Institutions, in Essentials of Managed Health Care, ed. Peter R. Kongstvedt, M.D., 2nd ed. (Gaithersburg, MD: Aspen Publishers, Inc., 1997), 169173. Used with permission.

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

Course Goals and Objectives

After 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 pays prospectively for healthcare services on the basis of the number of plan members who are covered for specific services over a specified period of time rather than the cost or the number of services that are actually provided. Under capitation, the provider is actually compensated per personoften referred to as per capitarather than per service delivered. Typically, capitation payments 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 the financial exposure for identified services from the health plan to the provider. For the provider, capitation also carries with it some potential advantages. If the provider manages utilization costs so that those costs are less than capitation payments, the provider retains the savings. In other words, in exchange for accepting financial risk of higher-thanexpected utilization costs, the provider receives the right to share in any savings that occur when actual costs are less than expected. Capitation reimbursement is also paid in advance, without claim delays, which makes the providers cash flow more stable. Stable cash flows reduce business risk for providers, enabling them to pay from a predictable income any salaries or expense obligations they have. Capitation is central to health plans and has far-ranging effects on many aspects of contemporary healthcare delivery. A movement away from FFS and toward capitation represents a fundamental shift in risk distribution in a health plan. Along with other aspects of health plans, capitation has been largely responsible for a transformation in the U.S. healthcare delivery system. In responding to capitation and health plans, nearly every healthcare organization in the United States has had to change its organizational strategies and operations.1 From the health plans perspective, capitation motivates providers and provider organizations to provide services that improve members health status and to limit services that are unnecessary or not cost-effective. Capitation increases physicians awareness of the financial costs associated with their treatment decisions and encourages them to be cost conscious by aligning their financial incentives with their role in making treatment decisions.

Capitation, like other health plan programs, also usually ties members to specific providers and provider networks, limiting a members choice of providers to the plans provider panel in exchange for cost-effective care. In this lesson we will explore what capitation is and how it is used. We will also discuss the benefits and drawbacks of using capitation as a reimbursement method. 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 in understanding capitation and creating capitation rates for specific types of providers, services, and situations. These issues vary according to the size of the plan and the way in which the risk of higher-than-expected utilization is divided among the health plan, providers, and stop-loss reinsurers. 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, on a 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 of plan members for whom the provider has responsibility, rather than the number and type of services 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 calculate a simple monthly capitation payment (or PMPM amount) by multiplying the average number of services used by a member in one year by the average fee-for-service equivalent payment per service, and then dividing by the number of reimbursement periods per specified time period (for example, if the reimbursement period is one month, then the number of reimbursement periods in one 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 service by plan members. Determining the expected average utilization requires at least a years worth of experience from a population of credible size. FFS equivalents will also vary by the type of service.

Determining the Services Covered by Capitation To develop a capitation rate, a health plan or provider group must define the services covered by the 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 a plan will not be capitated. Typically, the reason for not capitating specific services is that the plan does not have a credible block of business with respect to that service. For example, services that are rendered only in the case of unusual illnesses may be needed so infrequently that it is impossible to predict accurately the average number of plan members who will use the service each year, and it is therefore impossible to develop an accurate PMPM rate. In such cases, the providers will be reimbursed according to another payment system, such as discounted FFS. Covered services that are outside the capitation rate are typically defined at the procedure or service level (using CPT codes), or at the patient diagnosis level (using codes found in the International 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 a threshold number of plan members designate that provider as their caregiver. Contractual provisions that allow capitated providers to be paid on a discounted FFS basis until the providers enrollment 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 than 100 children covered by the plan use that pediatrician as their PCP. If the pediatrician serves more than 100 children covered by the plan, then the pediatrician will be reimbursed according to the capitated rate. Low-enrollment guarantees cause a capitation contract to transfer less risk to providers than it would otherwise. In order to develop a capitation rate, a health plan (or provider group) must have data on (or make assumptions about) the expected utilization of the services covered. This is the most complex part of the capitation development (or analysis). Typically, health plans rely on internal or consulting actuaries, who in turn rely on data obtained from multiple health plans.

The importance of acquiring accurate utilization data has implications for health plan and provider information systems and data collection. We will discuss some of these issues later in this lesson. Other Capitation Issues Fee-for-service equivalents for each service included in a health plans benefit design are necessary 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. In either case, the FFS equivalents reflect the local or regional market. The capitation rate for any given provider is also influenced by the presence of noncapitation contractual elements that apply either to the reimbursement agreement between the health plan and providers, or to the design of the healthcare plan itself. These elements, which we will discuss in more detail later in this lesson, include withholds, risk pools and reconciliations, and member 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 PMPM type of capitation. In practice, capitated PCPs often work under a PMPM contract. PMPM capitation is the most common type of capitation. The second type of capitation uses a percent-of-premium approach to reimbursement arrangements. Percent-of-premium arrangements are capitation contracts in which the reimbursement to providers is a percentage of the premium payment the health plan receives for providing healthcare coverage to plan members. Like PMPM capitation, percent-of-premium arrangements transfer the risk of overutilization from the health plan to the provider. Unlike PMPM capitation, which sets reimbursement at a specific dollar amount per plan member, the dollar amount paid to providers under percent-of-premium arrangements will vary according to the 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 with underwriting and rating from the health plan to the provider. In other words, under percent-ofpremium arrangements, the providers share some of the risk that the health plan has set premiums too low to cover the actual costs of providing covered benefits to plan members. Of course, in cases where the premiums have a sound actuarial basis and the plan members morbidity experience falls within the predicted range, providers share in profits generated by the premium rates. The exact amount of underwriting risk being transferred in any given percent-of-premium arrangement will vary according to the percentage of the premium that is being paid to the providers 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 provider organization to the health plan. For instance, if the health plan finds it necessary for competitive reasonsto decrease premiums, the provider organization will receive smaller payments because those payments are based on a percentage of the premiums. In contrast, a PMPM capitation rate will result in the same payment to providers no matter what premium rate the 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 provider organization may bear much of the risk for the financial and underwriting decisions made by the plan. For this reason, percent-of-premium arrangements are much more attractive to providers when these arrangements include provisions that set a limit on the underwriting risk that the providers accept. One method of limiting this risk that is therefore a critical part of the large majority of commercial group health plans percent-of- premium contracts is to set a minimum capitation payment, such as a PMPM floor. Such floor rates evolve out of actuarial considerations and market forces, but their purpose is to limit the underwriting risk providers accept. Under such contract provisions, the health plan guarantees a minimum capitation rate will be paid to providers regardless of any premium decreases. In situations where premium rates are established by 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 rather than on a per-service basis. Both also can be used as the reimbursement methodology for many different types of providers and provider groups. Within either type of capitation, variations occur based on what kind of providers and medical services are covered under the capitation contract. The following list describes some of the common types of variations: PCP capitation PCP capitation, also called partial capitation, is a capitation payment that reimburses the provider for primary care services only. Typically, the PCP will refer patients to specialist providers for services such as radiology, surgery, and laboratory tests. Specialty capitation Specialty capitation uses capitation reimbursement to pay individual specialists or single-specialty groups to provide a contractually defined set of services to a health plans members. Full professional capitation Full professional capitation , sometimes called full professional services capitation, is a capitation payment that covers all physician services, including primary care and specialty services. Typically, this method of reimbursement is used to compensate provider groups of various types, such as clinics and multispecialty IPAs, and these groups in turn accept responsibility for the costs of all physician services related to a patients care. Global capitation Global capitation, also called full-risk capitation, is a capitation payment that covers all physician and facility services, including hospital inpatient and outpatient services, primary and specialty care, and some ancillary services. We discuss each of these capitation variations in turn and how elements within capitation contracts 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 providers or plans performance.

PCP Capitation Primary care provider (PCP) capitation is, by far, the most common type of capitation. In health plans that capitate their PCPs, new enrollees are required to select a PCP who will serve as their main 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 visits to hospitalized plan members. Although plan members can receive emergency care without first seeing a PCP, for other services beyond the scope of primary care, members must be referred to specific 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 role are known as gatekeeper model plans. Thus, under a gatekeeper model, PCPs, whether they are capitated or not, manage the risk of overutilization of specialty services and diagnostic tests. Most primary care capitation arrangements do not make the provider financially responsible for the cost of major diagnostic tests (such as an MRI) that a PCP might order. This is because a single expensive test that is rarely required can be much more expensive than many months of average PMPM paymentsand so its inclusion in the covered services list creates a disproportionately large financial risk for the physician. In cases where the PCPs capitation contract does not make the PCP responsible for the cost of specified expensive tests or procedures, the utilization risk for such costly services is borne by an entity covering a large volume of members and services. Such entities are capable of accepting more risk than individual PCPs are able to accept. Examples of this type of entity include a large group practice, an independent practice association (IPA), an integrated delivery system (IDS), or the health plan itself. Provider organizations accepting such risk might act as the health plan would, if responsible for these services, and screen for the appropriateness of, and require prior approval for, these services. Specialists and other providers to whom members are referred by PCPs are usually paid under a separate capitated or discounted FFS contract with the health plan. If PCPs are reimbursed on a discounted FFS contract, then the charges for these outside lab and X-ray services will be paid by the health plan, which in turn typically subtracts that payment from the monthly capitation disbursement 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 when referrals exceed expected levels, and methods of providing PCPs bonuses when referral rates are lower than expected, serve as means by which a PCP can be financially motivated to avoid making unnecessary referrals. PCP capitation contracts also, however, usually include provisions intended to protect the PCP against the financial consequences of having a patient (or patients) with a catastrophic illness, and/or from high member utilization caused by forces beyond the PCPs control. We discuss these 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 specialists typically requires that members be tied to specialists in some way so that the specialists PMPM reimbursement can be determined. In some health plans, women designate an obstetrics-gynecology (OB-GYN) provider, in much the same way as they would designate a PCP. This designation makes it possible for the plan to reimburse that OB-GYN provider on a capitated basis. Aside from plans where a woman designates an OB-GYN provider, tying each member to specialists when the member enrolls is only possible if the plan design is aligned with the capitation reimbursement model. For example, the plan may tie the enrollees choice of a PCP to a specific referral circle, which is a geographically distinct group of physicians, usually those with privileges at a local hospital, for all specialty referrals. Similarly, the choice of a PCP can link the member to a multispecialty group practice, an IPA network, or an IDS. This type of arrangement ties the members to a group of specialists in advance of the members need for specialty care, which allows for capitation of those specialists. Certain highly specialized physician services (such as neurosurgery or organ transplants) generally would be excluded from the capitation. Capitation of specialized provider services tends 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 some services influence all providers in capitated contracts and why, for some specialty services, high cost 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 are extremely low. Although the population utilization rate may be low, a specialist who happens to experience even a small number of very expensive cases risks very high losses under such a contract.

This potential for unexpectedly high costs in some specialty care situations makes traditional capitation less attractive to specialists than it is to PCPs. Given these risks, specialty physicians and health plans usually choose some form of discounted FFS (or other service-specific) payment system. The specialist and health plan can also agree upon case-specific reimbursements for certain types of cases. For example, a case-specific reimbursement might cover professional services 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 of services that health plans consider primary care and specialty care. In most health plans with PCP capitation, a physician must choose whether to participate as a PCP or a specialist. A PCP cannot self-refer for specialty servicesservices beyond those typically provided by a PCP. Likewise, a specialist cannot receive specialty capitation and be the members primary contact with the plan. These provisions, while developed to avoid financial conflicts of interest, can impede continuity of 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 physicians group that is reimbursed through full professional capitation. Full professional capitation is a provider reimbursement method that capitates physician groups that provide both primary and specialty care. Full professional capitation payments cover all physician services and associated diagnostic tests and laboratory work. Typically, under full professional capitation, a health plan capitates an entire physician group 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 physicians will be remunerated. In an IPA, individual physicians may be paid on a subcapitation basis, a discounted FFS basis, an RVS-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, an IPA) receives either full professional or global capitation from a health plan and then separately subcontracts with a physician, physician group, or other provider organization for specific clinical services, using a capitated payment to reimburse the subcontractor. Only specialties that have high volume and predictable cost patterns are normally considered for subcapitation. The capitated entitys purpose in entering subcapitated arrangements is to minimize the utilization risk it bears in its capitation contract with the health plan, and to align the incentives of the subcapitated specialty providers with those of the capitated entity. For example, if an IPA receives capitation reimbursement from a health plan, the IPA accepts utilization risk under that capitation contract. By subcapitating providers, the IPA transfers some of its utilization risk to those providers. The type of capitationPMPM or percent-of-premiumreceived by the provider entity does not dictate 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 individual physicians using either a PMPM or percent-of-premium capitation methodology. If, however, the subcapitation is PMPM and the full professional capitation is percent-of-premium, then the capitated entity is incurring the risk that the percent-of-premium payments it receives from the health plan will be insufficient to meet the entitys fixed PMPM obligations to its subcapitated physicians. If the capitated entity in a full professional capitation arrangement pays any of its providers using FFS or RVS-based payments, there must be a year-end budget reconciliation comparing capitation payments received by the entity from the health plan against fees paid to individual physicians by the entity. In a multispecialty group practice accepting full professional capitation, individual compensation may be based on salary plus a bonus; some FFS, RVS, or RBRVS basis; or an internal subcapitation. Multispecialty groupsor even PCP groups may also accept a full professional capitation and then 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 have an advantage over individual specialty physicians in capitated contracting as long as the provider

organization has enough volume to prevent any one physician from shouldering a disproportionate share of risk. This advantage in capitation contracting is a factor in the growth of many physician groups Global Capitation Global capitation, also called full-risk capitation, is a capitation system that pays a provider organization to provide substantially all of the inpatient and outpatient servicesincluding clinical, primary, specialty, and ancillary services that the health plan offers. As a consequence of accepting a global capitation contract, the provider group accepts much of the risk that utilization rates will be higher than expected. However, out-of-network care that is rendered outside the plans geographical area is usually excluded from the reimbursement and is the responsibility of the health plan. At a minimum, health plans also retain responsibility for marketing, enrollment, premium billing, actuarial, underwriting, and member services functions. Global capitation is usually accepted and administered by an IDS, although other provider organizations also enter into global capitation contracts. Recall that an IDS is a provider organization that is fully integrated operationally and clinically to provide a full range of healthcare services, including physician, hospital, and ancillary services. Integrated delivery systems are typically built around a hospital or hospital system. The physicians might be employed directly by the IDS, or they might be affiliated through a physician-hospital organization (PHO) or a contracted network. Alternatively, a large multispecialty physician practice or a physician contracting organization called an IPA might accept global capitation and subcontract with hospitals for inpatient services. Generally these entities seek to improve operating efficiencies by creating economies of scale and reducing overhead. They also implement broad policies and procedures that include system-wide approaches to quality management and improvement. From a strategic perspective, they create a regional (or brand) identity, and they market a quality-oriented and customer focused image to consumers. However, under global capitation direct contracting arrangements, IDSs essentially have to replicate internally (or externally contract for) many of the functions a health plan otherwise performs. Again, however, IDSs face significant challenges in securing sufficient capital to develop operational and informational systems infrastructures and in developing expertise in plan management. In most markets, health plans have more experience performing most of these functions. In some states, providers must obtain a license and meet solvency requirements in order to participate in global capitation or other arrangements that require the provider organization to take on substantial risk. Securing a license involves time and financial investment and can present a significant barrier for provider organizations seeking global capitation arrangements. Another implication of global capitation is the need to divide reimbursement among the hospital(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 with health plans. As is the case with health plan provider payment systems, the system an IDS uses to divide 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 will not wish to renew their contracts. Dividing the global capitation payment may be much easier when one entity secures the global capitation contract and then negotiates subcontracts for specific servicesbe it a physician organization 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 to discrete programs covering entire categories of caresuch as mental health, pharmacy benefits, and even specific diseasesthat are usually administered by independent organizations. Examples of the first type of carve-out are specific services such as childhood immunizations or expensive lab and radiology services that are excluded from PCPs capitated reimbursement payment 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 independent organizations, the organizations are typically reimbursed under a capitated PMPM contract. For example, mental health services have often been carved out by health plans, which contract with 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 required to effectively manage mental health services. Over time, however, this trend in managing mental health services has slowed, and many health plans are integrating mental health care with medical care. 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 manage the 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 drug interactions, and negotiate significant discounts from drug manufacturers. One method commonly used to control utilization and cost is the use of formularies. A formulary is a listing of drugs, classified by therapeutic category or disease class, that are considered preferred therapy for a given health plan population and that are to be used by a health plans providers in prescribing medicines. Drugs are placed on the formulary because of their effectiveness 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 for identifying plan members with specific diseases, and structured programs of interventions designed to manage the disease, improve patients functional status, improve quality of care, and save 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 who are capitated, because the risk of having to provide high-cost treatments for these diseases is carved 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 DM program for patients with a given, usually chronic, disease. Contact Capitation Contact capitation is a form of payment in which specialists receive a flat, predetermined fee once a referred patient begins to receive treatment from them for a given condition. This is similar to a case ratea flat fee paid to the provider in order to care for a patient with a given conditionwhich we discussed in the last lesson. In general, contact capitation works as follows. A plan (or an IPA or IDS that accepts either capitation 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 a PCP refers a member to a specialist and the specialist sees the member, the specialist begins to receive a share of those funds on a monthly basis. The method used to determine the size of the share and the number of months the specialist receives the contact capitation payment vary by organization.2, 3 The monthly payment for each specialist is determined by taking the number of active contact capitation 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 capitation patient could be active for as little as two months or as long as a year, depending on the plan and the 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 working within a specific managed care model have a similar case mix on average. Other contracts may use a simple case mix adjustment that sets an amount of extra credit for each sicker or older patient. Finally, some contracts call for adjusting relative payments according to each patients diagnosis or diagnosis and age and sex. 4 Even under such a system, however, the essential model for contact capitation remains the sameto divide a pool of accumulated specialty-specific PMPM contributions by either the total number of active contact capitation patients or the active con- tact capitation patients total number of relative value units within an RVS or RBRVS system.

Contact capitation rewards the provider for controlling the costs of each case, which ultimately lowers healthcare costs. Because providers who are reimbursed through contact capitation are paid for each case they see, however, the risk of overutilization still exists unless some control is in place to monitor how many cases are presented to these providers. Often, the control is a gatekeeper PCP whose own reimbursement is not affected by the number of cases the gatekeeper refers 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 the absence of capitation, providers are sharing some of the financial risk associated with their treatment decisions. Withholds, risk pools, and periodic tracking and reconciliation of these accounts are all means of transferring some financial risk to providers who have some control over 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 exceed the budgeted costs for care during that period are charged against the withheld funds, and after such 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 groups to be cost- and quality-efficient. Historically, they have been a common feature of IPA model HMOs, which are HMOs that contract directly with independent physicians in private practice. In IPA model HMOs, PCPs are generally capitated, specialists are paid on a discounted FFS basis, and hospitals are typically reimbursed using per diems. The details that follow are based on that type of model. Health plans may create several risk poolsfor example, in hospital utilization and various types of specialty carewithin a given healthcare plan. A full professional capitation arrangement might include a risk pool for hospital utilization, but would not include a specialty risk pool because the capitation payment incorporates a fixed fee for specialty care. Similarly, in a global capitation 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 in any other provider reimbursement method: to financially reward providers who control utilization. For example, if a networks PCPs are capitated, then they are financially rewarded for transferring to specialists those patients who generate high costs. This motivation exists whether or not the patient is best served by seeing a specialist. But if a withhold or risk pool is incorporated into the PCPs contract, then some portion of the expense for the specialists can be deducted from the withhold or risk pool. This deduction puts the PCP at risk for overutilization of specialists, and therefore motivates the PCP to avoid making unnecessary referrals. Withholds are amounts withheld from physicians reimbursement pending year-end analyses of utilization 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 not have a portion of their payments similarly withheld. A portion or all of the withhold amounts may cover any shortages in the targeted risk pool funds. If there are surpluses, physicians can receive not 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 who negotiate actuarially defined risk pool targets. The targets are typically set as PMPM amounts for specialty care and days per 1,000 members per year for inpatient care. The target amounts are age- and gender-specific and are summed to generate the actual risk pool amounts. At the end of the year, PCPs with specialist costs and/or inpatient utilization costs that are over budget will lose some of their withhold amounts. PCPs with lower specialist costs and lower inpatient utilization costs will receive the withholds, plus a bonus. Physicians generally share risk with other physicians (for both the specialty and hospital risk pools), as well as with the local hospital (for the hospital risk pool only). There may be several levels of pooling of riskan aggregate level that determines the maximum payout level per physician and a local (or individual) level that determines a specific physicians 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 of physicians who practice independently into what is called a pool of doctors, or risk pod . A risk pod is a small group of physicians practicing independently within a geographic region who are treated as a group for the purposes of measuring performance or setting compensation. A risk pod will typically contain approximately five to ten physicians. Physicians within larger groups, such as 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 physicians typically will share in the risk pool for inpatient services (a "shared risk" arrangement). In other cases, 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 are not) covered by the capitation payment, the same applies to risk pools. In general, only those items that are within a physicians control should be part of the risk pool calculation, because the primary 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 the utilization rate of the covered services. For example, emergency hospital services are sometimes excluded from risk pool arrangements for capitated physicians, because physicians cannot control the number of emergency hospital visits plan members will make. However, physicians do have some control over the overutilization of hospital inpatient days for patients who are not receiving emergency 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, and how items charged against the risk pool will be priced. For instance, many services have professional 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, usually one year, though this may vary. In any case, as the year progresses, providers should receive monthly 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 a financial 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 and bonuses based on utilization rates alone and to shift toward reimbursement methods that consist of 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 financial factors 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 childrenor other similar measures (for instance, cholesterol screening, flu vaccination) Drug formulary adherence A health plan or delegated provider organization can design bonus amounts so that they vary for different levels of performance, and base the bonus paid on a percent of capitation or on a PMPM rate. In such bonus arrangements, however, it is important that the bonus amounts generated by quality-of-care measures do not exceed the total level of surplus available for distribution through the bonus. Quality-related bonus arrangements such as those described above can be applied to PCPs, specialists, and hospitalswhether or not the base payments are actually made on a capitated basis. PCPs paid on a discounted fee-for-service basis, specialists paid on a discounted FFS or case-rate basis, and hospitals paid on a percentage-of-charges, per diem or DRG (case rate) basis may 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 larger proportional bonus than the bonus received by providers who accept less risk through FFS contracts, 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 for reconciliations, or settlements, to be performed at year-end. Consequently, they are often called year-end reconciliations. However, they may be done quarterly or at any other frequency agreed to 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 calculations generally require that at least three months and possibly as much as six months have passed from the closing of the evaluation period. The time required to receive all (or nearly all) claims for a given period is known as the run out period. From a business point of view, the health plan must balance the additional accuracy gained from waiting an extra month for any claims straggling in against the importance to providers of the health plans reporting results as soon as possible. In any case there will almost always be missing datafor instance, claims incurred but not reported (IBNR) from out-of-network providers. Therefore, contract provisions should address situations involving 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 different organizations and health care professionals. The two most common types of providers receiving capitation are physicians and hospitalssometimes separately, sometimes together. In this section of the lesson, we discuss the capitation arrangements made most commonly by physicians, hospitals and integrated delivery systems (IDSs). Figure 4A-3 summarizes different providers and the types of services that are often capitated. Given all these variations and details, it should be no surprise that physicians increasingly rely on professional administrative expertise in negotiating contracts with health plans. A group practice may employ (or contract) with an internal practice administrator. But physicians also rely on IPAs, management service organizations (MSOs) and PHOs to help them gain access to members covered by a variety of health plans and to negotiate the best possible contract terms. To enable these organizations to negotiate the best arrangements, physicians may even give them single signature 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 outpatient services. Because hospitals operate in-house laboratories and radiology services, and may own satellite locations providing these services, they may be capitated for outpatient lab and x-ray services, 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 methods for 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 care to patients who are in the hospital. However, they may also provide financial motivation for hospitals to keep patients for as many days as possible. In practice, risk pools are also used to contain inpatient utilization. Inpatient risk pools may be structured so that physicians and the health 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 and integrated delivery systems that can accept global capitation payments. Then the hospital as a major player in these networks or IDSs can capture more of the premium dollar and retain more of the savings generated by reducing both costs per day and bed days per 1,000 enrolled plan members. Providers and hospitals, however, face many challenges in seeking to form IDSs. IDSs require significant start-up capital, as well as expertise in managing a large healthcare entity composed of many different types of providers. Furthermore, such IDSs still must be able to negotiate a successful global capitation or global percent-of-premium contract, and once a contract is in place, these global payments must be equitably divided among participating providers.

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, relevant feedback to providers is essential for controlling costs and monitoring qualitytwo essential functions in health plans. To perform these functions and set reimbursement rates on the basis of utilization, a health plan must have a sophisticated information system. A simple example of information requirements for health plans is member processing. To develop capitation rates, health plans must identify and capture demographic information for every covered member, because, at the most basic level, capitation contracts reimburse per member per month based on a members age and gender. Health plans and provider organizations that subcapitate other providers must have means of reporting utilization and costs on a per member basis. Without the systems infrastructure and accompanying data they would be unable to manage their business. Timely, accurate data supports day-to-day plan management and financial control. Although health plans generally own operational models and information systems that can process and analyze the information necessary to operate complex health plan functions, many providers such as hospitals and physicians still face the challenge of building information systems that reflect health plan requirements. The fast pace of change in provider organizations and the level of consolidation that has developed as a consequence of instituting health plan practices leaves 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 financial risk traditionally held by insurance companies and health plans. The challenge for providers is to merge 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 following elements:
A member information and eligibility module. This module contains basic

demographic information about plan members and includes on-line or frequent disk or tape updates from health plans. These updates include demographic information, health plan, plan type, copayment levels, deductibles, and coordination of benefit (COB) information. A patient utilization module allowing for real-time collection of all patient encounter information including diagnosis, service and procedure codes, and any relevant billing information (e.g., copayment levels, deductibles). An ability to track and reconcile member eligibility (member additions, changes, and terminations) and capitation payments made by multiple health plans, each with multiple product 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-line

data capture. Key Capitation-Related Information System Components In addition, provider organizations at risk for specialist and/or hospital utilization must have the ability to track incurred but not reported (IBNR) claims, especially if they will subcontract and reimburse some services on a FFS basis. Generally these systems involve matching referrals to claims paid and the systems must be able to accrue an estimated amount due for those referrals at a given point in time without accompanying claims. In percent-of-premium capitation systems, health plans must be able to obtain information on plan members. In the large majority of cases, the health plan will be charging different premium rates to different groups, which means that the information system must track which members from which groups sign up with a given provider. Then the health plan and provider must use this data to determine how the percent-of-premium payment can be divided as fairly as possible among the various capitated providers. Accuracy and timely data capture enables effective reporting, which in turn facilitates better management and improved planning. Reports showing utilization per member per month (and, if applicable, IBNR claims), gives provider organizations information on actual utilization relative to budgeted amounts. 8 Accuracy and timeliness are important elements in data management because they help both providers and health plans avoid significant losses. Data should be reportable by health plan, by product line (for example, commercial, Medicare, Medicaid)and possibly by the same age and sex categories used for capitation payments. In the case of percent-of-premium capitation contracts, both the health plan and the capitated providers will be motivated to analyze costs by employer group to make sure that the health plan is properly rating and underwriting each group. In cases where a groups premiums do not adequately reflect the actual risk the group represents, then both the health plan and the providers are unintentionally accepting greater-than-expected risk through the percent-of-premium reimbursement contract. Other internal reports might examine the cost side: physician time/cost per visit, non-physician clinician time/costs per visit, visits per member per year, and overhead. Together such data would enable the organization to monitor clinical productivity and to provide timely feedback to physicians 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 make assumptions about future utilization. The more accurate the utilization assumptions, the more realistic the capitation rate. More realistic capitation rates benefit both the health plan and the providers, since it reduces the financial risk faced by each. In addition, health plans typically have either in-house or external consulting actuaries available to support their efforts. Providers, provider organizations, and IDSs also contract with actuaries who provide the expertise that the providers need to negotiate knowledgeably.

Actuaries are experts in studying and modeling utilization and the effects of variations in cost sharing (copayment levels and deductibles), benefits (inclusions and exclusions), and plan design variations (gatekeeper versus open access, in-network only versus in-network and out-of-network benefits, etc.). Actuaries are also responsible for generating the standard age- and sex-specific PMPM cells in capitation reimbursement tables. We discuss underwriting and rating in more detail 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 service rendered by providers is important. Information used to determine these fees can come from many 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 each unit of service, and frequently want to adjust individual fee assumptions. After year-end settlements, physicians who are analyzing their contracts will want to know the fee-for-service equivalent 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 capitation contract covers physicians from different specialtiesphysicians in a multispecialty practice or those who are part of an IPA or an IDS with a full professional or global capitation contract. Use of 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 for specific services. Thus providers or a health plan can use an RVU scale to develop a capitation rate, analyze a rate or allocate a capitation payment among physicians within a single-specialty group or among physicians in a multispecialty group. 9 Once FFS equivalents have been chosen, they should be adjusted for the expected member copayment levels. Member Tracking and Eligibility Issues In plans with capitated payment arrangements, tracking eligibility is an important issue for providers and health plans. Because of their dealings with employer groups, health plans are accustomed to retroactive member additions and deletions. Providers, however, may be less accustomed 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 is added to a PCPs panel because he or she needed to see a PCP, and visits the office the same month that the PCP receives the first capitation payment for that member. If the member had been on the plan but had not previously selected a PCP, the provider typically can collect retroactive capitation payments from the health plan.

The second problematic situation occurs when a member is retroactively terminated after the provider has been paid one or more monthly capitation payments for the member, possibly after the member has received services from the provider. Although some health plans absorb the capitation expenses instead of passing them to the provider, many do not. Those health plans that do not absorb the expenses pass the expenses to the provider by retroactively adjusting the providers capitation paymentand then, if any services have been rendered, the physician must pursue 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 a payment, in a simple capitated environment there is no direct financial incentive for providers to accurately document the specific services received by patients on each visit (typically referred to as an encounter). Data collection in a capitated environment is thus sometimes inaccurate. However, any systematic underreporting of utilization leads to an overestimation of the effective reimbursement received per unit of care (the fee for service equivalency calculated by dividing total capitated payments by the number of services delivered). Underreporting therefore makes the provider organization appear to be achieving better financial results than it actually is under a given contractual capitation arrangement. Data that fails to capture all utilizaion will erroneously indicate that the capitation rate is excessively high. This in turn may cause the health plan to seek lower capitation rates. Providers will have no data to demonstrate that these lower rates would be inadequate. While underreporting of encounters may at first appear to be in the health plans financial interest, 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 those responsibilities to other parties. Health plans that retain claims payment responsibilities also retain the responsibility to gather information from and share results with providers. To correct information-reporting problems, an effective information system must be in place at the provider location. The system must capture data and regularly transmit it to the health plan so that utilization and financial analyses are based on the most accurate data available. In fact, some health plans make an incentive payment (e.g., an extra 1% bonus on capitation payments) to providers 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 financial reimbursement model that exerts a powerful influence on care delivery, continues to evolve as well. Some examples of capitation variations and provider reimbursement concepts are listed below. Most are still at the conceptual stage, while some have been put into practice in at least a limited way. These provider reimbursement concepts can be organized in the following categories:
Payment arrangements affecting PCPs (PCP capitation with FFS for preventive care, and

reimbursement for the gatekeeper role)

 Payment arrangements affecting both PCPs and specialists (specialists receive primary

care capitation, capitation for specialists and FFS for PCPs, and Open Access plans and reimbursement) 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-service basis, even if the PCPs are capitated for other services. For example, the HEDIS reporting formats show plan performance on providing eye exams for people with diabetes, flu shots for older adults, and childhood immunizations, among other measures. Paying PCPs for providing these services on a discounted fee-for-service basis encourages physicians to perform these services, which, in turn, improves the quality of patient care. The claim generated enables the plans information system to capture each service provided. Reimbursement for the Gatekeeper Role Primary care physician capitation payments theoretically cover the expected utilization of members with the PCP receiving a discounted FFS-equivalent for each service. However, there is an additional category of work involved in the PCP rolepatient care management. In response to physicians concerns that they were not being paid for this role, some plans have designated part of the capitation payment to PCPs as a PMPM payment for administrative tasks related to the gatekeeper role. Specialists Receiving Primary Care Capitation Individuals with chronic conditions are often treated predominantly by specialist physicians who are experts in treating these conditions. In some of these situations, quality of care is significantly improved by having specialists closely involved, monitoring these members and treating their conditions, even when the members require services otherwise considered primary care. However, a capitated health plan using a gatekeeper model typically requires these individuals to see their PCP first for a referral to the specialist. A relatively large percentage of complaints received by health plans that use gatekeeper models grow out of these situations because these members are regular users of healthcare services, and frequently both they and their doctors feel frustrated by the constraints of the gatekeeper system. (These situations are less frequent for health plans that do not capitate PCPs, and in open access plans that allow self-referral to specialists.) One possibility is to make the specialist the PCP of record. In some cases, the specialists managing these patients are, in fact, internists with a subspecialtyfor instance, endocrinology or cardiology. However, patients with chronic illnesses use healthcare services more than the average 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. But this is almost always impossible in a gatekeeper model because most plans make physicians choose at the outset whether to be listed as either a PCP or a specialist, and nearly all plans prohibit self-referrals as a means of controlling overutilization. Some health plans have devised special arrangements by modifying health plan contractual policies to accommodate these members and their special requirements. These modifications include 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 plan members who have chronic conditions. Capitation for Specialists, FFS for PCPs Typically, PCPs are capitated in gatekeeper models, but the majority of specialists are not. Some plans, however, are experimenting with reimbursement systems that pay PCPs on a FFS basis and specialists through capitation contracts. 10 The reasoning behind the creation of this payment system is that specialty care is very expensive relative to primary care, and therefore plans should encourage PCPs to provide as many of the covered services as they can. By paying them on a FFS basis, and capitating specialists, health plans can minimize their costs. Once capitated, specialists need not get prior authorization to provide a given treatment. Thus they gain a level of autonomy by assuming the risk for high utilization. Open Access Plans and Capitation Open access health plans are plans where members can self-refer to any network specialist. This plan design makes it harder to accurately capitate PCPs because members will self-refer to specialists for services otherwise included in PCP capitation payments. PCPs will also be reluctant 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 then have 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 Health Plan Agreements, Healthcare Financial Management (April 1998): 4750. 3. Judith Horowitz, Contact Capitaiton: An Alternative for Specialist Capititation, Healthcare Financial Management (Novemember 1997): 5455. 4. Bradley Munson, Douglas Cave, and Kurt Heumann, New Payments and Incentives in Contact 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. Healthcares Quality-Based Compensation Model, Health Care Financing Review 17, no. 3 (Spring 1996): 4359.

7. James Hager, Aligning Performance and Payment Criteria, in The Capitation Sourcebook, 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, Healthcare Finanical Management (November 1997), 7376. 10. S. Kullman, Capitation is for Specialists, Not for Primary Care Physicians, Health Plan (August 1997), 99109.

AHM Health Plan Finance and Risk Management: Risk Transfer in Health Plans Course Goals and Objectives After completing this lesson you should be able to Distinguish between the terms stop-loss insurance and stop-loss reinsurance from the insurance 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 parties to a health plan provider reimbursement contract. This lesson explores the management strategy of transferring risk. Health plans, employers with self-funded plans, and providers with capitation or other risk-sharing reimbursement contracts all face a number of risks in the course of playing their roles in managed healthcare. As we mentioned in Risk Management in health plan1s, health plans and provider organizations use various types of liability insurance to transfer a number of risks that are not unique to health plans. For example, a health plan may purchase fire insurance to 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 liabilities generated in health plan by utilization rates. Transfer Approaches Health plans use two basic means of transferring utilization risk and the risk of higher-thanexpected medical expense outcomes. The first, as we have discussed in previous assignments, involves reimbursement arrangements with providers, including capitation contracts and other payment 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 the risk of higher-than-anticipated medical expenses. The insurance typically used in this type of risk transfer includes various forms of stop-loss insurance and stop-loss reinsurance. In the healthcare industry, 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 what type of entity is purchasing the policy. According to this distinction, stop-loss reinsurance is a type of insurance that an insurer purchases to transfer the risk of loss on medical expenses above a certain amount, either for individual catastrophic cases, or for the total medical expense liability incurred 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-risk contracts, employers with self-funded healthcare plans, and health plans that are not regulated by state insurance departments.

Under a stop-loss reinsurance contract, a health plan that is regulated as an insurer is transferring risk from itself to a reinsurer. The reinsurer accepts this risk in exchange for a premium that the health plan pays. An entity that is not licensed as an insurer, but that is at risk for medical expense losses for example, a physician group under capitation or an employer offering a self-funded healthcare plan to its employeesbuys stop-loss insurance, but not reinsurance. In a few jurisdictions, however, courts have held that the stop-loss protection purchased by employers offering self-funded plans is reinsurance rather than insurance, even though such employers are not licensed insurers. Because the core function of both stop-loss reinsurance and stop-loss insurance is the samethe transfer of risk in exchange for a paymentwe will use the term stoploss coverage in cases that apply equally to insurance and reinsurance. In other words, stop-loss coverage can be either in the form of insurance or reinsurance and can be purchased by any of the parties 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 that provides 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 stoploss coverage. After describing these two types, we will examine some important features of each. Specific Stop-Loss Coverage Specific stop-loss coverage is insurance or reinsurance that provides protection against losses arising from individual cases in which medical expenses are disproportionately large or catastrophic. 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 acute illnesses of one or two plan enrollees do not wipe out all or a significant percentage of a providers capitation reimbursement or risk pool allocation. Specific stop-loss coverage normally applies to each and every member for whom the provider (or employer or health plan, as the case may be) is at risk. Thus, specific stop-loss coverage is triggered on a case-by-case basis when an individual member experiences serious illness or injury that requires expensive medical treatment. If, on the other hand, higher-than-expected medical costs occur exclusively because the plan 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 occur when utilization rates among a covered population as a whole are significantly higher than anticipated 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 under aggregate stop-loss insurance against losses associated with an unexpectedly large number of its covered employees seeking medical treatment during the same coverage period. In contrast to specific stop-loss coverage, aggregate stop-loss is triggered when the total covered medical expenses generated by the plan reach an agreed-upon level, rather than by individual high-cost cases.

Stop-Loss Attachment Points An important feature of any stop-loss coverage is that coverages attachment point. The attachment point is the loss amount that must occur before the stop-loss coverage begins to cover any expenses. The higher the attachment point, the greater the risk retained by the entity purchasing the stop-loss coverage, and the lower the cost of that coverage, all other things being equal. In other words, the attachment point of a stop-loss insurance or reinsurance agreement functions like a deductible. The purchaser of the stop-loss coverage pays all expenses up to the attachment point. For expenses 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 purchaser for 100% of the costs above the attachment point. Instead, there is usually a corridor of expense amounts 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 purchasers risk tolerance in relation to the cost of the stop-loss coverage, the size of the corridor, the amount of the attachment point, and other coverage variables. Beyond this corridor, the stop-loss coverage may reimburse the purchaser at 100% of all additional expenses as 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 greater than the attachment point, notice that both the hospital and the health plan benefit from the structure of this stop-loss coverage.

First, the hospital receives protection against the risk that one or two large-amount claims will wipe out the hospitals entire withhold pool. Second, because the hospital and the health plan share the exposure to risk for the first $75,000 of a patients 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, even though the hospitals total exposure to loss is only $35,000. Third, the hospital is motivated to notify the health plan of serious cases relatively early and to work with the health plan in developing the best treatment option for the patient, which enables the 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 hospital at risk for overutilization. Placing the provider at risk is a key cost-control element in many health plan strategies. The availability of stop-loss coverage allows the hospital (or other providers) to share risk and utilization management without placing the hospital in the position of assuming so much risk that its own solvency is in danger. Aggregate stop-loss also uses attachment points. These attachment points are set at some percentage above the predicted costs faced by the purchaser. Beyond the attachment point, the purchaser 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 provider groups predicted healthcare costs are $1,000,000 for the year. The provider group could purchase aggregate stop-loss with an attachment point of 115% of the projected $1,000,000 costs, and copayments of 10% for any costs above the attachment point. In this case, then, the attachment point is $1,150,000. If actual costs for the year were $1,350,000, then the provider group would be responsible for a) all of the costs up to the attachment point ($1,150,000), plus b) 10% of the costs 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 are responsible 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 purchase aggregate stop-loss coverage because most stop-loss carriers require high attachment points in aggregate stop-loss. Aggregate stop-loss essentially transfers underwriting risk from the purchaser to the carrier. As we noted in Risk Management in Health Plans, underwriting risk is the largest risk health plans face. Providing aggregate stop-loss with a low attachment point to a health plan would require that the stop-loss carrier accept most of the risk for the health plans core business. This degree of risk would therefore require the carrier to charge a premium that would be nearly as large as the premium the health plan charges to provide the group healthcare coverage. Thus, in most cases, aggregate stop-loss for health plans is either too expensive or has such a high attachment 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 important distinction between stop-loss coverages is the manner in which claims are settled. The stop-loss contract may provide that claims are settled using a paid claims method, or on an incurred claims method. Under the paid claims method, the stop-loss carrier is obligated to make stop-loss payments based on when the stop-loss policyholderfor example, a group employerpays the claim for the enrolled members medical expenses. Until the policyholder pays the claim, the stop-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 the applicable claims as of the date the medical expense was incurred. Figure 4B-2 provides examples of both the paid claims and incurred claims methods of settlement.

The difference between paid claims and incurred claims administration is an important issue for risk 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. At both the beginning and end of stop-loss contracts, some claims will have been incurred but not paid. In the example described in Figure 4B-2, for instance, if the term of the stop-loss contract ends on September 1, then in the absence of any other agreement, the stop-loss carrier will be obligated to pay its share of the expenses under the incurred claims method, but would not be obligated to pay under the paid claims method. The reverse would be true if the stop-loss coverage 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 for the plan to process the providers bill combine to cause most payment dates to follow treatments by more than 30 days. For this reason, some expenses will be incurred before the stop-loss contract year begins but paid after the contract year begins, and some expenses will be incurred before the contract year ends but not paid until after the contract year ends. Thus, the parties involved in stop-loss coverage must make certain that the coverage matches not only the level of risk that the entity seeking the coverage can tolerate, but also that the timing of the coverage is appropriate to the needs of the parties. Incurred Claims and Paid Claims in Stop-Loss Settlement A stop-loss contract can be written to cover any number of variables having to do with the contract period, when claims are incurred, and when claims are paid. Variation in contracts can include the following types of clauses (the "claims" listed below are assumed to have met the appropriate aggregate or specific attachment points): Claims paid- Claims will be covered if paid during the contract year, no matter when the expenses were incurred.

 Claims incurred and paid Claims that are both incurred and paid during the contract year will be covered. Claims incurred and paid with run-in 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 of months 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. A claim that was incurred on August 10, 1999, and was paid on October 10 would be covered, because August 10 falls within the 60-day run-in period. Claims incurred in contract year and paid within contract year plus X days Claims are paid if they both (1) occur within the contract year and (2) are paid within a specific number of days after the contract year ends. This form of agreement allows the purchaser of the stop-loss coverage time to process claims incurred in the last few months of the contract year. In stop-loss agreements, the carrier is seldom responsible for paying the purchaser before the purchaser pays the medical expenses. One reason stop-loss contracts are structured this way is that not all of the medical expenses are necessarily covered by the health plan; therefore the carriers liability is based on the medical expense payments the stop-loss purchaser actually makes. Claims will be covered if paid during the contract year, no matter when the expenses were 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 of months 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. A claim that was incurred on August 10, 1999, and was paid on October 10 would be covered, 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 a specific number of days after the contract year ends. This form of agreement allows the purchaser of the stop-loss coverage time to process claims incurred in the last few months of 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 purchase stop-loss coverage to limit its own exposure to large losses, but it may also supply stop-loss coverage to at-risk providers with whom it has reimbursement agreements or to groups with selffunded healthcare plans. For example, a health plan that capitates a provider group almost always provides 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 the law of large numbers. Recall that the larger the number of enrollees a health plan has, the closer the average medical expense of those enrollees will be to the average experience of the general population, assuming that the plan has attracted enrollees of average health.

This means, for example, that actuaries can predict with reasonable accuracy approximately how many enrollees in a large group plan will experience illnesses or injuries that result in extremely large medical expense costs. Even if actuaries accurately predict the number of large cases that will occur over a period of time, however, it is impossible to tell in advance which specific enrollees will become ill, and therefore impossible to tell which of the capitated providers will have to bear the expense of treating these seriously ill enrollees. Suppose, for example, the expected experience of the employer group includes two cases of highcost treatments. The premiums for that group can be designed so that the health plan is compensated for the risk of assuming these expensive cases. If the plan signs full professional capitation contracts with 10 provider organizations, these capitation rates reflect the average degree of risk assumed by the provider organization for each enrolled member who signs up with that organization. However, neither the providers nor the health plan knows which of the 10 provider 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 of these patients could be higher than the reimbursement any one individual provider group receives under 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 these groups are able to secure some form of protection. In the absence of stop-loss protection, such a capitation contract is much less desirable for the providers, because none of the 10 provider groups can tell ahead of time whether it will be responsible for a very expensive medical treatment.

If stop-loss coverage were not available to at-risk providers, health plans would also face disadvantages. First, as we have just seen, convincing providers to sign a capitation contract would be difficult. Second, if the risk for the large cases is factored into the capitation rate for all the provider groups, then two of the groups are disastrously undercompensated, while eight are slightly overcompensated. In other words, the reimbursement for the risk is spread out, but the risk 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 is to offer, in exchange for a premium, stop-loss coverage in the form of a separate insurance contract along the lines we have already discussed. The second method of supplying at-risk providers with protection against large losses is to structure capitation and other risk agreements in such a way that providers share only a small amount of the risk of catastrophically large losses. This second method, which is quite commonly used, is not an insurance contract. With this type of stop-loss protection, each provider is at risk according to the capitation contract, but once a case or course of treatment reaches a specified level of expense, the reimbursement method limits the providers risk. For example, on a case that reaches the specified expense level, the provider may be reimbursed for further treatment according to a discounted FFS schedule. The discounted FFS payments cover the providers expenses in treating the case, and thus eliminate much of the risk to the provider of large losses on individual catastrophic cases. Technically, this type of contractual arrangement is neither insurance nor reinsurance, although its 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 other words, because the capitation contract does not transfer the catastrophic risk to the providers in the first place, they do not have to seek insurance to transfer that risk back to the health plan or an insurer. 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, but just as coinsurance motivates an enrollee to avoid seeking unnecessary care, a share of the risk in large-amount cases motivates the provider to control costs in those cases. In our discussion of provider reimbursement methods, we stressed the importance of capitation as a means of transferring some of the risk of overutilization from the health plan to the provider in order to motivate the provider to supply cost-effective care. If a capitation contract transfers risk from a health plan to the provider, you may wonder why the health plan is willing to retain the risk of very expensive cases, or offer to transfer some of that risk back from the provider to the health plan. The answer is that the risks being transferred by capitation and those being transferred by stoploss coverage are different types of risk. The main goal for a health plan in seeking a capitation agreement from a provider is to motivate the provider to supply the most cost-effective care by managing 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 an enrollee who suffers a serious illness or injury and whose treatment costs under the most efficient care are still too high for that provider to absorb. The provider has no control over whether or not an 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 efficiently controlling costs and still suffer ruinous losses if one or two patients develop catastrophic illnesses. As we mentioned earlier in this lesson, stop-loss agreements also can be structured to motivate providers to inform the health plan soon after a serious illness is diagnosed, which allows the health plan to engage in large-case management as soon as possible. Providers with capitation contracts do not always purchase stop-loss coverage from the health plan offering the contract. Provider groups and hospitals in particular may shop for the least expensive stop-loss coverage. Large groups with self-funded healthcare plans also explore the stop-loss market, often with the help of a broker or agent. In doing so, both the providers and selffunded groups must have an accurate assessment of the liability that the healthcare plan exposes them to, and their own ability to retain risk. A health plan that retains a large-amount risk through stop-loss provisions in a provider reimbursement contract can expect to incur larger costs in the long run, either because the health plan will have to pay large-amount claims itself or because the health plan will have to purchase stop-loss coverage to protect itself against the risk of those costs. Typically, capitation contracts in which the health plan offers a provider stop-loss coverage or non-insurance stop-loss protection will offer capitation rates that are lower than those offered by contracts in which the health 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 the organization retains. For a health plan, decisions concerning how to deal with risks associated with its core business involve an assessment of opportunity costs. Risk retention and risk transfer both have benefits and drawbacks. The health plan must assess the benefits and drawbacks of these choices given the specifics of the risk involved. The central benefit of retaining utilization risk for a health plan is the possibility that the payments, such as premiums, that the health plan receives for assuming the risk will be greater than the actual cost of the risk. However, as we pointed out in our solvency discussion in Risk Management in Health Plans, by assuming risk a health plan assumes potential liabilities. The decision to retain risks carries with it the cost of making assets available to cover losses. As long as these assets are held in liquid investments, they cannot be used for long-term investments in many kinds of business opportunities, such as expanding into new markets or developing new products; nor, in the case of for-profit health plans, can they be distributed to stockholders as earnings. Transferring risk through stop-loss insurance or reinsurance reduces the health plans risk, particularly pricing or underwriting risk, and thereby reduces the health plans need for liquid assets in support of these risks. Typically, solvency requirements set by the RBC formula are higher than those set by the HMO Model Act. Consequently, for health plans that find themselves subject to new RBC requirements as a result of a states adoption of RBC solvency requirements, purchasing stop-loss coverage can reduce the need to raise money in order to increase the health plans net worth. The influence of stop-loss coverage on a health plans underwriting risk is limited compared to the influence of the health plans provider reimbursement contracts. Nevertheless, stop-loss does marginally reduce the health plans underwriting risk. An added benefit of stop-loss coverage as a means of reducing risk is that stop-loss contracts can offer the health plan a more flexible means of dealing with risk than many alternatives. The stoploss contract can adjust for the amount of risk transferred, the period of time that the risk is transferred, 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 carrier must not only set premiums at a rate high enough to cover the insured losses, but must also include in the premium an amount sufficient to administer the insurance and provide a return on investment. The health plan will also experience its own administrative costs in securing stop-loss coverage and making claims under that coverage. Furthermore, because stop-loss carriers are at risk based on the health plans underwriting and actuarial practices, the carrier may wish to review those practices before issuing stop-loss protection. The cost of a stop-loss contract varies depending on a number of factors. Costs will vary according to the type of stop-loss (specific or aggregate), the number of persons covered by the stop-loss contract, the types of losses that are covered, the predicted rate at which the plans population of enrollees will experience catastrophic illnesses or injuries, and the stop-loss coverages attachment point, among other elements. Finally, although purchasing stop-loss coverage reduces a health plans underwriting risk, the same stop-loss coverage will increase the health plans affiliate risk. Recall that affiliate risk is the risk that the financial condition of an affiliated entity (in this case, the stop-loss carrier) will cause an adverse change in capital (in this case, the health plan1s capital). Although the decrease in 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 stoploss carrier, the lower the health plans 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 an insurer or a specific type of health plan, rather than an employer or other group plan sponsor, is licensed to assume the financial responsibility for healthcare services rendered to or for health plan members.2 In other words, in a fully funded plan, a group plan sponsor pays a premium to a health plan and the health plan assumes the risk that the premiums will not be enough to cover the costs of services rendered to health plan members. Recall from Healthcare Management: An Introduction that a premium is a payment or series of payments 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 plan in force. Typically, fully funded health plans require group plan sponsors to prepay monthly premiums for healthcare services. In Pricing and Rating lesson, it discusses how an insurer or health plan establishes premiums for its products.

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

Under a fully funded health plan, upon acceptance of a premium, a commercial insurance company, Blue Cross or Blue Shield organization, or HMO, for example, bears the entire financial risk of paying for all claims for services provided as well as the administrative expenses associated 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 up the difference. On the other hand, if group plan members incur a lower dollar amount of healthcare services than the dollar amount of premiums collected, then the insurer may earn a larger profit on the health plan. Most health plans, including indemnity plans, incorporate the use of some health plan techniques in the financing and delivery of healthcare services. Indemnity carriers have offered various alternate funding arrangements for a long time, although, in many states, HMOs are prohibited from offering alternate funding arrangements. Even in those states that allow HMOs to offer alternate funding, most HMOs still enter into fully funded arrangements. A fully funded plan is the traditional funding arrangement for a group health insurance plan. The insurer usually issues the group health policy on a 12-month, renewable basis. The monthly premium is typically guaranteed for 12 months and provides coverage for that period. With proper notification to the group plan sponsor, the insurer may increase the premium for the next 12-month period. In recent years, multiyear premium rate guarantees have become more common. To prevent insurers from setting inadequate premium rates, some states require that the state insurance department approve all first-year premiums charged by insurers. States that have this requirement attempt to protect the insurer from insolvency and plan members from losing coverage because of insurer insolvency. Depending on the size of the group and the state laws that apply to the group, the insurer may establish new premium rates for the group at the end of the initial 12-month period. New premium rates may be determined in part by the sex and attained ages of group plan members, the location of the group, and the groups industry classification, for example. For large groups, the rates may also be determined on the basis of the groups experience. Insurers and employers have developed a variety of alternatives to this traditional arrangement of paying premiums in advance to fund a group health plan. These alternative funding arrangements modify the manner in which premiums are paid, thus enabling employers to reduce the total cost of providing a health plan to their employees.8 We discuss these alternative funding methods in Alternative Funding Methods. Self-Funded Plans9 A self funded plan, also called a self insured plan, is a form of group health coverage in which a group plan sponsortypically a large employerrather than a health plan or insurer, is financially responsible for the costs of healthcare services rendered to or for plan members. 10 A self funded plan may be completely or partially self funded. For example, in a partially self funded plan, an employer may purchase stop loss insurance to transfer part of the financial risks that 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. As a 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 healthcare costs. 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 Provide some profit for the health plan or insurer

agent commissions

Under a self funded plan with separate stop loss insurance coverage or a partially self funded health plan, the employer typically is financially responsible for paying a certain level of healthcare services. The risk for incurring costs above a specified level can be transferred to a traditional health insurance provider. For example, an employer could self fund the health plans first $50,000 of a plan members healthcare expenses and purchase supplemental medical insurance 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 agent commissions, that are included in the premiums for fully funded plans. Another advantage to self funding is improved cash flow for the employer, because the employer initially retains the money it would have paid in premiums. Instead, the employer pays for healthcare expenses as they occur. As a result, the employer can earn interest on that money. However, a potential disadvantage is that the employer may experience severe cash flow problems resulting from unexpectedly high costs for healthcare services rendered to plan members. Self funded plans are exempt from state laws and regulations that apply to health insurance policies. Therefore, employers that establish a self funded health plan may have more freedom with respect to state-mandated coverage requirements and may avoid premium taxes. However, most self funded plans are subject to the federal Employee Retirement Income Security Act (ERISA), because employee benefits that are subject to ERISA include medical, surgical, and hospital care benefits. Funding requirements under ERISA mandate that health plans develop written policies regarding the plans funding sources, procedures for carrying out these policies, and specified funding methods used to support the plans goals. Further, self funded health plans must comply with ERISA requirements concerning the limits on benefit discrimination for classes of employees. When an employer self funds a health plan, the money that the employer and employees normally would have paid in premiums to a health plan or insurer is deposited into an account until the money is used to pay healthcare expenses. The account into which the employer deposits the money is called the funding vehicle. The type of funding vehicle determines the type of self funded health plan. Two common types of self funded plans are general asset plans and trusteed plans. General Asset Plan A general asset plan, also called a non-trusteed plan, is a type of self funded health plan under which the employer pays covered healthcare expenses from its current operating funds, rather than from a trust fund established for this specific purpose.11 In a general asset plan, the employer usually 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 the employers current assets or operating funds, from which the employer pays all healthcare expenses. Therefore, in the meantime, the employer has the use of this money until it is needed to pay for healthcare services. One disadvantage of a general asset plan is that these funds are subject to the claims of the employers 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 self funded plan under which covered healthcare expenses are paid from a trust established by the employer or other group sponsor.12 Under a trusteed plan, the employer deposits into a trust funds set aside for the health plan. The trustee, not the employer, has the duty of managing the trust property 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 to the claims of the employers creditors. Other advantages of establishing a trusteed plan include the preferred tax treatment available to trusteed plans. Figure 5A-2 lists three common trusts that an employer may establish to fund a health plan. We discuss the 501(c)(9) (VEBA) trust in detail in Alternative Funding Methods.

Endnotes 1. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMAs 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 rights reserved. 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 rights reserved. 10. Desoutter and Huggins 11. 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 Huggins 15. Harker, 137-138.

AHM Health Plan Finance and Risk Management: Alternative Funding Methods Course Goals and Objectives
After 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, and administrative-services-only arrangements The methods of alternative funding can be divided into two general categories: those that primarily modify traditional fully insured group insurance contracts and those that have some self funding (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 plans because the insurance company has the ultimate responsibility for paying all benefits promised under the contract. Most insurance companies will allow only large employers to use these modifications. Although practices differ among insurance companies, generally a group insurance plan must generate between $150,000 and $250,000 in claims before these funding methods will be available to the employer. The second category of alternative funding methods includes Total self-funding from current revenue and self-administration Self-funding with administrative-services-only arrangements Funding through a 501(c)(9) trust In contrast to the first category of alternative funding methods, some of these alternatives can be used by small employers. Premium-Delay Arrangements Premium-delay arrangements allow the employer to defer payment of monthly premiums for some time beyond the usual 30-day grace period. In fact, these arrangements lengthen the grace period, most commonly to 60 or 90 days. The practical effect of premium-delay arrangements is that they enable the employer to have continuous use of the portion of the annual premium for other purposes. For example, a 90-day premium delay allows the employer to use three months (or 25%) of the annual premium for other purposes. This amount roughly corresponds to what is usually in the claims reserve for medical expense coverage. Generally the larger this reserve is on a percentage basis, the longer the premium payment can be delayed. Because the insurance company still has a statutory obligation to maintain the claims reserve, it must use other assets besides the employers premiums for this purpose. In most cases, these assets come from the insurance companys surplus.

A premium-delay arrangement has a financial advantage to the extent that an employer can earn a higher 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 an interest charge on the delayed premiums or an increase in the insurance companys retention charge. Upon termination of an insurance contract with a premium delay arrangement, the employer is responsible for paying any deferred premiums. However, the insurance company is legally responsible for paying all claims incurred prior to termination, even if the employer fails to pay the deferred premiums. Consequently, most insurance companies are concerned about the employers financial position and credit rating. For many insurance companies, the final decision of whether to enter into a premium-delay arrangement, or any other alternative funding arrangement that leaves funds in the hands of the employer, is made by the insurers financial experts after a thorough analysis of the employer. In some cases, this may mean that the employer will be required to submit a letter of credit or some other form of security. Reserve-Reduction Arrangements A reserve-reduction arrangement is similar to a premium-delay arrangement. Under the usual reserve-reduction arrangement, the employer is allowed (at any given time) to retain an amount of the annual premium that is equal to the claims reserve. Generally such an arrangement is allowed only after the contracts first year, when the pattern of claims and the appropriate amount of the claims reserve can be more accurately estimated. In succeeding years, if the contract is renewed, the amount retained will be adjusted according to changes in the size of the reserve. As with a premium-delay arrangement, the monies retained by the employer must be paid to the insurance company upon termination of the contract. Again, the advantage of this approach lies in the employers ability to earn more on these funds than it would 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 employers cash flow. Under the typical minimum-premium plan, the employer assumes the financial responsibility for paying claims up to a specified level, usually from 80% to 95% of estimated claims. The specified level may be determined on either a monthly or an annual basis. The funds necessary to pay these claims are deposited 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 is paid from the insurance companys own funds. No premium tax is levied by the states on the amounts the employer deposits into such an account, as it would have been if these deposits had been paid directly to the insurance company. In effect, for premium-tax purposes, the insurance company is only considered to be the administrator of these funds and not a provider of insurance. Under a minimum-premium plan, the employer pays a substantially reduced premium, subject to premium 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 burdensome for an insurance company to administer than would a traditional group arrangement, the retention charge may also be slightly higher. Under a minimum-premium arrangement, the insurance company is ultimately responsible for seeing that all claims are paid, and it must maintain the same reserves that would have been required if the plan had been funded under a traditional group insurance arrangement. Consequently, the premium will include a charge for the establishment of these reserves, unless some type of reserve-reduction arrangement has also been negotiated. Some insurance regulatory officials view the minimum-premium plan primarily as a loophole used by employers to avoid paying premium taxes. In several states, there have been attempts to seek court rulings or legislation that would require premium taxes to be paid either on the funds deposited in the bank account or on claims paid from these funds. Most of these attempts have been unsuccessful, but court rulings in California require the employer to pay premium taxes on the funds deposited into the bank account. If similar attempts are successful in the future, the main advantage of minimum-premium plans will be lost. Retrospective-Rating Arrangements Under retrospective-rating arrangements , the insurance company charges the employer an initial premium 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 insurance arrangement. However, if claims plus the insurance companys retention charge exceed the initial premium, the employer will be called upon to pay an additional amount at the end of the policy year. Because an employer will usually have to pay this additional premium, one advantage of a retrospective-rating arrangement is the employers ability to use these funds during the year. This potential additional premium is subject to a maximum amount based on some percentage of expected claims. For example, assume that a retrospective-rating arrangement bases the initial premium on the presumption that claims will be 93% of those actually expected for the year. If claims in fact are below this level, the employer will receive an experience refund (discussed in Rating 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 additional claims paid, up to some percentage of those expected, such as 112%. The insurance company bears claims in excess of 112%, so some of the risk associated with claims fluctuations is passed on to the employer. This will reduce both the insurance companys risk charge and any reserve for claims fluctuations. The amount of these reductions will depend on the actual percentage specified in the contract, above which the insurance company will be responsible for claims. This percentage and the one that triggers the retrospective-rating arrangement are subject to negotiations between the insurance company and the employer. In general, the lower the percentage that triggers the retrospective arrangement is, the higher will be the percentage above which the insurance company is fully responsible for claims. In addition, the better the cash-flow advantage the employer has, the greater will be the risk of claims fluctuations. In all other respects, a retrospective-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 from current 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 eliminating state premium taxes, avoiding state-mandated benefits, and improving cash flow, the employer has the potential to reduce its operating expenses to the extent that the plan can be administered at a lower cost than the insurance companys retention charge (other than premium taxes). A decision to use this kind of self-funding is generally considered most desirable when all the following 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 is either stable or shows a steady trend. Such a pattern is most likely to occur in those types of benefit plans that have a relatively high frequency of low severity claims. Although a self-funded plan may still be appropriate when the level of future benefit payments is difficult 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 is contributory. Some employees may resent paying their money to the employer for benefits that are contingent on the firms future financial ability to pay claims. If claims are denied, employees under a contributory plan are more likely to be bitter toward the employer than they would be if the benefit plan were noncontributory. Finally, the Employee Retirement Income Security Act (ERISA), which is discussed in Rating and Underwriting, requires that a trust must be established to hold the employees contributions until the plan uses the funds. Both the establishment and maintenance of the trust will result in increased administrative costs to the employer. A nonunion situation. Self-funding of benefits for union employees may not be feasible if a firm is subject to collective bargaining. Self-funding (at least by the employer) clearly cannot be used if benefits are provided through a negotiated trusteeship. Even when collective bargaining results in benefits being provided through an individual employer plan, unions often insist that benefits be insured in order to guarantee that union members will actually receive them. An employers decision about whether to use self-funding is most likely motivated by the potential to save money. When unions approve of selffunding, they also frequently insist that some of these savings be passed on to union members through additional or increased benefits. The ability to effectively and efficiently handle claims. One reason that many employers do not use totally self-funded and self-administered benefit plans is the difficulty in handling claims as efficiently and effectively as an insurance company or other benefit-plan administrator would handle them. Unless an employer is extremely large, only one person or a few persons will be needed to handle claims. Who in the organization can properly train and supervise these people? Can they be replaced if they should leave? Will anyone have the expertise to properly handle the unusual or complex claims that might occur? Many employers want some insulation from their employees in the handling of claims. If employees are unhappy with claim payments under a selfadministered plan, dissatisfaction (and possibly legal actions) will be directed toward the employer rather than toward the insurance company. The employers inability to handle claims, or its lack of interest in wanting to handle them, does not completely rule out the use of self-funding. As will be discussed later, employers can have claims handled by another party through an administrative-services-only contract. The ability to provide other administrative services. In addition to claims, the employer must determine whether the other administrative services normally included in an insured arrangement can be provided in a cost-effective manner. These services are

associated with plan design, actuarial calculations, statistical reports, communication with employees, compliance with government regulations, and the preparation of government reports. 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, selfadministration will not be economically feasible. As with claims administration, an employer can purchase needed services from other sources. The ability to obtain discounts from medical care providers if medical expense benefits are self-funded. In order to obtain much of the cost savings associated with health plans, the employer must be able to secure discounts from the providers of medical care. Large employers whose employees live in a relatively concentrated geographic region may be able to enter into contracts with local providers. Other employers may use the services of third party administrators who have either established or entered into contracts with preferred provider networks. Recall from Healthcare Management: An Introduction that a third party administrator (TPA) is a company that provides administrative services to health plans or self-funded health plans. The extent of total self-funding and self-administration differs significantly among the different types of group benefit plans. The larger the employer is, the more likely that its medical expense plan will be self funded. The major problem with a self funded medical expanse plan is not the prediction 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 small and medium-size employers are unwilling to assume the risk that they might have to pay such a large claim. Only employers with several thousand employees are large enough to anticipate that such claims will regularly occur and to have the resources that will be necessary to pay any unexpectedly large claims. This does not mean that smaller employers cannot self fund medical benefits. To avoid the uncertainty of catastrophic claims, these employers often self fund basic medical expense benefits and insure major medical expense benefits or self fund their entire coverage but purchase stop-loss protection. It is not unusual to use self-funding and self-administration in other types of benefit plans, such as those 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, these plans are commonly subject to maximums so that the employer has little or no risk of catastrophic claims. 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 of catastrophic claims and the employers inability to provide administrative services in a costeffective manner. For each of these problems, however, solutions have evolvednamely stoploss coverage and administrative-services-only (ASO) contractsthat still allow an employer to use elements of self-funding. Although an ASO contract and stop-loss coverage can be provided separately, they are commonly written together. In fact, most insurance companies require an employer with stop-loss coverage to have a self funded plan administered under an ASO arrangement, either by the insurance company or by a third party administrator. Until recently, stop-loss coverage and ASO contracts were generally provided by insurance companies and were available only to employers with at least several hundred employees.

However, these arrangements are increasingly becoming available to small employers, and in many cases, the administrative services are now being purchased from third party administrators who operate independently from insurance companies. We discussed stop-loss coverage in Capitation and Plan Risk. Following is a brief description of ASO arrangements. Under an administrative-services-only (ASO) contract, the employer purchases specific administrative services from an insurance company or from an independent third party administrator. These services will usually include the administration of claims, but they may also include a broad array of other services. In effect, the employer has the option to purchase services for 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 is under a minimum-premium plan; that is, the administrator has the authority to pay claims from a bank account that belongs to the employer or from segregated funds in the administrators hands. However, the administrator is not responsible for paying claims from its own assets if the employers account is insufficient. In addition to listing the services that will be provided, an ASO contract also stipulates the administrators authority and responsibility, the length of the contract, the provisions for terminating and amending the contract, and the manner in which disputes between the employer and the administrator will be settled. The charges for the services provided under the contract may 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 therefore not subject to state premium taxes. However, one similarity to a traditional insurance arrangement may be present: The administrator may agree to continue paying any unsettled claims after the contracts 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 from Health Plan Funding that 501(c)(9) trusts are funding vehicles for the employee benefits that are offered to members. The trusts have been allowed for many years, but until the passage of the 1969 Tax Reform Act, they were primarily used by negotiated trusteeships and association groups. The liberalized tax treatment of the funds accumulated by these trusts resulted in their increased use by employers as a method of self-funding employee benefit plans. However, the Tax Reform Act of 1984 imposed more restrictive provisions on 501(c)(9) trusts, and their use has diminished somewhat, particularly by smaller employers who previously had overfunded their trusts primarily as a method to shelter income from taxation. Advantages The use of a 501(c)(9) trust offers the employer some advantages over a benefit plan that is selffunded from current revenue. Contributions can be made to the trust and can be deducted for federal income tax purposes, just as if the trust were an insurance company. Appreciation in the value 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 have been incurred but not paid or a fund for possible claims fluctuations. If the employer does not use a 501(c)(9) trust in establishing these funds, contributions cannot be deducted until they are paid in 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 maintained regarding the investment of the trust assets, the employer does have some latitude and does have the potential for earning a return on the trust assets that is higher than what is earned on the reserves held by insurance companies. A 501(c)(9) trust also lends itself to use by a contributory self-funded plan, since ERISA requires that, under a self-funded benefit plan, a trust must be established 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 Revenue Service will not permit a tax deduction for overfunding a trust, there is no requirement that the trust 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 this underfunding in good times with larger-than-normal contributions. However, any underfunding must be shown as contingent liability on the employers balance sheet. Disadvantages The use of a 501(c)(9) trust is not without its drawbacks. The cost of establishing and maintaining the trust may be prohibitive, especially for small employers. In addition, the employer must be concerned about the administrative aspects of the plan and the fact that claims might deplete the trusts assets. However, as long as the trust is properly funded, ASO contracts and stop-loss coverage can be purchased. Requirements for Establishment In order to qualify under Section 501(c)(9) of the Internal Revenue Code, a trust must meet certain requirements, some of which may hinder its establishment. These requirements include the following conditions:
Membership in the trust must be objectively restricted to those persons who share a

common employment-related bond. Internal Revenue Service (IRS) regulations interpret this broadly to include active employees and their dependents, surviving dependents, and employees who are retired, laid off, or disabled. Except for plans maintained pursuant to collective-bargaining agreements, benefits must be provided under a classification of employees that the IRS does not find to be discriminatory in favor of highly compensated individuals. It is permissible for life insurance, disability, severance pay, and supplemental unemployment compensation benefits to be based on a uniform percentage of compensation. In addition, the following persons may be excluded in determining whether the discrimination rule has been satisfied: (1) employees who have not completed three years of service, (2) employees under age 21, (3) seasonal or less-thanhalf-time employees, and (4) employees covered by a collective-bargaining agreement if the class of benefits was subject to good-faith bargaining.
With two exceptions, membership in the trust must be voluntary on the part of

employees. 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 not regarded 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 broad enough that a trust can provide benefits because of death, medical expenses, disability, and unemployment. Retirement benefits, deferred compensation, and group property and liability insurance cannot be provided. The sole purpose of the trust must be to provide benefits to its members or their beneficiaries. Trust assets can be used to pay the administrative expenses of the trust, but they cannot revert to the employer. If the trust is terminated, any assets that remain after all existing liabilities have been satisfied must either be used to provide other benefits or be distributed to members of the trust. The trust must be controlled by (1) its membership, (2) independent trustees (such as a bank), or (3) trustees or other fiduciaries, at least some of whom are designated by or on behalf of the members. Most 501(c)(9) trusts are controlled by independent trustees selected by the employer. Limitation on Contributions The 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 direct cost 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 would have 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 additions includes (1) any sums that are reasonably and actuarially necessary to pay claims that have been incurred but remain unpaid at the close of the tax year and (2) any administration costs with respect to these claims. There are several potential adverse tax consequences if a 501(c)(9) trust does not meet prescribed standards. If reserves are above permitted levels, additional contributions to the reserves are not deductible 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 prefund postretirement medical benefits.) In addition, an excise tax is imposed on employers maintaining a 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 the separate accounts that must be established, (2) discriminatory medical or life insurance benefits for retirees, and (3) any portion of the trusts assets that revert to the employer. Endnotes 1. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMAs Glossary of Insurance Terms, 3rd ed. (Atlanta: LOMA, 1997). 2. Burton T. Beam, Jr., Group Benefits: Basic Concepts and Alternatives, 7th ed. (Bryn Mawr, 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 and Medicaid for Health Plans Course Goals and Objectives After 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 these directives Describe some of the financial risks for a health plan that provides healthcare services to the Medicare or Medicaid populations versus the commercial population List the key features of a state Medicaid program that will determine a Medicaid managed care plan's level of risk Describe some of the aspects of a health plans regulatory environment that impose additional 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 further increase enrollment in and availability of Medicare and Medicaid contracting health plans. The BBA amended Medicaid law to facilitate states ability to mandate the enrollment of most Medicaid beneficiaries into health plans. In addition, the BBA expanded the range of health plan choices available to Medicare beneficiaries and significantly revised the program under which health plans enter into risk-based contracts to provide services to Medicare beneficiaries. The revised Medicare risk-contracting program, known as Medicare+Choice, began on January 1, 1999. In December, 2003, the Medicare Modernization Act of 2003 was signed into law. This Act changed the name of the Medicare+Choice program to Medicare Advantage, and provided a number of short term and long term reforms to the program to enhance benefits for enrollees and encourage 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 Modernization Act of 2003 (MMA), taking steps to expand private sector health care choices for current and future generations of Medicare beneficiaries. The MMA proposes short-term and long-term reforms 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 made available to all Medicare beneficiaries in 2006. Additional changes to the M+C program include:
M+C programs 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 are required 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 for millions of Medicare beneficiaries who are covered by health plans in the Medicare Advantage program, previously known as the Medicare+Choice program. These coverage improvements became effective on March 1, 2004. On June 1, 2004, beneficiaries saw additional improvements in Medicare under another important 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 option of purchasing prescription drug discount cardssponsored by private sector entities and endorsed by Medicarewhich offer discounted prices on prescription drugs. Furthermore, the discount card program is providing low-income Medicare beneficiaries with up to $600 annually in 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 health plan 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 Medicare beneficiaries, regional PPO-style plans will be available as a permanent option under the Medicare Advantage program. Beginning in 2006, all beneficiaries will have the option of choosing prescription drug coverage delivered through private sector entities. This coverage will be available as a stand-alone drug benefit or, in other cases, as part of a comprehensive benefits package offered by Medicare Advantage health plans. Other important provisions of the MMA address Medigap choices and specialized Medicare Advantage plans for beneficiaries with special needs. Public comments on the regulations are currently in review, and changes to the draft regulations are anticipated. Final regulations are expected in the spring of 2005, and content updates will be made after the release of the final regulations. Contracting to provide services to Medicare and/or Medicaid beneficiaries presents a range of financial issues for health plans. In this lesson, we discuss Medicare and Medicaid payment to health plans, the distinct financial risks and costs associated with providing services to Medicare and/or Medicaid beneficiaries, and issues related to paying providers for services rendered to a health plans Medicare and/or Medicaid enrollees.

This discussion focuses on health plans that have Medicare and/or Medicaid beneficiaries enrolled 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 Medicaid programs. However, an important issue to keep in mind is that almost every health plan has participating Medicare beneficiaries who are not enrolled under a Medicare contract but are enrolled under the health plans 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 the methods for paying health plans for providing healthcare services to the Medicare and Medicaid populations. Medicare Prior to 1998, Medicare contracting plans were paid 95% of the estimated cost of providing the services to a beneficiary under Medicare fee-for-service, known as the adjusted average per capita cost (AAPCC). The payment amounts were calculated on a county-by-county basis and were beneficiary specific in that they adjusted for demographic factors including age, sex, and institutional 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 and B. Under AAPCC payment methodology, the payment rate for plans tended to vary significantly by geographic region. In many areas, particularly rural areas, the rates of payment were so low that Medicare risk-based contracts were not feasible. The payment rates for plans also tended to vary significantly from year to year, making the program unreliable for many contractors. In 1998, CMS implemented a new payment methodology authorized under the BBA. Under the new methodology, Medicare-contracting health plans are paid the highest of the following three amounts: A rate reflecting a blend between national and local fee-for-service cost (unlike the old methodology which was based entirely on local costs) and subject to other adjustments such as a phased-in carve-out of graduate medical education payments and a budget neutrality factor The health plans 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 1998 and is increased annually by a rate that reflects the national rate of growth in per capita Medicare expenditures Payments are adjusted by the same demographic and other factors applied under the previous payment methodology. The new payment methodology has significantly decreased the rate of growth in payments to health plans. As a result of basing payments on the new methodology, the payment rate in rural and other low-payment counties was raised to the payment floor. The increased payment rate in these counties, however, was financed by reducing the rate of increase in payments in other counties 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 1998 or 1999. During 1998 and 1999, the vast majority of plans were paid an amount equal to their previous years 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 greater than 5%. Citing the decreasing growth in Medicare payments to health plans in conjunction with increasing growth in medical costs, in 1998 some plans with risk-based Medicare contracts announced their intention to terminate their Medicare contracts or significantly decrease their service areas in 1999. Beginning in the year 2000, CMS will further revise the payment methodology by implementing a risk adjustment methodology known as the Principal Inpatient Diagnostic Cost Group (PIPDCG) to account for variations in per capita costs based on health status. This risk adjustment methodology will be integrated with recalculated adjustment factors for age, gender, Medicaid eligibility, and institutional status to adjust payments to health plans. Because CMS currently only has inpatient data on which to base such a risk adjustment methodology, the agency is constrained initially to using a model that requires only inpatient data. 1 The application of the risk adjustment methodology could make payments to health plans vary significantly from current payment levels and over time, therefore making participation in the Medicare program less attractive to health plans that have a healthier-than-average enrollment by substantially reducing their overall payments. Under both the old and new payment methodologies, health plans with risk-based Medicare contracts are required to calculate and submit to CMS a Medicare adjusted community rate (ACR). The Medicare adjusted community rate (Medicare ACR) is the plans estimate of the premium it would charge Medicare enrollees in the absence of Medicare payments to the health plan. To determine this estimated premium, the health plan uses the same rates it charges enrollees 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 plan compares its Medicare average payment rate (APR), which is the average amount the health plan receives or expects to receive from CMS per beneficiary covered, to its Medicare ACR. If the average rate of Medicare payment exceeds the health plans Medicare ACR, the plan is required to use the excess amount either to provide additional benefits or to reduce enrollee cost-sharing obligations. Medicare-contracting health plans compete on premium amounts and benefits with other Medicare-contracting health plans, Medigap insurers, and the Medicare fee-for-service program for beneficiaries. The more benefits a health plan can provide and the lower the premium, the better the health plan will be able to compete by attracting beneficiaries to enroll in their health plan. In the past, one of the key benefits health plans used to differentiate themselves from competitors was pharmacy benefits, particularly in markets with relatively high Medicare payments to health plans. Pharmacy benefits have extremely limited coverage under the fee-for-service program and are an expensive 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 treat chronic or long-term conditions or diseases. These same beneficiaries tend to have higher-thanaverage needs for other healthcare services as well. One effect of the application of the new payment methodology has been to cause a number of Medicare-contracting health plans to reduce their 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 their own Medicaid programs after obtaining federal government approval of their programs. The federal 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. Federal Medicaid law does not contain any provisions regarding payment methodology but sets forth two directives for states. First, a states payment to health plans for providing Medicaid services can not be more than it would have cost the state to provide the services under Medicaid fee-forservice (FFS), known as the upper payment limit.3

Second, states must pay Medicaid-contracting health plans that accept risk for comprehensive services on an "actuarially sound basis."4 One way that states comply with the requirement that payments not exceed FFS cost is to base their payment rates on the actuarial FFS equivalent, and then apply a factor of 95% or less to determine 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 their payments on FFS equivalents. States use a variety of methodologies to determine payments to health 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 payment because 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 for which 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 health plans. Such services may be provided through a separate health plan that is paid to provide only those carved-out services (mental health and substance abuse services are frequently provided in this 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 capitation payment 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 to provider facilities and provide reimbursement for the services on a fee-for-service basis to the health 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 state uses to pay its Medicaid-contracting health plans. However, across states there has been a general trend toward tightening payments to health plans while increasing contracting requirements and oversight. As we mentioned earlier, Medicaid is a joint federal-state program, which means that some of the funds for the Medicaid program are provided by the federal government and some by the states. The trend toward tightening payments is likely to become more pronounced as federal Medicaid cuts (or decreases in the rate of growth of payments to health plans with Medicaid contracts) are implemented over the next five years. Moreover, the federal Medicaid cuts are likely 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 to Medicaid health plan contracts becoming less attractive to health plans in some states. Medicaid programs in some areas are unstable as states struggle with implementing and financing the programs. A few states have solicited health plans to participate in proposed Medicaid managed care programs that were never implemented. Other states have missed target dates, which had been proposed to and approved by CMS, to move from voluntary to mandatory health plan programs, 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 on health plans that are distinct from those related to providing services to the commercial population. 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 less assured of recovering their initial enrollment and service provision costs through monthly payments for ongoing enrollment. However, the BBA may provide some relief to both Medicare- and Medicaid-contracting plans through its provisions. The BBA contains provisions that allow states greater flexibility in locking in Medicaid beneficiaries. Medicare provisions allow for modified lock-in periods beginning in the year 2002. Modified lock-in periods allow an enrollee to disenroll during a period of timein the case of Medicare after the year 2002, that period of time is three months--after making an initial election to a plan. After the time period, the enrollee is locked in until the annual election period. Medicare and Medicaid enrollees tend to have a high level of costs in the first few months of enrollment as the health plan educates them about the system and performs initial health screenings to evaluate their health. Health plans also tend to have high costs for providing healthcare services during the initial months of enrollment as they address any healthcare issues identified in the initial screenings and initiate members into appropriate routines of care. A significant issue in Medicare contracting health plans, and one that differentiates the Medicare market from the commercial market, is the amount of time that it takes to recover these initial costs. In addition, the costs involved in providing care to the Medicare and Medicaid populations are significantly 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 for Medicare and Medicaid beneficiaries in order to ensure that the beneficiaries understand their enrollment in a health plan system and the appropriate protocols and sites for accessing covered care. State and federal laws require that health plans follow certain procedures to ensure that Medicaid enrollees understand their coverage. States with mandatory health plan programs assign Medicaid beneficiaries to a health plan in cases where the beneficiaries have not selected a health plan themselves. These Medicaid managed care plans may incur significant costs in providing outreach to inform the beneficiary that they have been enrolled in the health plans plan and to educate the beneficiary about the implications of their enrollment. Furthermore, Medicare and Medicaid plans have higher costs than the costs experienced by health plans that contract for commercial business. These higher costs relate to coordinating care and case management due to the higher incidences of chronic illness in both the Medicare and Medicaid populations. An important area of difference between Medicare and Medicaid and commercial populations is how each group utilizes medical services. The Medicare population tends to utilize a higher proportion of specialty care than do enrollees in commercial group plans do. In contrast, the Medicaid population tends to utilize a higher proportion of primary care services than do either the Medicare or commercial populations. A final area in which Medicare and Medicaid plans are likely to incur additional expense is associated with individual marketing. With commercial products, health plans typically enroll members by groups. For example, when a health plan provides health plan options to a large employer, the employees sign up individually but all the individuals that sign up for each option can 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 commercial members about product options requires less time and money per enrollee than that required to present the same types of information to Medicare- and Medicaid-eligible beneficiaries. Typically, under Medicare, a large portion of a plans enrollees will be enrolled individually rather than through groups, despite an increasing willingness by employers to contract with Medicare health plans to provide coverage to their Medicare-eligible employees and retirees. Medicare-contracting health plans must market and appeal to individual beneficiaries by communicating the advantages of enrolling in a health plan to receive Medicare benefits. Medicaid-contracting health plans must also appeal to individual enrollees. However, under Medicaid, the ability of a health plan to market and the extent to which they need to market will depend upon state law regulating Medicaid health plan marketing and whether the relevant state uses 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 be successful because health plan techniques have the potential to significantly decrease the cost of providing services to beneficiaries from the amount it would have cost to provide the services under FFS programs. For Medicaid populations, the central challenge that health plans face is influencing the behavior of enrollees. Medicaid-contracting health plans can decrease costs by ensuring that Medicaid beneficiaries (1) access care at appropriate sites (and that they avoid inappropriate utilization of expensive emergency room services) and (2) receive appropriate care for chronic illnesses. Medicare-contracting health plans can decrease costs by influencing physician behavior to ensure appropriate utilization of specialty and inpatient services, to better coordinate care, and to manage chronic illnesses. Risk Related to the Structure of State Medicaid Programs The risk involved in providing care to the Medicaid population depends largely on the structure of the relevant states Medicaid program. Key features of state programs that determine the level of 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 Whether the state mandates participation in the health plan program.

health plans plan remain in that plan for a certain period of time

Medicaid Eligibility Groups Eligible to Enroll in Health Plans The Welfare Reform Act replaced a federal welfare program called Aid to Families with Dependent Children (AFDC) with Temporary Assistance to Needy Families, but Medicaid eligibility for women and children remains tied to state AFDC eligibility levels as they existed in 1996 (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 eligibility standards. 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 and disabled Medicaid beneficiaries account for the majority of Medicaid costs. Historically, state Medicaid managed care programs have focused on enrollment of the AFDC population. However, states are beginning to enroll their disabled populations into health plans as well. Financial risk is particularly high with disabled enrollees, partly because states have struggled to find an accurate payment methodology to account for their higher costs. Aged Medicaid beneficiaries are both Medicare and Medicaid. This dual eligibility means that technically, 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 of the difficulty in coordinating Medicare and Medicaid payments and services. Medicare requirements allow Medicare beneficiaries to receive Medicare benefits from the Medicare participating 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 a Medicaid-contracting health plan, but would not be able to require the same beneficiary to obtain Medicare-covered services from a health plan. In addition, if a beneficiary is eligible for coverage under both Medicare and Medicaid, Medicare is the primary insurer. In effect, many of the Medicaid benefits would simply be coverage of copayments and deductibles for Medicare-covered services, and these Medicare services would be delivered in a non-health plan environment. Because Medicaid managed care enrollees are likely to be women and children, the Medicaid population has a different spectrum of healthcare needs than do typical enrollees in commercial group plans. Medicaid-contracting health plans focus their resources on providing prenatal and obstetrical care and well child services. However, as previously noted, health plans must be prepared to manage the chronic care needs of this population. As government policy expands Medicaid 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 persons eligibility for Medicaid is the amount of financial resources and income that person has. Thus, changes in financial status can cause a person to gain or lose eligibility. The temporary nature of Medicaid eligibility poses significant problems for Medicaid-contracting health plans. Medicaid beneficiaries change eligibility status so frequently that it is often difficult to average costs over time or provide any continuity of care. Fluctuations in enrollee eligibility may make it difficult for a health plan to recover its costs of providing initial services such as education, any initial outreach, or physical examinations. Moreover, fluctuations in eligibility decrease the incentive for health plans to provide additional non-Medicaid-covered preventive services as a cost savings mechanism because a beneficiarys enrollment may be of short duration. Prior to the BBA, states had a limited ability to guarantee eligibility of Medicaid beneficiaries for periods of longer than a month. The BBA amended Medicaid law to allow states to guarantee eligibility for 6 months for any individual enrolled in a health plan entity and to allow states to guarantee 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 all enrollees of health plan entities because of the potential cost of such a measure. However, a few states have already adopted and implemented guaranteed eligibility provisions for beneficiaries under the age of 19 in connection with implementation of their State Childrens Health Insurance Programs, which are federally funded and are designed to allow states to create programs to ensure 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 choice for a certain period of time, such as a year. Lock-in provisions increase the financial stability of the Medicaid market for health plans because typically an enrollee must stay with a given plan for some period of time before the health plan recovers the initial costs attributable to signing up that enrollee. In the absence of a lock-in provision under state law, Medicaid beneficiaries can disenroll from a health plan on a monthly basis. Prior to the BBA, states could only lock-in beneficiaries to a few limited categories of Medicaidcontracting health plans. Because it was unlikely that all Medicaid-contracting health plans in a state fit into these categories, this provision was of limited use. States were more likely to seek a waiver of the monthly disenrollment requirement, which was a requirement that Medicaid beneficiaries 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 beneficiarys health plan enrollment for up to a year. However, the provision requires that beneficiaries be allowed to disenroll without cause for 90 days after enrollment. Therefore, the law may not address 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 with federal and/or state regulatory requirements. At the same time the rate of increase in Medicare and Medicaid payments to health plans is slowing, the regulatory requirements imposed on participating health plans are increasing. Both Medicare- and Medicaid-contracting plans are required to comply with federal and state requirements relating to the submission of data in order for the regulating entity to oversee the quality of care provided in the plan. Under Medicare, plans are required to report on the Health Plan Employer Data and Information Set (HEDIS). Many state Medicaid programs are also requiring reporting on HEDIS measures or on similar quality of care measures. Beginning in 1998, CMS required that all Medicare-contracting health plans HEDIS data be audited. Although CMS covered the cost of the audit in 1998, it is likely that 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 Medicarecontracting plans that began in the 1998 contracting year. The BBA amended Medicare law to authorize an assessment on Medicare-contracting health plans to fund CMS efforts to educate Medicare beneficiaries about their Medicare health plan choices. For 1998, the assessment equaled 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 previous years rate for 1998. Although the law sets forth guidelines regarding the amount of the annual assessment, the specific amount of the assessment will be set each year through the legislative appropriation process. In addition, Medicare-contracting health plans were required to begin submitting inpatient encounter data to CMS to serve as a basis for CMS risk adjustment of health plan payments. 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 number of additional regulatory provisions that will impose additional costs on the health plans. Most of the requirements came from the provisions of the BBA that authorized the Medicare+Choice program (see Figure 6A-1). The requirements include, but are not limited to, shorter timeframes for making routine coverage determinations and new requirements regarding physician participation in the Medicare health plan. One of the most significant new requirements for Medicare-contracting health plans is compliance with the Quality Assessment Performance Improvement (QAPI). The Medicare+Choice regulations require that Medicare contracting plans comply with the quality standards and requirements beginning January 1, 1999. In addition, CMS will issue the QAPI standards to states as guidance for the development of quality assurance and improvement strategies in their Medicaid programs. Although adoption of QAPI is voluntary for states, it is likely that states will adopt the QAPI standards as a mechanism for compliance with new Medicaid requirements regarding quality assurance standards. The BBA amended Medicaid law to require that states contracting with health plans develop and implement quality assessment and improvement strategies consistent with the requirements set forth in QAPI. One of the requirements is that the states strategy be consistent with standards established by the Secretary of Health and Human Services. The Secretary will use QAPI as those standards. Another new requirement that may result in additional health plan costs and are applicable to both Medicare- and Medicaid-contracting health plans are requirements to cover emergency room services under a prudent layperson standard. This standard holds that if a prudent layperson would reasonably believe that an emergency medical condition existed, the health plan must pay for the cost of the emergency care, regardless of whether such an urgent medical condition actually existed. Finally, further new requirements regarding coverage of services provided in an emergency room after an enrollee is stabilized may also increase costs. In early 1998, the President issued an executive order to all federal agencies responsible for administering healthcare programs. The order required the agencies, to the extent possible through administrative measures, to implement the provisions of the Consumer Bill of Rights and Responsibilities, developed by the Presidents Advisory Commission on Consumer Protection and Quality in the Health Care Industry. Many of the requirements of the Consumer Bill of Rights and Responsibilities were incorporated in the Medicare+Choice implementing regulations. Those requirements include, but are not limited to, allowing women direct access to a womans health specialist for routine and

preventive services, providing direct access to specialists for enrollees with complex or serious medical conditions, and taking specified actions to provide for continuity of care. It is likely that CMS will require state Medicaid agencies to impose similar requirements on their Medicaidcontracting health plans. Paying Providers to Provide Medicare and/or Medicaid Services To remain financial viable, a health plans Medicare or Medicaid product must accurately calculate payments to providers and develop arrangements that encourage providers to appropriately control utilization. In this section, we discuss issues involved in developing effective 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 Medicaidcontracting health plans is compliance with federal law regarding such payments. There are a number of provisions under Medicare and Medicaid law that affect the structure of provider payment arrangements and the relative amounts that certain providers must be paid or that the providers must accept as payment. The Physician Incentive Law 7 Under federal law, Medicare and Medicaid contracting health plans are prohibited from making specific payments to physicians or physician groups as an inducement to limit or reduce medically necessary services to specific individuals. The law further requires that if a Medicare or Medicaid contract places a provider at substantial financial risk for services that the provider does not directly provide (i.e. referrals), then the health plan must provide stop-loss protection to the provider and must conduct beneficiary satisfaction surveys. Under the regulations, a provider is at "substantial financial risk" if incentive arrangements place the provider at risk for amounts in excess of 25% of the providers total potential reimbursement, where the risk is based on the use or cost of referral services and the size of the patient panel is not greater than 25,000 patients. The patient panel may be determined by "pooling" physician group enrollees from different product lines and even different Medicare- or Medicaidcontracting health plans if specified conditions are met. Finally, the law requires that the health plans provide the HHS Secretary or state Medicaid agency with sufficient descriptive information to determine whether the health plan is in compliance with the law. 8 The regulations also define the requirement that the health plan provide adequate stop-loss protection where physicians or physician groups are at substantial financial risk. Under the regulation, health plans must meet this requirement by ensuring that the physicians or physician groups have adequate stop-loss coverage. The health plan may either pay for stop-loss insurance itself or ensure that another organization pays for it. Either aggregate or individual stop-loss protection may be used to meet the stop-loss requirement. If aggregate stop-loss protection is used, it must cover 90% of the cost of referrals that exceed 25% of total potential payments. If individual stop-loss protection is used, the limit per individual must be decided based on the number of patients assigned to the patient panel, and the stop-loss protection must cover 90% of the cost of referral services that exceed the per-patient limit.

Finally, the regulations specify the information that health plans must disclose to CMS or the state 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 not discriminate with respect to participation, reimbursement, or indemnification against any provider who 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 the same service incases where the reimbursement differences are based solely on differences in how the providers are licensed or certified. For example, a Medicare or Medicaid contracting health plan would be obligated to pay a social worker and a psychiatrist the same amounts for providing the same type of counseling. Similarly, a Medicare or Medicaid contracting health plan would be required to pay an anesthesiologist and a nurse anesthetist the same amounts for providing the same services. Anti-Kickback Law In general, the federal anti-kickback law prohibits any individual from offering or accepting anything of value in exchange for making a referral for, or ordering, an item or service for which payment may be made in whole or part under a federal health program, including Medicare or Medicaid. For example, a primary care physician cannot accept a payment from a specialist for referring a patient to the specialist. 9 The anti-kickback law contains several exceptions for practices that are not considered to be in violation of the law. These exceptions include
Discounts that are properly disclosed and reflected in the costs claimed or charges made

by the provider;
Payments by an employer to an employee for bona fide employment in the provision of Remuneration between an organization and an individual or entity providing items and

covered items and services;

services pursuant to a written agreement where the organization has a Medicare contract or the organization places the individual or entity at significant financial risk for the services 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 other exceptions to the anti-kickback law for some types of arrangements that are unlikely to lead to fraud or abuse. In other words, the Secretary of HHS has identified activities that do not violate to the anti-kickback law. There are two sets of final safe harbor regulations. The first set identifies safe harbors in several broad areas. The second set of regulations offers three safe harbors designed 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 providers to negotiate price reductions or discounts with health plans in anticipation of increased business.

An activity does not have to meet one of the statutory or regulatory safe harbors to avoid antikickback prosecution. An arrangement that does not meet the requirements for safe harbor protection is not necessarily illegal. The safe harbors were provided to give health plans assurance that those arrangements are generally immune from potential criminal and civil sanctions. 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 there is no potential for anti-kickback liability. Second, the arrangement may be implicated by the statute but fall under one of the anti-kickback safe harbors. In such a case, unless the arrangement is a sham transaction, there is no potential for anti-kickback liability. Finally, the arrangement may 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 a health plans Medicare and Medicaid contracts, but also to any services for which federal health program payment may be made. This would include services to employer group enrollees who have Medicare as primary or secondary payor because in some instances payment may be made under the Medicare program. The Physician Self-Referral Law The physician self-referral law prohibits physicians from making a referral to another provider entity for designated health services if the physician, or an immediate family member of the physician, has a financial relationship with the entity. 10 A "financial relationship" includes a direct or indirect relationship between a physician and an entity with which the physician has an ownership or investment interest or compensation arrangement. Therefore, if a physician has a payment arrangement with a health plan and makes referrals to an entity owned by the health plan or in which the health plan has an investment interest, the self-referral law may be implicated. To bill for a service that falls under the physician self-referral ban, any financial relationships that a physician has with an entity must meet one of the exceptions provided in the law. A general exception 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 of exceptions to the self-referral ban. Structuring Provider Payment Arrangements In addition to the Medicare and Medicaid laws set forth above, payment arrangements between Medicare- and Medicaid-contracting health plans and providers are subject to the same legal requirements as those for providing services to the commercial population. In addition, Medicare and Medicaid physician payment arrangements are subject to the same informal influences as commercial arrangements.

As under commercial contracts, geographic location and experience with health plans play a role in the structure of physician payment arrangements. For example, if the health plan is located in a geographic region in which physicians are reluctant to take financial risk in connection with the commercial population, the same or greater reluctance will apply to the Medicare and Medicaid population. Consequently, health plans with commercial lines of business are likely to use similar structures in their provider payment arrangements under Medicare and Medicaid and their commercial population. The payment amounts will be different, however, reflecting the different utilization patterns of these populations. Typically, health plans enter into one contract with a provider that covers all the health plans lines of business. The mechanisms for payment (FFS, capitation, withholds, bonuses, and the formulas for calculating withholds and bonuses) are typically the same across the health plans lines of business, unless the providers refuse to accept risk for a specific population, or state law prevents certain 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/or Medicaid, the health plan will either provide for stop-loss protection or limit any risk for referral to avoid delegation of substantial financial risk under the physician incentive law. Most health plans also refine their provider reimbursement methodologies for their Medicare or Medicaid products to focus on areas of specific concern, such as specialty referrals for Medicare beneficiaries, including ophthalmology (cataract treatment, etc.), cancer treatment, and cardiac services. In some instances, a health plans Medicare or Medicaid payment arrangements may also be affected by its partnership with another healthcare organization that specializes in Medicare or Medicaid managed care. Such organizations focus on Medicare or Medicaid health plans and frequently collaborate with an existing commercial health plan or develop a new health plan product with a provider organization. Often these specialty Medicare/Medicaid health plans use their own proven Medicare or Medicaid provider payment methodologies. Payment Amounts In determining the amount to pay providers to supply services to individuals enrolled under their Medicare or Medicaid contracts, health plans need to balance two objectives that may be conflicting. First, the health plan needs to pay providers at levels that ensure the health plan will have an economically viable Medicare or Medicaid program. Second, the health plan needs to pay providers enough to make participation in their Medicare or Medicaid products attractive to the provider. In many markets, health plans pay providers an amount similar to the amount the provider would have received under fee-for-service Medicare or Medicaid. This is true whether the provider is paid on a fee-for-service basis or on a capitation basis where the capitation amount is calculated by 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 Medicare payments to health plans have been based on a percentage of the AAPCC, which often means that the health plans are paid less than the market FFS rate. To pay providers an amount similar to that they would receive under FFS, the health plan must achieve savings through utilization management. But in competitive markets where services such as inpatient days have already been reduced, such savings are difficult. Moreover, in Medicare, in some areas of the country there has been a trend in FFS provider payments toward paying providers less than the Medicare fee schedule amount. This is particularly 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 with Medicare 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 care providers 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 capitation arrangements made with providers rendering services to the Medicare and Medicaid plan members. Therefore, if provider capitation payments for services provided to Medicare beneficiaries are calculated by applying a multiplier to the commercial provider rates to account for 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 might be 3 to 4 times the multiplier used in a commercial capitation contract. For other services such as those 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 two conditions. 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 to enroll in a plan. Therefore, a health plans most important tool for achieving profit is the control of utilization rates. A key method of controlling overutilization in health plan environments is, as we have seen, provider reimbursement contracts that put providers at financial risk in cases of overutilization. It is important to remember that there are two basic categories of services for which providers may accept riskservices they provide directly and referral services. For physicians, referral services include inpatient services and specialty physician services. A provider payment arrangement 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 similar role in determining whether a provider will accept risk under Medicare or Medicaid as it does with the commercial population. In addition, physicians and providers who have experience with the commercial population, but not the Medicare or Medicaid population, may be reluctant to assume risk in connection with the Medicare or Medicaid population or may request significant utilization data from the health plan before entering into a risk arrangement. There is typically more provider reluctance to accept risk in connection with providing services to the Medicaid population than with providing services to the Medicare population. For physicians or physician groups, the size of the patient panel is a key factor in whether the physician or physician group will be willing to accept risk. Other factors being equal, the more patients 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 a predictable range. Providers who are already accustomed to accepting capitation payments are most ideally suited to provide services to a Medicare-contracting health plan, particularly if those providers have had experience treating large number of older patients, or have had experience with Medicare populations. These providers understand the need to manage the overall care of the member and establish an ongoing relationship with members rather than providing episodic treatment for disparate illness or injuries.11 As a practical matter, a key influence on the structure of payment arrangements between Medicare- and Medicaid-contracting health plans and their physicians is the federal physician incentive law discussed earlier. Recall from our earlier discussion that the physician incentive law regulates payment arrangements with physician and physician groups and only regulates financial risk for services the physician or physician group does not directly provide. A health plan typically designs its risk-sharing arrangements to serve its business purposes, and then performs an analysis of the arrangements compliance with the physician incentive law. In some cases, the risk imposed by an arrangement meets the definition of substantial financial risk. If the health plan can make small adjustments to the arrangement to bring it under the substantial 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 are imposed when a health plan places a physician or physician group at substantial financial risk. If bringing the compensation arrangement under the substantial financial risk threshold undermines the basic structure of the arrangement, the health plan can choose instead to buy (or require providers to buy) stop-loss insurance. The health plan can also provide stop-loss insurance to providers as a means of complying with the physician incentive regulations for its Medicare or Medicaid products. Providers' Financial Risk and Medicaid Under Medicaid, some providers that have traditionally provided services to low-income persons and served as a safety net have relatively little experience with accepting financial risk. However, it is important to include such providers in the health plans network, and health plans may be required 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 were required to pay FQHCs 100% of reasonable costs unless the FQHC negotiated another arrangement with the health plan. As discussed earlier in this lesson, the BBA amended Medicaid law to require states to make supplemental payments to FQHCs and RHCs to guarantee that the level of payment from the health plan equals the guaranteed payment level set forth in federal law. Effective use of hospital utilization is the single most likely factor to contribute to the success of a Medicare-contracting health plan.12 Therefore, it is useful for Medicare contracting health plans to structure their physician payment arrangements in a manner to provide incentive to avoid the risk of overutilization of hospital services. 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 for that health plans commercial population. Managing the use of specialty services is also an important consideration for Medicarecontracting health plans. Because of the higher use of specialists required to provide care to the Medicare population, health plans should implement an incentive that addresses effective referrals 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 to requirements to share risk with its providers. As defined under Medicare law, a PSO is a public or private entity that is established or organized and operated by a provider or group of affiliated healthcare providers and that provides a substantial portion of healthcare items and services under its 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 providers must share financial risk with respect to the provision of items and services under the Medicare contract and must have a majority financial interest in the PSO.

The implementing regulations to the law specify that each affiliated provider must share, directly or indirectly, in substantial financial risk. The regulations indicate that the following mechanisms may constitute risk-sharing arrangements and may have to be used in combination to demonstrate substantial financial risk in the PSO:
Capitation payment for each Medicare enrollee Payment of a predetermined percentage of the PSO premium or the PSOs revenue The PSOs use of significant financial incentives for its affiliated providers, with the aim

of achieving utilization management and cost containment goals. For example, the use of significant withholds or bonus arrangements would fall under this category 13 Other mechanisms that demonstrate significant shared financial risk. It is likely that a PSO would not have commercial lines of business and therefore would not have agreements to provide services to commercial enrollees on which to base its Medicare provider payment 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 evaluating the Medicare or Medicaid markets, health plans should be mindful of the payment amounts the organization will receive, the regulatory environment, and the special needs of the populations to be served. Finally, a health plans relationships with providers are an important factor in its success. To make a Medicare or Medicaid product financially viable, a health plan must
Structure its payment arrangements to attract providers who will work well in a health Provide incentives to appropriately control utilization and manage care, and to be

plan environment

consistent with the health plans financial goals given the payment rate that the health plan receives from the state or federal government. Endnotes 1. PREAMBLE TO COMMENT SOLICITATION ON RISK ADJUSTMENT METHODOLOGY, 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 with permission. 8. SECTIONS 1852(j)(4) (relating to Medicare) AND 1903(m)(2)(A)(x) (relating to Medicaid) 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 Plans View,in The Managed 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 and Underwriting Course Goals and Objectives After 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 core business: pricing health plan benefits and other products in such a way that the rates for the health plans 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 regularly monitors how well its assumptions about expenses and risk match the costs that the health plan incurs. Demographic factors, medical treatments, technology, and health plan techniques change over time. As a result, a health plans expenses change, so the health plan analyzes and incorporates 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 charge purchasers, given the degree of risk represented by an individual or group, the expected costs to deliver healthcare services, and the expected marketability and competitiveness of the healthcare services.1 Underwriting is the process used to assess the risks associated with providing healthcare services for an individual or group and to determine the conditions under which those risks are acceptable. 2 The process of rating is usually accomplished by using a mathematical formula that considers the specific costs that affect the delivery and financing of healthcare services to a particular group or individual. The rating formula represents each cost by a specific, measurable, cost-generating variable. This formula is sometimes called the book rate formula or the manual rating structure. We discuss manual rating later in this lesson. A health plans underwriting process may modify the book rates and/or establish certain conditions that must be satisfied by the group or individual before the health plan accepts the risks associated with providing healthcare services. The rating structure that a health plan uses must

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 employee category through the use of an appropriate tier rating structure, which we discuss later in this lesson and in Pricing and Rating lesson. The rating formula and its components have other important applications to a health plan. These applications include establishing budgets or cost objectives by medical service category or department; establishing funding for provider-based risk pools; and identifying, quantifying, and ranking opportunities for healthcare services within the health plan. A health plan can use these data to establish provider-based education and incentives necessary to realize business opportunities. A health plans actuarial and underwriting functions are involved in the development of premium rates and risk selection. The Actuarial Function Generally, the actuarial function is the work group and/or processes that a health plan establishes to be responsible to see that the health plans operations are conducted on a mathematically sound basis.3 Recall from the Health Plan Financial Information lesson that an actuary develops premium rates and evaluates claims experience with respect to the risk associated with healthcare benefits for product pricing, provider contracting, and other purposes. Ultimately, the determination of the appropriate rate (price) to charge for a given level of healthcare benefits and administrative services (cost) in a particular market (competition) is a critical component of managing the profitability of a health plan. Employees in a health plans actuarial function typically:

Calculate premium rates Identify the type and amount of the health plans liabilities Conduct research to establish underwriting guidelines Determine the health plans overall profitability Play a key role in managing the health plans risk-based capital (RBC) requirements, if applicable Design and revise healthcare products and services (with employees in the health plans marketing function) The Underwriting Function Recall from the Health Plan Financial Information lesson that an underwriter assesses and classifies the degree of risk represented by a proposed group or individual. The underwriting function is the work group and/or set of processes that a health plan establishes to assess the risks associated with a group or individual and which determines the conditions under which those risks 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 providing healthcare benefits for each purchaser do not exceed the costs that were assumed when the price of those benefits was calculated. A health plans underwriters and other employees who perform the underwriting function use purchaser-specific quantitative or qualitative considerations to modify the results obtained from the rating formula to reflect accurately the health plans risks in underwriting the purchaser or group. For large employer groups, underwriters may include minimum penetration requirements, which we discuss in the next lesson. For small employer groups, underwriters also may consider the result of medical underwriting, which we discuss in the Small Group Underwriting and Individual Underwriting lesson. Either the actuarial function or the underwriting function in a health plan also negotiates and manages stop-loss insurance contracts and reinsurance contracts that the health plan uses to transfer some or all of its risk. Underwriters and other employees who perform the underwriting function in a health plan rely on the premium rate structure developed by the actuarial function and consider which assumptions should be accepted as is or modified through additional general or specific procedures. Underwriting, Rating, and Risk Management In Risk Management in Health Plans, we discussed how a health plan uses risk management techniques to avoid, assume, share, or transfer the risks associated with the financing and delivery of 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 health plan reviews the risk assessment factors associated with that group or individual. Risk assessment factors associated with group healthcare benefits may include the size, stability, experience, geographic area, industry, level of participation, and demographics associated with a group and the 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 the individuals age, gender, health status, occupation, hobbies, and the existence of other healthcare benefits. Although some of the same factors apply to both group and individual underwriting, an analysis of these factors is typically less detailed for large groups because group members with high utilization rates are expected to offset those with low utilization rates. We discuss key risk assessment factors in group underwriting in the next lesson. Key risk assessment factors in small group and individual underwriting are discussed in the Small Group Underwriting and Individual Underwriting lesson. Risk Classification To assist in the development of appropriate premium rates, a health plan classifies the risks associated with groups and individuals. In the context of establishing premium rates, risk classification involves sorting group members into classes or tiers. The actuarial function develops 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, up to 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 who enrolls for employee-only coverage (Tier 1), and another amount for each employee who enrolls for family coverage (Tier 2). In other words, the premium is determined by multiplying the Tier 1 rate by the number of employees who enroll for employee-only coverage and the Tier 2 rate by the 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 the development of premium rates by tier in the Pricing and Rating lesson. A health plan usually develops premium rates on the basis of a groups risk profile. The degree to which a groups rates are based on its own risk profile depends on the size of the group and applicable state regulations regarding rating practices. For example, some states do not allow health plans to use a rating differential based on the health status of small groups. Risk classifications for group underwriting include those based on utilization patterns and/or average claims 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 the lowest 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 members have the highest utilization patterns and/or average claims costs. Between these two ranges are groups whose members exhibit less extreme levels of utilization patterns and/or average claims costs. As you may have expected, health plans usually charge groups or individuals with lower utilization patterns and/or average claims costs a lower premium rate for a given level of healthcare coverage. After classifying the risk, a health plan decides to accept or to decline the risk, based largely on the health plans 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 plans ability to decline coverage for some individuals and groups. Suppose an employer group offers its employees a double option: an HMO and a traditional indemnity plan. Assume that the premiums are lower for the HMO than for the indemnity plan. In this case, individual low utilizers are more likely to enroll in the HMO because they are less likely 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 the indemnity plan, for the same reason. In contrast, individual high utilizers of healthcare services are more likely to enroll in a health plan with a POS option or an indemnity plan because they want 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 in a 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, the HMO that charges the lowest premium would be selected by both high and low utilizers of healthcare services, if access is similar across the HMO options. In many cases, to remain competitive or to comply with regulatory requirements, a health plan that ordinarily would decline to accept the risk represented by a specified group may opt to contract with that group for the provision of healthcare benefits. For example, in some states, health plans that compete in the small group marketthose with fewer than 50 employeesmust comply 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 to a group in order to obtain or retain business in a particular market. Although health plans may reduce benefits to maintain or to lower premiums, health plans that do so accept the risks that the plan 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 plans underwriting guidelines address the level of overall risk and the risk classifications that the health plan is willing to accept when offering a given level of healthcare benefits to individual or group plan members. The underwriting function determines what degree of risk is so high that a health plan cannot underwrite the business at all, thereby declining the risk. These determinations are established according to the health plans strategic goals, its attitude (conservative or aggressive) toward risk, and its pricing decisions. Underwriting guidelines influence a health plans cash flowsmoney coming into the plan in the form 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 plans cash flows positively. The underwriting cycle is the historical occurrence of a period during which health insurers generated underwriting profits on their business, followed by a period during which the health insurers generated underwriting losses on their business. For the past three decades, 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 more strict underwriting guidelines after three unprofitable years of underwriting healthcare coverage. Strict underwriting guidelines typically result in premium rate increases for a health plan. As a result of higher premiums, the health insurers and health plans experienced three highly profitable years, which provided them a financial cushion from which they could relax their underwriting guidelines. The establishment of lenient underwriting guidelines usually resulted in lower premium rates for the health plan. Charging lower premium rates improved the health insurers or health plans ability to respond to market competition. However, lower premium rates could result in several unprofitable years for the health plan, the health insurer, or the health plan. During years in which health 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 to generate company-wide net income (profit). Following several years of losses, the health insurer or health plan was likely to tighten its underwriting guidelines once again. Strict underwriting guidelines usually resulted in higher premium rates, thereby improving the plans profitability for the next few years. Finding the appropriate balance between competitive premium rates and actuarially sound premium rates is therefore critical to managing the underwriting cycle and predicting healthcare cash flows. By the late 1990s, conventional wisdom is that the effect of the underwriting cycle has been alleviated by the evolution of health plan techniques, which have improved a health plans ability to predict costs. Rating Components 7 To develop an effective rate formula, health plans pay close attention to two major components in setting premium rates: (1)the cost of incurred claims and (2) the retention charge. The cost of incurred claims, also called incurred claims expense, is the portion of the premium that a health plan determines will be needed to pay claims. For large group plans, a health plan projects the cost 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 (contract renewal date) to give the health plan enough time to review the data, develop the new rate, and give the purchaser advance notice of a rate change, if any. The new rate then becomes applicable at 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 of healthcare benefits, the retention charge is the portion of the premium that is not paid out to cover the cost of incurred claims. In other words, it is the portion of premium that a health plan retains to cover administrative expenses such as processing claims, staff salaries, taxes, conversion charges, and to allow a margin for profit. Retention charges also include risk charges and other charges. A health plans retention charge differs on the basis of the health plans structure. For example, a capitated health plan includes most of the costs incurred by the plans medical management functionincluding utilization management and quality managementin its cost of incurred claims rather than its retention charge. On the other hand, costs incurred by the medical management function in health plans that are not capitated typically are included in the retention charge component of the plans premium. Figure 7A-3 presents an example of how a health plan computes 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 market competition and group size. For example, health plans that operate in very competitive markets may choose to accept greater risks than they would be willing to take on otherwise in order to obtain market share. They then use risk management techniques to transfer some or all of these additional risks. Government mandates influence the degree of underwriting that a health plan undertakes in order to obtain group business. Legal and regulatory requirements often mandate that all members of a group, particularly small groups of 2 to 50 members, be accepted regardless of the risk posed by any individual group member. In assessing, classifying, and selecting the risks for a group, a health plan may use medical underwriting. Medical underwriting is the use of health questionnaires, medical histories, paramedical examinations, or physical examinations to assess, classify, and select or decline the risk. There is an inverse relationship between the degree of medical underwriting a health plan undertakes and group size. In other words, health plans use medical underwriting regularly in underwriting individuals and small groups, unless prohibited by law or regulation, but seldom use it in the case of large groups. We discuss medical underwriting in more detail in Small Group Underwriting and Individual Underwriting. The following sections discuss common rating methods 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 direct result of the actuarial function (calculating the appropriate premium rate for a given level of healthcare 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 deal upon its ability to appropriately price its products. Recall from Risk Management in Health Plans that antiselection is the tendency of people who have a greater-than-average likelihood of loss to seek healthcare coverage to a greater extent than people who have an average or lower-than-average likelihood of loss. Antiselection, also called adverse selection, can also occur when the highest utilizing groups or individuals enroll in a particular health plan, rather than choose no option or another healthcare benefit option. This type of antiselection typically occurs within groups that have a dual option or triple option available to them or within highly competitive markets. Although health plans that attract the healthiest (lowest utilizing) groups experience favorable selection, competition for these groups business is so keen that a health plan may be tempted to undercharge a group in order to obtain or retain the groups business. In this case, the group would most likely retain their current health plan because the group would not be able to obtain the same level of healthcare benefits at a lower cost in the marketplace. We discuss the issue of pricing in a multiple-choice environment in more detail in Pricing a New Health Plan . Undercharging may be an appropriate short-term solution in certain circumstancesfor example, to enter a new market or to increase market share in an existing market. However, undercharging a group is not a viable long-term strategy because a health plan must charge premium rates that are adequate to cover at least the health plans costs. Further, competing on the basis of price alone may encourage employer groups to view healthcare benefits as a commodity to be purchased from the health plan that charges the lowest price 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 they must set premium rates that are adequate to cover their expenses and generate a fair profit. A variety 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 benefits according to the expected costs for healthcare in a market or segment, known as a block of business, rather than to a subgroup within that block of business. In other words, a health plan calculates the premium rate according to the costs for the block as a whole, rather than as a function of each risk class within the block of business. Because both low-risk and high-risk classes are factored into community rating, the expected costs are spread across the entire community. Community rates may vary by type of health plan or group size, although all groups pay similar premiums for the same level of benefits. If actual costs exceed expected costs, then the health plan is financially responsible for the difference. Community rating is seldom used for large groups, 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 groups premium using community rating as a point of reference for calculating the premium rate under another rating method.

The use of modified community rating methods has increased for small groups, spurred by several federal and state initiatives that have mandated such community rating methods for small groups. Some small groups benefit from modified community rating methods because these groups incur less fluctuation in premium rates and have more stable contract relationships with health plans than they are likely to have under other rating methods. However, typically 70% to 80% 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 using community 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 plan can receive a steady flow of premium income. Community rating is also compatible with health plan provider reimbursement techniques such as capitation. The use of community rating enables a health plan to spread the risks it assumes for both highrisk and low-risk groups throughout the market or segment it serves. Community rating is a relatively straightforward processtypically only a few factors are considered in determining premium ratesso a complex information system is not required in most circumstances. Although community rating tends toward stable premium rates, the advantages of such stability may be undercut by a competitor that uses another rating method or is willing to charge a lower premium. In the latter case, a competing health plan may be willing to assume greater underwriting risk in order to obtain or retain market share. Artificially low premium rates may attract a group initially, but a health plan most likely would have to increase premiums significantly after it determines the communitys actual utilization rates and actual costs. In 1991, the National Association of Insurance Commissioners (NAIC) promulgated a small group model act that allows health plans to use a modified form of community rating to underwrite small groups. This modification, referred to as community rating by class (CRC), also called factored rating , allows a health plan to use tiers on the basis of experience or duration. We discuss 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 CRC results from calculating the weighted average of these factors. In this context, the term experience means a specific groups historical healthcare costs and utilization rates. All members of the same class or group pay the same premium, which is based on the experience of the class or group. The average premium in each class may not be more than 120% of the average premium for any other class. A 1995 amendment to this model act eliminated the class rating rules and promulgated the use of adjusted community rating. Adjusted community rating (ACR) , also called modified community rating, is a rating method under which a health plan calculates the ratio of a groups experience to its historical manual ratewhich is based on age, sex, industry, and so onthen multiplies this ratio by the groups 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 developing premium rates. Note that, because NAIC model acts and their amendments do not carry the force of law, laws based on the 1991 small group model act still exist in many states. Also, another modified 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 rates that are plus or minus 25% of the index rate. The Centers for Medicare and Medicaid Services (CMS) requires health plans that assume Medicare risk to use ACR so that premium rates reflect expected utilization levels, rather than the actual costs of healthcare benefits. The Health Maintenance Organization Act of 1973 (the HMO Act) 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 experienceand sometimes the experience of other health plansrather than the purchasers actual experience, to estimate the groups expected experience. Manual rating is similar to community rating in that both rating methods use demographics to determine the rate for a block of business. Manual rates are typically developed with the use of proprietary data or published morbidity tables, which we discuss in the next lesson. In developing manual rates, a health plan assesses primarily its own experience. For example, a health plan may derive its own average manual rate, perhaps adjusted by a groups characteristics, industry, or geographic area. Manual rates are sometimes called book rates because a health plan often 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 to see what the manual rate is for a given level of healthcare benefits. Manual rates are often used to establish 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 groups actual experience, including its healthcare costs and utilization rates, to determine premium rates. In other words, the health plan analyzes a groups healthcare costs by type and calculates the groups premium in part or in full according to that experience. Under experience rating, health plans charge lower premiums to groups that have experienced low 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 of different groups to determine a manual rate, experience rating is specific to a particular group. Because a groups experience changes over time, a health plan frequently uses at least two years of the groups experience to calculate experience rates. In most cases, the size of the group is important in determining the degree to which experience rating applies. Generally, health plans experience rate groups that have more than 250 employees, although many health plans have started to use experience rating for groups of 50 or more employees. Experience rating methods may be either prospective or retrospective. Prospective Experience Rating Prospective experience rating is an experience rating method that uses a groups experience to establish the premium for the next contract period. Often the premium rate is based on a weighted

average of a groups own experience and the experience of many small groups. A health plan may pool (combine) the experience of many small groups to obtain a large enough group to experience rate. Pooling enables small groups to obtain lower premium rates than would otherwise be possible. Twelve-month periods are typically used for prospective experience rating for an employer group. Because prospective experience rating does not carry over gains or losses from one rating period to the next, health plans that use prospective experience rating absorb the gains or losses generated by a groups experience. Adjusted community rating, discussed earlier in this lesson, is a type of prospective experience rating. Another type of prospective experience rating is durational rating. Under durational rating, premium rates increase automatically with group tenure in a health plan for a specified period, such as six months or a year. For example, a health plan may charge a large employer group a $120 premium PMPM in the first year, $130 in the second year, and $135 in the third year for a three-year contract for the same level of healthcare benefits, before inflation. Medical underwriting 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 plan considers both the gains and the losses experienced by a group during each rating period. The health plan refunds part of a groups premium, called an experience rating dividend or experience refund (also called an experience rating refund) after the rating period is over if the groups experience has been better than expected during the rating period. A health plan determines a premium rate, in part, on the basis of its assumptions about a groups expected utilization rate or claims costs. At the end of the covered period, the health plan compares the groups actual experience with its expected experience. On the other hand, if the groups experience has been worse than expected during the rating period, the health plan charges the group extra premiums for the excess costs, either in a lump sum or in future premium increases. Often, when a health plan notifies a group of a premium rate increase because the groups experience was worse than expected, the group will drop its health plan with the health plan and move to another plan. Therefore, the health plan must include a risk charge in its premium rate to cover for such losses. We defined risk charge in the Fully Funded and Self-Funded Health Plans lessons. Because the excess costs will be paid by the purchaser after the covered period, the purchaser must have a good credit rating to qualify for retrospective experience rating. In some cases, if a groups experience is significantly worse than expected, the health plan may choose not to renew the groups coverage. In effect, under retrospective experience rating, a group assumes some of the financial risk associated with its experience. Many large groups that have low healthcare costs and low utilization rates expect to obtain either a rate decrease in the next contract period or an experience rating dividend. The opportunity to obtain an experience rating dividend or to sustain the same premium or a lower-than-average increased premium in the next rating period is an incentive to the group to control healthcare costs and utilization. However, many states prohibit HMOs from using retrospective experience rating.

Note also that the premium determined under retrospective experience rating usually is higher than the premium under prospective experience rating, because some of the premium will be returned to the purchaser in the form of a refund. Whether a health plan uses prospective or retrospective experience rating, the health plan can expect similar profit levels from either type of experience rating method. Blended Rating Blended rating is a rating method that combines experience rating and manual rating. Under blended rating, a health plan develops a premium rate using a groups own experience, weighted by the health plans manual rate and the groups credibility. Credibility is a measure of the statistical predictability of a groups experience, which is expressed as a percentage or in decimal form as a credibility factor. The calculation of the statistical probability of a groups credibility is beyond the scope of this course. Generally, the experience of a large group is generally more credible than that of a small group. The values of credibility factors typically fall between 0 and 1.00. The closer a groups credibility factor is to 1.00, the more reliable the groups experience, and the more likely that a health plan will weight the groups experience more heavily than it weights the manual rate in calculating the groups overall premium rate. A credibility factor of 1.00 means that a groups premium rate is based entirely on the groups experience. Most experience rating is a blended rating, unless the group is large enough to have 100% credibility (that is, a credibility factor of 1.00) assigned to its experience. The blended rate is found by (1) multiplying the experience rate by the credibility factor, (2) multiplying the manual rate by the difference between 1.0 and the credibility factor, then (3) adding the retention to these amounts, as follows: Using a groups experience may not necessarily be predictive of its future utilization rate or claims costs, however. A health plan addresses the risk that a groups experience may not be independent from one year to the next by lowering (discounting) the groups credibility factor by a 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 groups credibility factor include:

Using two or more years of the groups experience Removing the groups 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 groups experience into determining a blended rate.

In this case, Legrand would charge Holcomb a $144 premium (based on claims costs) per member per month (PMPM), plus retention. Note that Holcombs blended rate is greater than its experience rate, but less than its manual rate. The higher a groups credibility factor, the closer its blended rate would approach its experience rate.

Renewal Underwriting and Rating The processes of renewal underwriting and renewal rating, which are sometimes combined, serve to determine whether a health plan should continue to underwrite the risk, and, if so, at what premium rate. Renewal underwriting and rating consume a significant amount of time and effort on 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 that were considered when the health plan contract was first issued, then compares the actual and expected dollar amounts and utilization rates to determine if the health plan should continue to underwrite the risk. 9 Renewal rating is the process by which a health plan, through reviewing utilization rates, claim costs, and other factors, determines the dollar amount of premium to be charged to a group or individual in a renewal contract. All rating methods, including prospective experience rating, that we described in the previous sections may be used to determine the initial premium rate for an initial contract. Often, a health plan can use prospective experience rating when the health plan obtains a proposed groups experience from the groups previous health plan. Experience information of this type is generally not available for HMOs or groups with fewer than 100 employees. Note also that prospective experience rating can only be used in renewal rating 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 plans use to determine initial premium rates for a group. A health plan also considers several other factors, 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 combine several factors in determining renewal premium rates.

Exposure Period In the context of renewal rating and underwriting, the exposure period is the amount of time during which a health plan is financially responsible for any or all risks that it assumed under a group healthcare contract. A one-year contract period between a health plan and a group may enable the health plan to more closely correlate the premium rates it established for that group with the groups actual utilization rates and overall experience. Sometimes, to remain competitive and to minimize disenrollment, health plans contract with groups for two-year or three-year periods. However, the longer the contract period, the higher the risk that the assumptions, under which the initial premium rate was established, will not correlate closely 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 one contract period. In this case, a health plan has a number of options with respect to consideration of that catastrophic claim in the renewal rating process. The health plan can include all of the catastrophic claim cost in the groups experience and adjust the groups premium rate accordingly. Conversely, the health plan can choose to exclude the total catastrophic claim from the groups experience. In either case, the health plan may consider the probability that a similar claim will occur in the future and adjust the groups premium rate to reflect that probability. Another option available to a health plan is to exclude a percentage of the catastrophic claim costs from the groups experience. Although the premium rate might increase for that group, this increase may be lower than it would have otherwise been, if the total cost of the catastrophic claim had been included. The preceding example depicts the impact of a catastrophic claim on one group. Suppose that, in a given block of business, several groups had catastrophic claims. In this case, a health plan may deduct the catastrophic claims from the renewal rate calculation, then incorporate a catastrophic claims 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. LOMAs 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 Shield Association, April 1996), 10. Used with permission; all rights reserved. 6. Adapted from Susan Conant, Nicholas L. Desoutter, Dani L. Long, and Robert MacGrogan, Managing for Solvency and Profitability in Life and Health Insurance Companies (Atlanta: LOMA, 1997), 109. Used with permission; all rights reserved. 7. Adapted from Blue Cross and Blue Shield Association, Pricing and Financing the Product (Chicago: Blue Cross and Blue Shield Association, 1992), 67. Used with permission; all rights reserved.

8. Adapted from Academy for Healthcare Management, Managed Healthcare: An Introduction , 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," in Essentials 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 Objectives After 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. This lesson 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 that affect group underwriting (other than small group underwriting, which we discuss in Small Group Underwriting and Individual Underwriting). Then we discuss key aspects of group underwriting and group underwriting procedures. If a health plan is incorporated, then it is subject to all federal and state laws and regulations that apply to corporations. In addition, health plans that serve the group market must comply with other laws that concern employee benefit plans, such as laws that pertain to medical records. In the course of assessing, classifying, and selecting risk, health plans gather a great deal of personal information about individuals. General laws and court cases relating to confidentiality of medical information apply to the handling of this information. Some states also specifically address procedures, including specific methods for filing and retrieving information and a specified period 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 that offer 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 health plans that cater to these markets. The Health Maintenance Organization Act The Health Maintenance Organization Act of 1973 (HMO Act), which applies only to federally qualified HMOs, originally required HMOs to use community rating to determine premiums. At the time of its enactment, the HMO Act prohibited HMOs from using experience rating. A 1981 amendment to the HMO Act expanded the allowable rating options to include community rating by class, which enabled HMOs to consider certain characteristics of each groupsuch as the groups industry and the age, gender, and marital status of its memberswhen determining the groups premium rates. In 1988, the HMO Act was amended to expand the allowable rating options to include prospective experience rating (also called adjusted community rating in the context of federally qualified 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 have allowed an HMO to adjust a groups prior premiums on the basis of the groups experience during the prior rating (contract) period. Note that, although federal qualification is no longer of critical importance to HMOs, federally qualified HMOs must comply with the HMO Act and its amendments. Employee Retirement Income Security Act Employer-sponsored benefit plans that provide healthcare benefits must comply with the Employee Retirement Income Security Act (ERISA) of 1974, a broad-reaching law that established, among other things, requirements for the disclosure of plan provisions and funding information to plan participants. Also contained in ERISA are strict reporting requirements, including requirements for the preparation and submission of reports to the Department of Labor and the Internal Revenue Service. Underwriters appraising the risk of a group that previously had a self-funded plan may use the documents files under ERISA reporting requirements to assess the risk. However, when a group previously has been insured by another health plan, underwriters typically do not rely upon ERISA reports. Instead, the underwriters use reports provided by the groups previous health plan to address the groups claims experience and to establish premium rates. Consolidated Omnibus Budget Reconciliation Act The Consolidated Omnibus Budget Reconciliation Act (COBRA) of 1986 requires plan sponsors to allow qualified beneficiaries (employees and their dependents) to continue their group healthcare coverage for a specified period of time following a qualifying event that causes the loss of group healthcare coverage. Because this continuation requirement applies to plan sponsors, 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, the health plan is not required to continue coverage for the COBRA- qualified beneficiaries, because COBRA places this responsibility with the plan sponsor. The successor health plan, in determining whether to accept or decline the risks associated with this group, would also consider the risks associated with the groups COBRA-qualified beneficiaries. Under COBRA, a health plan is not required to cover these individuals. However, the successor plan must decide whether to cover the COBRA beneficiaries outside the policy as a condition for doing business with the purchaser. Americans with Disabilities Act The Americans with Disabilities Act (ADA) of 1990 is a federal law that protects disabled individuals from various types of discrimination. Because of its scope, the ADA applies to the facilities and activities of all types of health plans. For example, the ADA requires that a health plan facility must be accessible to wheelchairs. Also, a health plan must not discriminate against disabled providers.

In addition, underwriting guidelines that exclude or reduce benefits that apply to a specific disease have been challenged in court as violations of the ADA. However, a health plan that reduces benefits for a particular service, for example, that does not discriminate against a particular 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 health plan may be found in violation of ADA. On the other hand, if the health plan reduces prescription drug benefits for all employee classes, the health plan is less likely to be found in violation of the ADA. Further, if a health plan has a sound underwriting reason for eliminating or reducing benefits that impact only individuals with a particular disease or disability, the plan may not be in violation of ADA. Health Insurance Portability and Accountability Act The Health Insurance Portability and Accountability Act (HIPAA) of 1996 contains provisions to ensure that prospective or current enrollees in a group health plan are not discriminated against based on health status (for example, there are rules and limits on the use of pre-existing condition exclusions). This law also requires guaranteed access to health insurance for small employers and certain other eligible individuals. Similarly, HIPAA generally requires the guaranteed renewal of healthcare coverage for certain individuals and for both small and large groups, regardless of the health status of any member. These and other requirements restrict a health plans ability to accept or decline certain risks and they may directly impact a health plans 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 in Provider Reimbursement Arrangements, requires that a health plan cover hospital stays for childbirth for both the mother and the newborn for at least 48 hours for normal deliveries and 96 hours for Caesarean births. The Mental Health Parity Act (MHPA) of 1996 prohibits a health plan, under certain circumstances, from imposing annual or lifetime dollar benefit limits for mental illness on a group if there are no such limits for physical illness. The MHPA does not require that a health plan offer benefits for mental healthcare. However, if a health plan does offer mental health benefits, then the MHPA mandates that the annual or lifetime limit on such benefits cannot be less 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) that providing mental health parity would increase health plan costs by at least 1%. This exemption means that few health plans offer mental health parity. Benefit mandates such as the federal NMHPA and MHPA and numerous state laws and regulations (briefly discussed in the following sections) have a major impact on a health plans underwriting 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 in calculating premium rates.

State Laws and Regulations 2 Most state insurance laws contain provisions that in some way affect the underwriting and rating practices of health plans. Often the purpose of state underwriting laws and regulations is to protect consumers from unfair discrimination in terms of eligibility. For example, most states require that any differences in healthcare benefits for members of an employer group must be based on conditions pertaining to employment. This means that an employer group would not be permitted to have separate benefit levels for certain employees listed in a memorandum sent by the companys human resources manager to a health plan. However, the employer group would be permitted to provide separate benefit levels based on conditions pertaining to employment, such as hourly or salaried status, job class, or salary range. In deciding whether or not to accept risk for an employer group, a health plans underwriters must be aware of state group insurance laws that specify the individuals who can or must be covered under a group policy. For example, some state laws specify whether or not dependent coverage must be provided. Also, most state laws define certain types of dependents that must be covered if dependent coverage is provided under a health plan. As we mentioned in The Relationship Between Rating and Underwriting lesson, states sometimes place limits on how much a health plan may charge for healthcare benefits. Generally, the purpose of these limits is to ensure reasonableness and adequacy in rating. For instance, in a state that requires rate filings for a particular product, an insurance department might reject a rate increase because of concerns about the reasonableness of the proposed rates. Alternatively, a state insurance department might reject a rate decrease submitted in a rate filing on the grounds that the rates are not adequate to meet the health plans operational costs. In addition to eligibility and rating requirements, many states have enacted benefit mandates that have a significant impact on underwriting and rating decisions. Recall from the Provider Reimbursement Arrangements lesson that mandated benefit laws require a health plan to cover certain conditions or treatments or to pay a specified level of benefits for certain conditions or treatments. Similar to benefit mandates are provider mandates, which, among other things, may require a health 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 plans actuaries and underwriters because for certain portions of the health plan, at leastthese mandates determine what 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 health plans 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 mandates because 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 state laws and regulations govern guaranteed issue, guaranteed renewal, reinsurance pools, and rate certification requirements. Discussion of these additional laws and regulations is beyond the scope of this course.

Major Risk Factors in Group Underwriting 3 Underwriters may use many information sources to assess and classify the risk represented by a group seeking healthcare benefits. In this section, we discuss published morbidity tables, which are 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 at which sickness and injury occur within a defined group of people. Factors that may limit the direct application of published morbidity data include such variables as geographical cost variances, group composition, benefit level, and the timeliness of reporting cost data. Because of these factors, many health plans develop their own sources of morbidity statistics. A groups morbidity rate is of particular concern to a health plan. Generally, in pricing a health plan, a groups own morbidity data is the most preferred source. Recall from The Relationship Between Rating and Underwriting that the use of experience rating usually results in the establishment of equitable, reasonable, and adequate rates for a large group. However, sometimes a health plan may not have sufficient information to effectively forecast a groups morbidity, or a health plan may be prohibited by law from using experience rating. In these situations, a health plan may use the manual rates that it developed from its aggregate experience, published morbidity data to fill in the gaps, data from similar groups, or a combination of these approaches. Figure 7B-1 depicts an example of how a health plan would develop 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 nonsex-related differences. For example, an HMO with half its plan members from a steel company that has a significant number of retirees would have to adjust published morbidity rates to reflect the actual population it serves. Figure 7B -2 summarizes the key risk factors associated with group underwriting.

Key Aspects of Group Underwriting 4 To evaluate a group prospect, an underwriter considers the characteristics of both the group and the requested coverage. While each health plan has its own specific guidelines for assessing group risk, most underwriters adhere to certain general underwriting principles. Group underwriting usually does not involve evaluating individual members, but it does require careful assessment of a group. After considering the major underwriting risk factors, a health plans underwriters evaluate the risk assessment factors associated with that group. If the requested coverage falls within a health plans underwriting guidelines, then the health plan figures the cost of the coverage and of the services that will be provided to the group. The cost includes the health plans expected claims expenses and claims reserves, risk charges, administrative expenses, selling expenses, and the health plans expected surplus or profit. The health plans underwriters use these costs to determine the appropriate price to charge. The health plan may increase or decrease the premium rate at policy renewal.

If the requested coverage does not fall within the health plans guidelines, where state law allows, the underwriter adjusts the coverageand the premiumso that the health plan more closely meets the health plans guidelines. If the underwriter cannot structure the coverage to the satisfaction 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. Then the underwriter decides whether to approve coverage for the group. We discuss the risk assessment factors in the following sections. Characteristics of the Proposed Group A health plans underwriters gather and evaluate several types of information about the proposed group. The risk of one factor may vary independently of other risksthat is, a given group may present a greater-than-average risk associated with geographic factors, but at the same time a lower-than-average risk in terms of age. For this reason, underwriters are likely to analyze many of a groups risk assessment factors simultaneously, then analyze the total risk presented by the group. 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 of obtaining healthcare coverage. In addition, some state laws prohibit insurers from issuing coverage to such a group. This precaution protects health plans from antiselection that may occur when several peopleall of whom present poor underwriting risksjoin together to purchase healthcare coverage. Where permitted by state law, some health plans underwrite groupssuch as professional organizations and trade associationsthat were formed in part to obtain healthcare coverage. Type of Group Most organizations that obtain group healthcare coverage can be classified as one of three types of groups: Employer-Employee Groups Employer-employee groups (private employers and public employers). Large private employer-employee groups tend to present the fewest underwriting risks because they typically present a balance of ages and health conditions, which helps to prevent antiselection. Further, the opportunity for individual antiselection is minimized because an 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 medical examination before being hired. Because large employers typically coordinate the record keeping associated with group healthcare benefits, administrative expenses are lower for the health plan. However, some large groupssuch as employers involved primarily in contracting or subcontracting arrangements, professional sports, or seasonal industries, for exampletypically represent a greater risk than other employer-employee groups. Public employersthat is, federal, state, and local government employerspresent slightly different concerns to a health plans underwriters. Because of budgetary constraints and changes in 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 do private employers. Multiple-Employer Groups Multiple-employer groups (trade associations, negotiated trusteeships, and Multiple- Employer Welfare Arrangements). When two or more employers in the same industry provide coverage for their employees through one group plan, the employers have formed a multiple-employer group. Individual members of a multiple-employer group or a professional association are not required to obtain coverage through the group or association. Therefore, the risk of antiselection is higher for both multiple-employer groups and professional associations than it is for employer-employee groups. To avoid antiselection in multiple-employer groups, a health plan follows clearly defined underwriting guidelines, focusing especially on the size of the group. The health plan also checks the groups prior coverage and claims experience. Professional Associations As noted above, antiselection risk is higher in a professional association than it is in an employer-employee group. One way that an health plan evaluates the risks represented by a professional association is to consider the industry experience of the agent or 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 assess the risk represented by this new business. If the health plan is uncertain about approving coverage for a professional association, then the health plan can require each association member to submit evidence 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 to avoid the risks associated with underwriting small groups. Currently, some health plans underwrite groups with as few as two members. Increasingly reliable information about the morbidity experience of small groups, increased market competition, and expanded legislation concerning small group healthcare benefits have contributed to this trend of underwriting small groups. Small groups still present unique challenges to underwriters. We discuss small group underwriting in the next lesson. Age Although a health plans underwriters do not consider the insurability of each member of a proposed group (except for some small groups), they do examine the age spread of the entire group. Specifically, underwriters watch for groups with a majority of older members because these groups tend to experience higher morbidity rates. A groups turnover rate usually has a significant effect on the groups average age. A group with low turnover tends to increase in average age because fewer new, usually younger, individuals join the group. Underwriters look more favorably upon a group that has a steady flow of new particularly youngenrollees, because such flow helps maintain the desired age spread in a group.

Sex A health plans underwriters also consider the ratio of females to males in a group. Actuarial studies 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 to have 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 of younger, new members to replace or balance the gradual aging of older members. A group whose composition either changes too frequently or remains static for a long period of time presents higher risks to the health plan. If a groups members change too frequently, the health plans administrative expenses increase. Sometimes a high turnover rate of group members indicates that members are joining the group for the purpose of receiving healthcare benefits for a short period of time. This situation would result 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 has members that are older than average, compared to the average age of groups that have greater turnover. Because morbidity increases with age, a group with low turnover and a high average age of members is likely to produce high claims costs. A sound rating methodology will accommodate this demographic profile. If a health plan identifies an imbalance in a group, the health plan may adjust the premium rates upward to cover the risks associated with higher utilization, higher claims costs, and higher administrative expenses. Also, health plans can encourage group stability by specifying which group members are eligible for coverage. For instance, some health plans set a service requirement for groups. Under a service requirement, also called an employment waiting period , a person must be employed for a certain length of timeusually three to six monthsbefore being covered under the plan. Geographic Location Many employers and other groups maintain offices or facilities in multiple locations. When evaluating groups in which group members are geographically dispersed, a health plans underwriters consider each locations applicable laws and regulations, morbidity rates, and medical services costs. Some laws regulating group coverage vary from state to state. Many states have group coverage requirements relating to required policy provisions, group size, group eligibility, and mandated benefits. Underwriters consider the laws applicable in each location where coverage is provided for 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 health plan. To develop appropriate group underwriting guidelines, health plans use information on

claims experience data showing the likelihood of people in certain jobs to experience high utilization rates. Some health plans use pricing factors to reflect the effect of a groups specific industry on the premiums charged to the group. A health plan develops a pricing factor by using experience-based statistics. A pricing factor is a number that illustrates the risk represented by group members working in a particular industry. The health plans underwriters multiply the pricing factor by the premium it has calculated for standard risks to calculate a premium appropriate for the risk represented by a certain group, as shown: Nature of Business Instead of using a pricing factor, some health plans issue certain types of coverage to groups with high-risk characteristics if the group pays a flat extra premium. The extra premium is charged because the group has one or more characteristics that increase the risk of illness or injury for its members. When evaluating risk, a health plans underwriters also consider the economic strength or weakness of an industry. Suppose market trends cause companies in certain industries to slow production or to lay off workers. In this case, a companys employees are more likely to utilize healthcare benefits if they are likely to lose them as the result of a layoff, for example. Also, the companys ability to pay premiums may be compromised. Employee Classes Group members can be classified in several different and objective ways. Generally, an employee class is a group of employees categorized by position, earnings, or rank. To comply with regulatory requirements, health plans generally must establish employee classes on a nondiscriminatory basis according to conditions pertaining to employment. Figure 7B-3 illustrates typical, nondiscriminatory classes established for group coverage. In calculating premium rates, a health plans underwriters carefully consider the mix of higherincome and lower-income employee classes. Actuarial experience has shown that higher-income employees are statistically more likely to seek expensive healthcare or to seek healthcare more often than lower-income employees. Also, lower-income employees sometimes choose not to enroll in a contributory plan, which may adversely affect the plans 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. Recall from the Fully Finded and Self-Funded Health Plans lesson that, in a noncontributory plan, the enrolled employees pay no portion of the premium for coverage. Instead, the employer pays the entire premium and coverage is automatic for all eligible members of the group. Typically, health plans 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 that groups come as close as possible to a 100% participation level because a high participation level reduces the effects of antiselection. Most health plans require that contributory plans have a participation level of between 75% and 100% of eligible employees, depending on the groups size. As group size increases, a health plans 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 total premium in contributory plans. This requirement enables a health plan to obtain a sufficient number of eligible employees to meet the minimum participation requirement, which in turn lowers the risk to the health plan. Traditionally, many families were eligible for just one group healthcare plan. Now, families often find themselves in the position to choose from among two or more health plans. Sometimes this choice is available because both spouses work for employers that offer group health plans to eligible employees. In other cases, a spouses employer may offer two or more health plans. Whenever several health plans are competing for individual enrollees within a group, the health plans underwriters must find ways to adjust minimum participation requirements without increasing the risk of antiselection.

Dependents Most health plans define a dependent as either (1) a spouse or (2) an unmarried childincluding an adopted child, stepchild, or foster childwho is under age 19, or under age 23 or 25 if a fulltime student, and who relies on the employee for support and maintenance. In addition, most health plans expand their definition of a dependent to include incapacitated dependent children to age 25. The following list presents some of the questions that underwriters ask regarding dependent coverage:
Is the employee eligible to participate in the group plan? Usually an employees

dependent can be covered under a group plan only if the member is eligible and enrolled in the plan. How many employees want to cover their spouses? If only a few eligible employees choose to cover their spouses, antiselection may become a factor, because the covered spouses might have existing health impairments. Is an eligible dependent confined to a hospital or under the care of a healthcare provider on the date that coverage begins for the employee? Under these circumstances, health plans usually delay the effective date of group coverage for a dependent until the dependent is discharged from the hospital. This contractual provision is known as the nonconfinement requirement. Did the employee enroll dependents when he or she became eligible or when the dependent became eligible (for example, within 30 days for a newborn or newly adopted child)? If not, antiselection may occur. Prior Coverage and Claims Experience Suppose an employer group requests that its existing coverage be transferred to a different health plan. In this case, the succeeding health plans underwriters would thoroughly assess the groups case. This assessment typically includes a review of the

Reasons for the transfer request Amount of premiums paid to the previous health plan Groups claims experience and utilization rates Previous health plans underwriting guidelines, medical policies, and provider network arrangements Changes in premium rates for the groups coverage since the coverage began The successor health plan also considers the people who currently have claims on file with the previous health plan. These people must be protected from loss of benefits when the group switches to the successor health plan. If some employees are not actively at work, but are not disabled on the effective date of the new coverage, the successor health plan determines the reason for these members absence. They could be on vacation or taking a leave of absence, or could be sick or injured. Typically, health plans require eligible employees to be actively at work on the effective date of coverage. Coverage for eligible employees who are not actively at work on that date is usually deferred until they return to work. Also, most health plans do not collect premiums on absent group 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 plans health plan and would otherwise lose coverage as a result of the employers changing to a new health plan, the successor health plan usually would provide coverage for these individuals outside the plan contract. This extra contractual provision is sometimes called continuity of coverage or no-loss, no gain . Generally, health plans require three years documentation of the groups
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 Billing statements Employee plan description material Information about disabled employees and dependents

claim

Note, however, that it may be difficult for health plans to obtain even one years 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 standard plan design offered by a health plan, many purchasers choose to customize their plan designs. An important part of the underwriting function is to ensure that the proposed coverage falls within the health plans parameters and is appropriately priced to reflect any variations from these parameters. Plan administration and plan changes must also fit the health plans underwriting guidelines. Plan Design When evaluating a proposed plan design from a potential purchaser, a health plans underwriters consider two key elements: (1) Eligibility requirements, and (2) Covered services/supplies and benefit levels. Eligibility requirements. Generally, health plans require that only full-time, permanent employees and their dependents can enroll in a group plan. Therefore, a health plans underwriters verify the eligibility of each group member. Under a contributory plan, members who choose to participate usually can enroll in the plan any time during the 31 days following the date they become eligible for coverage. Most health plans require employees who do not enroll during the 31-day enrollment period to provide evidence of insurability before they can subsequently enroll. This requirement prevents the antiselection that might occur among employees who originally declined coverage, but later learned that they had a serious health problem. Some group plans do, however, allow a previously nonparticipating employee who has a life eventfor example, an employee acquires a dependent spouse through marriage, acquires a dependent child, or loses coverage under his or her spouses planto enroll in the plan without

providing evidence of insurability. In such cases, the nonparticipating employee must enroll within 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 largely determine a health plans financial success. For example, if a health plan provides an overabundance of benefits, plan members tend to have higher utilization rates and higher-thanaverage claims costs. On the other hand, a health plan that provides minimal benefits or unevenly distributes benefits among employee classes probably will not appeal to many employees. As a result, the health plan probably wont achieve the desired participation level. The health plans underwriters strive to approve plans that reach a balance between these two extremes. Some plan purchasers establish benefit plans that avoid unequal distribution of benefits among members by offering the same benefit for all employees, regardless of job class, salary, or length of 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 to manage and administer benefits. Because the employer often serves as a link between the group members and the health plan, the employer plays a vital role in the successful administration of the plan. Effective plan administration is crucial to keeping plan costs low and helping ensure the long-term satisfaction of both the employer and the plan members. Therefore, a health plans underwriters evaluate the willingness and ability of a prospective purchaser to cooperate in plan administration. Specifically, an employer should be able to promote the health plan and encourage all eligible employees to enroll in the plan. The employer should also be able to maintain accurate and complete records of plan enrollments and changes in employee eligibility, as well as the status of each employees plan contributions. In addition, the employer should be able to assist employees with 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 its health plan, the health plans underwriters first consider the groups claims experience. As noted earlier, where state laws allow, if the group has had higher-than-expected claims experience, the groups request may be denied. Alternatively, the groups premium rate may be increased to cover the cost of additional healthcare benefits. Conversely, if a group has had lower-than-expected claims experience, the health plans underwriters might determine that additional benefits can be provided without an increase in premium. Likewise, a group that requests a reduction in its healthcare benefits might receive a lower premium rate, or a lower premium rate increase, provided that its claims experience has not been unfavorable.

When an employer wants to offer coverage to employee classes that were previously excluded from the health plan, the health plans 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, Whether the proposed employee classes comprise a considerable proportion of the whole

in which case the underwriter usually approves coverage

group, in which case the underwriter evaluates the age, sex, and salary of the individuals in each class The geographic location of the employees in the proposed employee classfor example, in situations when one company purchases another company or establishes a branch office 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 is covered 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 obtain coverage under an individual healthcare policy. Many states require health plans to include a conversion privilege. Under the terms of a conversion privilege, the health plan must issue an individual healthcare policy to all eligible individuals who request one, regardless of their medical condition. Because the health plan cannot decline coverage for an eligible individual, the bulk of the underwriting for conversion policies is accomplished through health plan design. Often, health plans provide the minimum covered services and benefit levels that are required under applicable federal and state laws and regulations. Dental and vision benefits are rarely provided under conversion policies. Because healthy employees typically move to another employer group, rather than apply for individual coverage, the cost of the conversion privilege is high. Often a group plans premium is higher to cover these costs. Premium rates for conversion policies are subject to the health plans rating guidelines for individual coverage, which we discuss in the next lesson. Note that the introduction of COBRA benefits and the guaranteed issue requirements for qualified individuals under HIPAA have greatly reduced the need for conversion policies. Endnotes 1. Portions adapted from Academy for Healthcare Management, Managed Healthcare: An Introduction , 2nd ed. (Washington, D.C.: Academy for Healthcare Management, 1999), 11-111-9 and from Academy for Healthcare Management, Health Plans: Governance and 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: An Introduction , 2nd ed. (Washington, D.C.: Academy for Healthcare Management, 1999), 11-1011-33 and Academy for Healthcare Management, Health Plans: Governance and

Regulation (Washington, D.C.: Academy for Healthcare Management, 1999), 5-1536. Used with permission; all rights reserved. 3. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life and Health 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 Health Insurance Underwriting (Atlanta: LOMA, 1998), 311-334. Used with permission; all rights reserved.

AHM Health Plan Finance and Risk Management: Small Group and Individual Underwriting

Course Goals and Objectives After 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 benefit plans, historically, few small employers have offered healthcare benefits to their employees. During the 1990s, to increase small employer access to affordable healthcare, many states enacted small group reform laws. The definition of small group varies from state to state but typically specifies employee groups that range from 1 to 50 or more employees. Not all small groups are employee-employer groupsfor example, some professional associations fall into small group categoriesbut 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 have developed 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 lifetime and annual benefits, and a limited list of covered services and supplies. Many states have also developed standard plans. Standard plans are health plans that require health plans to offer small employers and their employees a choice of a more comprehensive healthcare benefit plan than the low option plan. Standard plans approximate the healthcare benefits available to large employers. Usually states require that health plans offer at least two health 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 underwriting practices that health plans can use to reduce overall risk. Health plans that must accept larger risks ultimately incur higher costs. Consequently, although the intent of mandated restrictions on underwriting practices is to improve access to healthcare, one result of these restrictions is an increase in the cost of providing that healthcare. Several of these restrictions have been incorporated into the federal Health Insurance Portability and Accountability Act (HIPAA) of 1996. These restrictions may be divided into two types: (1) those that apply to employer groups and (2) those that apply to individual group members. Underwriting Employer Groups Most small group laws contain a guaranteed issue provision, and HIPAA now mandates guaranteed issue in the small group market. A guaranteed issue provision requires each health plan that participates in a small group market to issue a contract to any employer who requests healthcare 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 particular group if the group has had poor claims experience or has a member who is suffering from a catastrophic illness or injury that would result in substantial healthcare expenses. Laws pertaining to small groups prohibit this underwriting practice. State and federal small group laws also contain a guaranteed renewal provision, which prohibits health plans from canceling a small groups healthcare coverage because of poor claims experience or other factors that relate to group 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 minimum number of employees in an eligible employer group at 10 or more. This meant that employers with fewer than 10 employees were not considered employer groups for the purpose of group insurance laws. Therefore, insurers and health plans used medical underwriting for the individual employees of a small employer. In other words, an employer group could be accepted for healthcare benefits, but specified employees within that group could be excluded because of health conditions. The small group reform laws typically changed the definition of an employer group to include employers with as few as two employees, thereby subjecting small groups to group 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 preexisting conditions exclusions to individuals in certain high-risk categories who might have otherwise been eligible for group healthcare benefits. Small group reform laws seek to improve access to healthcare by limiting these restrictions. Requirements on Premium Rating To reduce healthcare costs for small groups, small group market reform laws place restrictions on the rates that health plans can charge small employers. Typically, these laws prohibit health plans from using experience rating and prescribe a method that limits the rate spread that health plans can 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 rating or an adjusted community rating. Other state laws are based on the rating method contained in the unamended 1991 NAIC model small group laws and regulations. This rating method, which is referred to as community rating by class (CRC) , allows health plans to use up to nine rating classes with prescribed minimums and maximums in each class. Also, the rate spread cannot be more than 120% from the highest to the lowest block of business, which is usually defined by market approaches. Requirements for Disclosure of Plan and Rating Information Small group laws typically include disclosure requirements that specify the types of information that health plans must share with plan purchasers to educate them and to help them make informed choices. Some states require that health plans obtain approval for all marketing pieces and that they file a copy of the approved pieces with the state insurance department before these materials are distributed for use. From a financial standpoint, these requirements increase a health plans 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, this market 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 to health plans that are entering into or already operating in the small group market. The market also presents 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 to state 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 high turnover adds to the administrative costs of serving small groups. Third, the owners of small businesses often have much more information concerning their health and the health of their families and their employees than the health plan has, which means that this 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 healthcare coverage if they believe that they, their family members, or their employees are likely to have high healthcare costs. Over time, health plans and their underwriters have gathered increasingly reliable information about the morbidity experience of small groups. 2 Generally, in comparison to large groups, small groups 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 the

group pays As a result of these market characteristics, an underwriter can have difficulty determining an appropriate premium for a small group. Although small group laws have made healthcare coverage more accessible to groups that previously would have been declined, these same laws have actually reduced access to healthcare benefits for others. By limiting the ability of a health plan to reject individual employees within an accepted group and by restricting premium rate methodology, these laws have caused premiums to increase for many small groups. High premium rates are typically the most important barrier to coverage for any group or group members. Thus, for example, a small group with a heavy composition of young males who are in good health might, because of small group laws, experience premium rate increases that make the cost of healthcare coverage prohibitive to some members of the group, thereby limiting their access to healthcare benefits. Where state laws allow, health plans sometimes use an underwriting method called pooling to help more accurately estimate a small groups probable claims costs and to calculate an equitable premium. Pooling is a method of determining a groups premium in which underwriters treat several small groups as one large group for assessment purposes. The more plan enrollees (or proposed enrollees) that are grouped in a pool, the better the underwriters chances of accurately estimating the whole groups claims costs. Underwriting the Small Group 3 Underwriting small groups traditionally takes place on two levels: (1) evaluating the business entity, and (2) examining the health status and other characteristics of each individual to be covered. Unlike underwriting large groups, variation in coverage is not a major factor for small groups. Small group plan designs are typically kept standard. With the passage of small group reform laws, the approach health plans take to underwriting small groups has become much more important than in the past. These laws impose limitations on a health plans 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 itself are considered. Examples of these characteristics include the nature of the employers 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 characteristics that the large and medium group underwriter examines. The rating structure used by the health plan, which is more and more often dictated by small group law, has an important bearing on the significance 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 group purchaser 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 businesses fail each year. Nature of Employers Business As we saw in our discussion of large groups, the type of business and the duties performed by a groups employees are also related to expected future claims costs. Certain types of businesses are exposed to higher health risks. Some of these risks are clearly work-related, such as a job that requires 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 a greater risk than employees of an accounting firm. Traditionally, some small group carriers would not cover certain industries or occupations; others would charge a premium surcharge for coverage. The list of ineligible industries and industry rate-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 in which they are engaged. Group Size Group size is another important group characteristic, affecting both expected claims levels and per member acquisition and maintenance expenses. The larger the group, the more lives over which the morbidity risk can be spread. For a group of 25 as opposed to a group of 5, an individual employees health status will be a smaller factor in the employers decision to purchase coverage and the level of benefits chosen. Also, the administrative expenses incurred in covering the 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 as employer group size increased. However, one typical objective of small group reform laws is to mandate that small group health plans pool the group-size risk over their entire small group portfolios, by either disallowing or limiting variations on premium rates by group size. For example, states that require health plans to use adjusted community rating generally do not allow adjustment for group size. This can create additional risk for a health plan that provides healthcare coverage in small group markets. Participation Level To qualify for medical coverage, a small group is expected to meet certain participation requirements set by the health plan. As we saw in the previous lessons, these requirements provide the health plan some protection against antiselection at the point of sale by prohibiting a significant number of employees (presumably the most healthy) from declining the coverage. Participation requirements also help protect the health plan from case stripping, a process in which a few employees and/or dependents with expected high medical costs remain under the plan, but over time, the healthier plan members drop coverage or purchase less expensive group coverage elsewhere. The majority of states continue to allow health plans to set participation levels as a requirement for coverage, even where coverage is otherwise guaranteed issue. Often, however, the participation 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 offering the group coverage. Some states, however, require that, in cases where employees have coverage from other sources such as a spouses plan, the health plan cannot consider these employees when determining participation levels. Contribution Level Another underwriting consideration that is particularly important for small groups is the employers contribution to the cost of healthcare coverage. As we saw in Rating and Underwriting lessons, the higher the percentage of the total cost the employer pays, the higher the employee participation tends to be. Generally, health plans require that the employer make some contribution to the cost. Although large employers frequently contribute 80% or more of the cost of coverage, small employers typically cannot afford such high contributions. It is not uncommon for small employers to pay a portion of the employees premium (50% for instance), but require the employee to pay the full cost of dependent coverage. Employer concern over the cost of these employer contributions often results in a decision by the employer not to sponsor a plan. The lower the employer contribution rate (and therefore the participation rate), the more likely it is that the employees who enroll in the health plan will be less healthy than the entire group as a whole. Some states will not allow a small group to be covered unless the employer contributes a minimum level of the premium and the group meets minimum participation levels. Health Status and Prior Coverage In underwriting a group as a whole, a health plans underwriters gather and review information regarding the health status and prior coverage of the group. If the group is obtaining healthcare coverage for the first time, discovering the reasons for seeking coverage at this time can point to other areas that should be investigated more fully. For example, the spouse of a valued executive may 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 important underwriting consideration, particularly today because most states require portability of coverage (usually without regard to the differences in healthcare benefits). Such portability does not allow a health plan to apply a pre-existing conditions provision to those enrollees who were previously covered, which consequently increases the health plans 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 premium Is the group seeking to add employees who were not covered under the prior health Are certain dependents being added who were not covered by the prior plan?

rates?

plans health plan and would have been considered late entrants under that plan?

Individual Underwriting Considerations 4 The key to successfully underwriting a block of small employer healthcare programs is to assure a reasonable mix of healthy and unhealthy members. If a health plans underwriting guidelines are too liberal compared to those of the competition, the health plans block of business could attract 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 of health plans to single out individuals within an employee group by rejecting them or by rating them up. Although individual risk evaluation techniques continue to be used, they are now employed by underwriters in making a decision about the groups rates, rather than about whether to offer coverage to particular individuals. Enforcement of Eligibility The underwriter, using information in the application for coverage, checks for the eligibility of each employee and the employees dependents. Eligibility checks tend to be more critical for underwriting the smallest groups because of the number of family businesses that seek healthcare coverage and the temptation of a family business to present unhealthy relatives for coverage. In such cases, investigating each employees and dependents eligibility at the time of issue may be less 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 came in 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 new underwriting considerations. Where previously an underwriter might have accepted a group knowing that the pre-existing condition exclusion period would provide adequate short-term protection 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 for late entrants (each of which is reduced by qualified prior coverage). Therefore, underwriters distinguish between new and late entrants to avoid the extra antiselection risk introduced by later entrants. Individual Medical Assessment Both the employees of a small group and their dependents are usually individually medically underwritten, even though small group reform prohibits health plans from singling out individuals for rejection or substandard rate-ups. In the absence of laws mandating otherwise, underwriting standards grow stricter as group size gets 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 the premiums generated by a 20-member group. Even in a 25-member group, however, one especially expensive ongoing medical condition can assure that the group will be unprofitable at any reasonable premium level.

While such an underwriting approach had been relatively straightforward in the past, small group reform laws passed in the last decade require objective and nondiscriminatory application of underwriting criteria, regardless of group size. As such, the underwriting criteria must assure objectivity and yet recognize the risk implications inherent in small groups. Health plans use various underwriting approaches. Some enrollment applications use a short-form questionnaire that asks a few broad questions; others ask a long list of detailed questions. Examples of these supplemental sources are attending physicians' statements (APS) and clearinghouses of medical and insurance information. Gathering underwriting information, however, increases costs for the health plan. These costs must be compared to the gains the health plan expects to achieve by using this information to reduce claims costs. Small Group Rating Approaches Small group reform laws have, as we have noted earlier, caused a health plans small group underwriting to become more like large group underwriting. State laws have also increasingly limited 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 those used to rate large groups, as we discussed in Group Underwriting lesson. These factors are the type of group, the age of the group members, the ratio of males to females in the group, the geographical location of the group, the size of the group, and the nature of the groups business. Rating Structures In the past, as a result of the underwriting and pre-existing condition exclusions used in the small group market, initial claim costs per member started out very low, but increased rapidly as the selection and pre-existing condition exclusions wore off, eventually leveling off after the third year. This phenomenon, coupled with competitive pressures for sales, led to the practices of durational and tiered rating, in which low entry rates were offered to groups at issue followed by fairly significant rate increases in the subsequent renewal periods, especially for groups with prior adverse claims experience. These practices caused healthier groups with good experience to shop for a health plan that offered cheaper premium rates or that would place the group on the lowest rating tier. Less healthy groups had to either accept the hefty rate increases or cancel their coverage, and face a new pre-existing conditions period from a new carrier, or risk the possibility of not being accepted for new coverage. The legislative and regulatory response was the adoption of the limits we have referred to throughout this lesson. These new rules limited durational and tiered rating to a specified maximum range, and in some states disallowed durational rating while still permitting limited tiered rating. More recently, states have been compressing the allowable rate ranges or moving to adjusted community rates. Many states have established specific risk pooling programs for small group business. These can be categorized into (1) reinsurance programs and (2) risk-adjustment formula programs.

Reinsurance Programs Many states that require guaranteed issue of at least two mandated plans (sometimes referred to as Standard Plans and Basic Plans) have established health coverage reinsurance programs for small employer groups. These programs develop reinsurance pools into which a carrier can place entire groups or individuals enrolled in a group plan. In contrast to the commercial reinsurance we discussed in Capitation and Plan Risk, the reinsurance offered through these programs is administered by not-for-profit entities whose board members are appointed by the state insurance commissioner for each state. The purpose of these programs is to reinsure health plans and other carriers who offer guaranteed healthcare plans to small employers. These carriers are sometimes referred to as small employer carriers. Under these programs, a small employer carrier can reinsure either an entire small group, or specific individuals within a group. The programs pool the risks of several small employer carriers and enable these carriers to offer guaranteed issue plans to small employers without taking on the entire risk of catastrophic loss often present in guaranteed issue plans. As we have seen, this risk is higher than usual in small group, guaranteed issue plans because they are particularly 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 employer healthcare plans that have benefits similar to benefits of the plan being reinsured. This base reinsurance premium is then multiplied by a factor of 1.5 in the case of reinsurance on entire groups, or a factor of 5 for reinsurance on individuals. The result of the base reinsurance premium multiplied by the appropriate factor is the reinsurance premium. To obtain reimbursement under the program, a small employer health plan may have to meet certain cost-sharing requirements. For example, the small employer health plan seeking the reinsurance might have to pay a $5,000 deductible and 10% of the next $50,000 on a claim covered by reinsurance. Any shortfalls in the pool are funded through assessments of the participating health plans. Risk-Adjustment Programs Some states have developed risk-adjustment formulas to be applied to the premium that the state reinsurance program charges to participating small employer carriers. These formulas attempt to produce an equitable reallocation of premiums reflecting differences in risk among participating health plans. However, establishing effective risk adjustment systems such as this has proven to be difficult due to the complexity of the process and a lack of experience and technology in this area. 7 Underwriting Individual Healthcare Healthcare coverage is provided to millions of Americans as an employee benefit, but millions more people are covered under individual (sometimes called nongroup) health policies that they have purchased. Indemnity carriers rather tha health plans write most individual coverage, but in some markets health plans will underwrite individual healthcare coverage. In this section, we examine the underwriting considerations for this coverage. We begin by briefly discussing applicable 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 in that both sets of laws seek to improve healthcare access and affordability. For example, many state laws on individual healthcare benefits require guaranteed issue provisions and place restrictions on pre-existing conditions provisions. Also, some small group laws, which define a self-employed individual as a small group, are actually applying their small group laws to individual healthcare benefits. States that do not address individual healthcare benefits defer to the HIPAA for specific requirements. Underwriting Substandard Risks Health plans use an underwriting manual that contains information needed to underwrite individual coverage. The manual usually describes and evaluates a number of impairments. The underwriter can accept, rate, or (if state law allows) decline an application according to the degree of risk the applicant presents to the health plan. If an applicant represents a risk greater than standard, and if the risk is not so great that the underwriter must decline the application, the underwriter 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 of loss. To ensure that the risk accepted is within the health plans guidelines, a rated policy may be issued with
A premium rate higher than the rate for a policy issued to a person with an average or Modifications and exclusions Any combination of a higher premium rate, modifications, and exclusions

less-than-average risk of loss

To evaluate the risk represented by an applicant, underwriters use a numerical rating system based on standard morbidity. The standard premium is based on 100% of standard morbidity. The underwriter 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 a table that enables an underwriter to convert the total of the debits to a rating percentage. Each health plan develops its own rating schedule. The rating percentage from the rating schedule is added to the percentage (100) that represents the standard risk for which a standard premium is charged. 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 applicants present health, medical history, health habits, family history, occupation, or activities that could increase that persons expected morbidity risk. An impairment rider, also known as an impairment waiver or an exclusion rider , is a policy attachment that excludes from coverage any loss that (1) arises from a specified disease or physical impairment or (2) concerns a specific part of the body. An impairment rider might be used with a health policy if the applicant has a chronic condition for which future treatment seems likely. An impairment rider excludes from coverage a medical condition, a disease or disorder of a specified body part, or both. To help an applicant to understand clearly what condition is being excluded from coverage, each impairment rider is worded in simple, straightforward terms. A health plans 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 allow impairment riders. To save the underwriter time in producing an impairment rider, most underwriting manuals suggest wording for a large number of conditions that generally warrant the use of such riders. Key Elements of Individual Underwriting In underwriting individual coverage, several key elements are critical. The following sections discuss these elements. Insurable interest Insurable interest is the condition in which a person would suffer a genuine loss if the covered event were to occur. Under individual healthcare, the requirement for insurable interest is met when the applicant can demonstrate a risk of economic loss if he or she requires medical care. Antiselection and Moral Hazard A health plans underwriters are aware that antiselection and moral hazard can be factors in some applications if the individuals seeking coverage have certain types of impairments such as nervous conditions and chronic depression or chronic pain. In general terms, moral hazard is a characteristic that exists when the reputation, financial position, or other circumstances of an applicant 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 not necessarily result in undue numbers and amounts of claims, but some of them do, and health plans often face difficulties in determining the validity of such claims. Some health plans exclude coverage for conditions like these by using riders; other health plans do not issue policies to applicants with these or other serious impairments. In contrast, health plans do not usually exclude benefits for impairments that are considered temporary, because such impairments are not statistically indicative of possible antiselection or moral hazard. For instance, if an individual seeking coverage has a sprained shoulder or has undergone successful shoulder surgery a month before applying for coverage, but has no previous history of shoulder problems, most health plans would issue a policy without excluding shoulder or joint problems. Health History The individual underwriter pays particularly close attention to the applicants health history and seeks complete information about certain impairments that warrant in-depth scrutiny. The underwriter focuses especially on impairments associated with two types of concerns: (1) future medical treatment and (2) probability of accidents. Certain impairments are of considerable significance in underwriting individual coverage because these impairments have been shown statistically to result in higher-than-average claims resulting from 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 higherthan-average probability of accidents. Some impairments, such as epilepsy, vertigo, narcolepsy, numbness in hands and feet (neuropathy), paralysis, and impaired eyesight and hearing are often associated with accidents and are examined thoroughly. In addition to looking at the probable effects of impairments, the underwriter examines information relating to health conditions that have been diagnosed or treated recently. Some conditions, especially certain types of cancer, are considered more serious when they have been recently discovered or treated. Some conditions that have been stable for a number of years as specified in a health plans underwriting manual may not negatively affect an applicants rating because the condition is not considered to have a significant potential effect on the future health of the applicant. Even a history of acute illness, such as pneumonia, may not be significant if the applicant has recovered fully. An underwriter can accept some applicants for coverage after a period of time following treatment for an impairment. Moreover, an underwriter does not consider each impairment in isolation, but tries to obtain a clear understanding of the possible connections between various impairments and their combined effect on the applicants health. Finally, the health underwriter pays special attention to factors in the life of an applicant that can decrease or increase the probable effect of an impairment on the persons health. Suppose that an individual who is seeking coverage has been diagnosed with mild to moderate asthma and also smokes. Such a person is underwritten more conservatively than is a person who has asthma but does not smoke. Existing Healthcare Coverage Individual underwriters check the application to determine the amount and type of healthcare coverage that the applicant already has in force. Health plans attempt to ensure that an individual has adequate coverage, but that such coverage does not result in excessive benefits or profit for the individual. Experience shows that people with excessive amounts of healthcare coverage tend to overutilize their coverage. Lifestyle If an applicant participates more frequently than average in some avocationsas examples, road racing, mountain climbing, hang gliding, or horse racingthe underwriter usually adds an impairment rider to the policy. Underwriters also thoroughly investigate applicants who have a record 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 applicants motor vehicle record, most health plans severely limit benefits or decline coverage if state law allows. The underwriter pays special attention to any indication that an applicant has a record of driving under the influence of alcohol or other substances (DUI). Some health plans do not approve coverage for applicants who have had a DUI conviction during the past three years.

Endnotes 1. Adapted from Academy for Healthcare Management, Health Plans: Governance and Regulation (Washington, D.C.: Academy for Healthcare Management, 1999), 6-14616. Used with permission; all rights reserved. 2. Barbara Foxenberger Brown and Jane Lightcap Brown, Life and Health Insurance Underwriting (Atlanta: LOMA, 1998),320, 322. 3. Portions of this section excerpted and adapted from William F. Bluhm, ed., Group Insurance, 2nd ed. (Winsted, CT: ACTEX Publications, Inc., 1996), 298301. Used with permission. 4. Portions of this section excerpted and adapted from William F. Bluhm, ed., Group Insurance, 2nd ed. (Winsted, CT: ACTEX Publications, Inc., 1996), 302305, 310312. Used with permission. 5. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMAs 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), 4546.

AHM Health Plan Finance and Risk Management: Pricing a Health Plan Course Goals and Objectives After completing this lesson you should be able to Describe the relationships among health plan risk, rate-setting, and provider reimbursement Describe how demand and costs combine to establish the upper and lower limit on pricing a health plan Explain how a health plan uses underwriting margins, expense margins, and investment margins 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 than the premiums on traditional indemnity plans. As a result, health plans obtained significant amounts 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 indemnity plans (now better known as managed indemnity plans) has decreased. This decrease has further increased price competition among health plans. Therefore, to enter a new market or to build or retain current market share, health plans must offer competitive prices on their healthcare products. Price sensitivity in the marketplace is a key factor in how a health plan determines a health plans premium 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 health plan must first determine whether to accept the risk that a prospective group represents. If the health plan decides to assume the risk, then the health plan must establish a premium rate that covers 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 a health 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 which are listed in Figure 9A-1.

Margins1 A health plan that assumes risks incurs the costs of those risks. To ensure their solvency and profitability, health plans use margins in calculating the costs associated with the risks that they assume. The amount by which a products price exceeds its costs is called the products margin, also called the spread or profit margin. The following sections discuss the use of margins in pricing a health plan. Note that the same pricing principles also apply to a health plans other healthcare products. Once a health plans actuaries have analyzed and forecasted a health plans costs, the health plan generally determines a premium that exceeds the plans expected costs to provide the plan with an appropriate profit. To analyze product costs and margins, a health plan generally divides a health plans costs into two categories: (1) the costs of the benefit payments associated with the plan and (2) all other plan expenses. A health plan also generally considers that a health plans costs are offset, or reduced, by a third factor: the investment income that is earned on plan premiums. Investment income may be negligible on some healthcare products, however. Generally, a products overall margin, which is added to the products price, can be thought of as having three components: an underwriting margin, an expense margin, and an investment margin. Some health plans combine or net the expense margin and the investment margin into one margin. Other health plans may use other margins in pricing a product. Regardless of the approach a health plan uses to develop margins, the health plans purpose is the same: to provide enough income to meet current and future claims obligations and to provide a profit. Before we discuss the underwriting, expense, and investment margins, we first discuss a health plans expected, assumed, and actual margins with respect to pricing a health plan. The underwriting margin is the difference between a health plans actual benefit costs and 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 a health plans nonmedical expenses and the assumed expense level that a health plan uses to price the plan The investment margin is the difference between the amount of investment income that a health 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 expected value is a value that a health plans actuaries believe is most likely to occur. In contrast, an assumed value is the value a health plans actuaries use in calculating the premium on a health plan. An actual value is the value that actually occurs after the plan has been in force. Unlike expected values and assumed values, which are estimates developed before the pricing decision is made, actual values are only available after a health plan has been in forcein other words, after the pricing decision has been made. In calculating a plans premium, actuaries frequently assume different values from those they expect to occur. For example, if a health plans actuaries have observed a 50% utilization rate for mammography screening, then the actuaries may assume a 75% utilization rate in pricing a health plan. In another example, a health plans 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 is most likely to occur. An assumed margin is the difference between a health plans assumed value and its expected value for the premium that the health plan charges for a health plan. A health plans actual margin, which emerges after the health plan has been in force, is the difference between the assumed values and the actual values for the plans benefit costs, expenses, or investment income. Keep in mind that assumed margins and expected margins are built into the price of a product. Actual margins are not known during the pricing process; they are known only after the product has been in force. The actual margin may be higher or lower than the assumed margin. In addition, one of the components of total marginthe underwriting margin, the expense margin, or the investment marginmay be higher than expected and another component may be lower than expected. Suppose a health plan observes that a health plans actual morbidity is lower than its assumed morbidity and that the plans actual administrative expenses are higher than its assumed administrative expenses. In this case, the plans actual underwriting margin would be larger than its assumed underwriting margin. However, the plans actual expense margin would be lower than its assumed expense margin. A products total marginwhether actual, expected, or assumedcan be composed of any combination of the three margin components (underwriting, expense, and investment). For example, a health plan may base a health plans price on a large underwriting margin, a moderate expense margin, and a very small investment margin. The health plan may base the price of another product on relatively large underwriting and expense margins and a moderate investment margin.

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 a products underwriting margin, expense margin, and investment margin, a thin margin is a narrow or small margin and a wide margin is a relatively large margin, expressed in monetary or percentage terms. Specific products tend to have relatively thin margins; other products tend to have wider margins. For example, administrative-services-only (ASO) contracts usually have thin margins. Often, margin width is a function of group size in that large group business typically has a thinner margin than small group business. Figure 9A-2 lists several factors that help determine the size of a products margin. Actuaries typically conduct several iterations of premium rates and margins before arriving at the price and margins that will be used for a particular product such as a health plan. After the plan has been on the market, actuaries monitor its performance. Where possible, actuaries adjust the margins and price to improve plan performance.

Note that, even after a health plan has been in force, determining the plans actual underwriting, expense, and investment margins may be difficult. Some medical expenses may be known, but actual 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 plan must decide what portion of the salaries paid to employees in the claims function should be allocated to the administrative expenses of a particular health plan. Consequently, the determination of an existing plans actual margin is as much a result of the allocation method that

a health plan uses as it is of the plans true profitability. We discuss the underwriting margin, the expense 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 and the market competition it encounters directly affect the size of the assumed underwriting margin in a health plan. For example, a smaller assumed underwriting margin reduces a health plans price, thus making the plan more competitive. Therefore, the more competition a health plan faces in the marketplace, the smaller the plans assumed underwriting margin. A health plan can take steps to reduce its exposure to underwriting risk and thereby adjust its underwriting margin. One way that a health plan can reduce underwriting risk is to use stop loss insurance, which we discussed in Capitation and Plan Risk. Because a health plans underwriting risk can arise from a number of sources, the plan can also look at the sources of those risks and find ways to control or manage them. Common sources of underwriting risk include (1) lack of a health plans experience in forecasting underwriting results, (2) the number and length of rate guarantees, and (3) antiselection. We briefly look at two of these sources and how they might be controlled in order to improve a health plans underwriting margin. A health plan takes on a greater underwriting risk when it has no direct experience on which to base its morbidity forecasts. For example, a just-introduced health plan may have no credible morbidity experience, so it may include a proportionally greater underwriting margin than that of an established health plan. In this case, effective utilization controls and provider reimbursement arrangements help to minimize the impact that the lack of credible experience has on a health plans underwriting margin. A health plan may also use a shorter or longer price or premium rate guarantee for specific groups. Suppose a health plan offers a particular health plan to two groups, Group ABC and Group XYZ, which are similar in size. The health plan offers a two-year premium rate guarantee to Group ABC and a one-year guarantee to Group XYZ. In this case, the health plan may offer the longer price guarantee to retain Group ABCs business in a competitive environment because Group ABC has lower utilization rates than does Group XYZ. Expense Margins 3 Earlier in this lesson, we defined a products expense margin as the difference between the products actual expenses and the expenses that a health plan assumed in pricing the product. The expense margin, therefore, is the part of the retention charge that is intended to contribute to the health plans profit (or surplus, for those health plans that must company with state insurance requirements). Recall from Assignment 5 that a products retention charge, also called expense charge or simply retention, 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 products expected expense margin. In traditional individual insurance products, the retention charge is frequently called loading. Note that the retention charge does not include medical expenses or investment expenses.

Recall also from Assignment 5 that a products risk charge helps to ensure that a health plan will be able to fulfill its contractual obligations even under difficult circumstances. Contingencies are unexpected events that cause expenses, investment earnings, morbidity rates, or other factors to vary significantly from a companys forecasts. Keep in mind that the actual expense margin on a health plan is not known until after that plan has accumulated experience. When any of the expense factors in the retention charge varies from a health plans expectationscausing the health plans revenues to decrease or its expenses to increasethe negative result is called an adverse deviation. Note that a favorable deviationa situation in which a health plans revenues increase or its expenses decreasecan also occur. Investment Margins 4 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, these health plans have little cash to invest to earn investment income. In such cases, the development of assumed investment margins and comparisons of assumed and actual investment margins may be irrelevant. Other health plans develop investment margins on their products because investment income is a large dollar amount, even if not a significant percentage, of their total revenues. One factorthe interest margindetermines the size of a products investment margin. A products interest margin is the difference between the products assumed interest rate or assumed crediting rate and the actual interest rate earned by a company on the assets supporting that product: The assumed interest rate is the interest rate that a company assumes when pricing a product. A crediting interest rate is the interest rate that a company uses to credit investment return to a product. A health plan builds an assumed interest margin into the price of a health plan by assuming an interest rate that is lower than the interest rate that the health plan actually expects to earn on its investments. A crediting interest rate is not built into a products investment margin, however. A health plan determines the actual interest margin by calculating the actual interest rate that was earned on a products investments. Purchasers are generally unaware of the interest rates a health plan assumes when pricing products. A health plan establishes a premium rate, based on a specific assumed interest rate, that will generate enough revenues to pay the benefits promised by a health plan. The funds that a health plan uses to pay plan benefits generally come from two sources: (1) premium income from plan premiums that are paid by purchasers and (2) investment income from interest and dividend income earned by the health plan from investing those plan premiums. Again, investment income is a less significant factor than healthcare benefit expenses and administrative expenses in pricing a health plan because benefit expenses are typically 82% to 90%, and administrative expenses are typically 10% to 18%, of a plans premium. In many cases, a health plans investments must be short-term; because short-term investments earn lower interest income than long-term investments, the interest income may be negligible. Also, many health plans must comply with statutory requirements concerning the type of investment and the amount of risk that they are able to assume.

Pricing Factors We have seen how a health plan considers the risks associated with healthcare benefit expenses and administrative expenses in pricing a health plan. Other factors also limit the range within which a specific health plans premium must fall. For example, market forces determine the maximum price that a health plan can charge for a health plan. If a plans premium is too high, compared to the premiums of other plans, then, given a choice between two plans, most employers 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 is determined by the costs that the health plan expects that the plan will incur. The plan premium must be high enough to cover the plans costs of paying for both the delivery of healthcare benefits and the costs of selling and administering the plan. Statutory requirements are another factor that may influence a plans minimum or maximum price. Also, the existence of a number of plan options, which occurs when employers offer employees 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 primary concern. Generally, as the price of a particular product increases, compared to the prices of competing products, the quantity sold of that product decreases. Suppose a health plan establishes too 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 will be so low that premium income will be insufficient to meet plan costs and contribute to the health plans profit or surplus. Therefore, market competition imposes an upper limit on a plans price, although the exact level of this upper limit on price can change over time. When making decisions among competing plans, purchasers also consider other plan characteristics. Keep in mind that competitive forces are dynamicnot staticand the demand for a specific product or category of products can change. In this context, demand refers to the quantity of a product that purchasers will buy at different price levels. Generally, the greater the demand for a product, the more of the product that purchasers will want at a given price. Also, the greater the demand for a health plans product, the higher the products maximum price. Figure 9A-3 lists some factors that influence the demand for healthcare products.

Costs Set the Lower Limit on Price Just as the demand for a product creates an upper limit for a products price, the costs associated with developing and supporting the product usually set a lower limit on the products price. If a health plan prices a health plan in such a way that the plans benefits and expenses are greater than 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 can profitably be priced. If a health plan prices a health plan above the level indicated by the demand for the plan, then the plan will not achieve adequate sales. As a result, the plan will not provide enough revenues to fulfill the health plans profit goals for the plan. If a health plan is priced below cost, however, its revenues will be lower than its costs, so the health plan will incur a loss on the plan. In some situations, a healthcare products price, as indicated by the market, could be lower than the price necessary for a health plan to cover its costs on the product. As a result, no market price will allow the product to be profitable to the health plan. If a health plan finds one of its products in 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 productfor example, by redesigning the

product to make it more attractive to purchasersbut without significantly increasing the products costs Sell the product at or slightly below cost in an effort to enter a new market or to increase market share in an existing market Withdraw the product from the market, because the product is not attractive enough to purchasers to be sold at a profit. Despite the possibility that, in a particular situation, a health plan might offer one or more products at a price below cost, the costs of the health plans entire portfolio of products cannot exceed the revenues earned from all products. Otherwise, the health plan will be unable to operate profitably 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 and regulations may place additional constraints on product prices. For example, some statutory requirements dictate the range of prices that a health plan can charge for a product by requiring that the health plan develop plan premiums on the basis of community rating. Regulations can also have an indirect impact on the prices that a health plan may charge for its healthcare products. Often, federal and state laws concerning benefit mandates increase the cost of providing and 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 choice between several of a health plans products. Individuals might be independent and have a wide range of choice, or might be part of an employer group and have more limited choice of product options. Healthcare products or services can include any and all items in an employee benefit plan or, for individuals, any item that can be chosen on an optional basis. The development of premium rates for healthcare coverage in a multiple-choice environment presents a challenge to a health plans standard rating formulas, which normally just focus on a products expected benefit costs. The existence of choice may also encourage antiselection, which can result in greater costs for healthcare products that attract a significant number of high utilizers of healthcare services. When a health plan offers more than one type of health plan, the basic pricing strategy is for the health plan to determine the aggregate premium necessary to cover the aggregate cost of claims for 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 plans consider in pricing several health planssuch as an HMO, a PPO, and an HMO with a POS optionin a multiple-choice environment include the
Actuarial value of each plan options benefits, provider reimbursement arrangements, 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,

utilization management differences, retention charges, and expense margins

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 plan options. Issues concerning rating in a multiple-choice environment also exist in a scenario under which two or more health plans offer several plan options to an employer group. A detailed discussion 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 per service or of per member per month (PMPM) costs. Health plans identify and monitor several key trends in order to establish premium rates for health plans. Because of the potentially significant

impact that trends can have on a health plans financial performance, it is critical that the health plan devise a system of long-term trend analysis. Trend analysis, also called trend percentages or index-number trend analysis, is a type of financial analysis designed to identify changes in a companys financial statement values over the course of several financial reporting periods. 7 A health plan may conduct trend analysis to compare a health plans financial information across different accounting periods, such as months, quarters, or years. Trend analysis may use either dollar amounts or ratio values. We discuss trend analysis in the context of a health plans financial performance in Financial Statement Analysis in health plans. Choosing meaningful time periods and units of measurement is critical in conducting trend analysis. Maintaining consistency in tracking trends is also important. Suppose a health plan conducts trend analysis on a health plan on a quarterly basis. In this case, each year, the health plan will use the same quarterly time periods in conducting trend analysis. Similarly, a health plan that elects to analyze the trend associated with PMPM, for example, would use this same unit 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 each trends possible impact on another trend. For example, an increase in outpatient utilization usually results in an increase in drug utilization. In addition, health plans typically conduct trend analysis 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 provider receives over time for the same service. For most health plans, the provider reimbursement trend has the most impact on total trend. A health plan usually monitors the provider reimbursement trend 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 a particular hospital and an 8% increase in a primary care physicians capitation rate. To calculate the financial impact of provider reimbursement trend on premium rates, health plans generally analyze each type of provider reimbursement trend by product, then by type of service within each product. Residual Trend The residual trend, also called the residual component of trend, is the difference between total trend and the portion of the total trend caused by changes in provider reimbursement levels. The residual 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 estimate more accurately the residual trend. The magnitude of the residual trend often determines the degree of effort that a health plan spends in analyzing the trends various components. Also, the pattern of the residual trend may indicate specific areas that should be more closely analyzed.

Analyzing a health plans experience helps a health plan to quantify the total trend rate. Monitoring trends provides a health plan with vital information for more accurate cost projections and 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 and Health Insurance Companies (Atlanta: LOMA, 1996), 267273. Used with permission; all rights reserved. 2. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life and Health Insurance Companies (Atlanta: LOMA, 1996), 264266. Used with permission; all rights reserved. 3. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life and Health Insurance Companies (Atlanta: LOMA, 1996), 225239. Used with permission; all rights reserved. 4. Adapted from Susan Conant et al., Managing for Solvency and Profitability in Life and Health Insurance Companies (Atlanta: LOMA, 1996), 239248. Used with permission; 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, 325326. 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), 453457. Used with permission of 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 Health Insurance Companies (Atlanta: LOMA, 1996), 494.

AHM Health Plan Finance and Risk Management: Rate-Setting in Health Plans Course Goals and Objectives After completing this lesson you should be able to Describe the rate-setting process for HMOs, traditional indemnity plans, PPOs, and plans in a multiple-choice environment

In Rating and Underwriting, we introduced key underwriting principles and rating methods used in health plans. In Small Group Underwriting and Individual Underwriting discussed the issues and risks associated with underwriting small groups and individuals. In the previous lesson, it discussed the components used in determining a health plans premium. This lesson builds on this foundation 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 premium rate for a health plan. While various state regulatory requirements, federal guidelines for federally qualified HMOs, and actuarial and industry standards set some parameters, individual health plans 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 single or has any number of covered dependents Two Tier Rates(1) Single and (2) Family. The family rate includes any combination of subscriber plus dependents. Three Tier Rates(1) Single, (2) Couple, and (3) Family. Couple means the subscriber plus spouse (or partner). In some plans, couple means the subscriber plus any one dependent. In this context, the family rate applies to the subscriber plus all other combinations 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 of the fourth tier.

Rate Ratios To convert the premium PMPM into single rates for any of these tiers, a health plan applies a formula, which considers the assumed mix and family size of each of the rate categories, and the rate ratio for each tier. While the basis for the formula is constant, it must be adjusted for each tier. For example, the calculation for a two-tier rate is different than the calculation for a four-tier rate. What is a rate ratio? A rate ratio is the "markup" factor from a single rate to any other rate category. Suppose the rate ratio for a couple rate category is 2.0. In this case, you would multiply the single premium times 2.0 to get the premium for the couple rate category. Suppose a family rate has a rate ratio of 2.7. To calculate the family rate premium, you would multiply the single premium times 2.7. How are rate ratios determined? They are assigned by a health plan to a health plan. Rate ratios should consider family size, but most often they are based on competitive factors, including the ratios that competitors are using and what ratios employers and other plan sponsors are requesting. A rate ratio for a rate category can be arbitrarily increased or decreased, but the premiums for other rate categories will be affected as well. The end result of a typical family rate ratio is that the family rate is subsidized by the single premium rate. In other words, the single rate is somewhat higher than it otherwise should be, and the family rate is somewhat lower than it otherwise should be. The reason for this subsidization has to do with employer contributions and coordination of benefits. 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-choice environment, family rates become more price competitive. Also, some subscribers with families choose single coverage and let their spouse include all dependents on the spouses health plan. A higher single rate helps to maximize revenues for the health 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 of this course. Rate adjustments may be applied to the beginning premium PMPM. This means the premium PMPM is multiplied by a risk adjustment factor to increase or decrease the starting premium rate. The most common adjustments are for age and sex, where groups composed of people of younger ages get a lower risk adjustment factor, resulting in a lower premium rate, than those composed of people at older ages. There are countless other adjustments, including effective date, location, industry class, and group experience. Pricing Policy and Pricing Strategy The above discussion focused on the calculation of a health plans premium rate calculation for an HMO. The premium rate formula that a health plan uses to develop premium rates depends in part on the health plans pricing policy and pricing strategy.

Pricing Policy A health plans pricing policy typically addresses how the health plan will calculate plan premiums. A health plans pricing strategy indicates the health plans approach to the type of marketfor example, commercial, small group, or Medicareand the level of premiums charged, compared to those of competing products. Figure 9B-1 outlines the effects that a health plans pricing policy may have on its market.

Pricing Strategy The pricing process for most health plans involves the calculation of expected claims costs that result from utilization of (1) in-network providers, (2) out-of-network providers, and (3) out-ofarea providers for a health plan. These various claims costs are then combined, according to the health plans assumptions on how often each type of utilization will occur. Other costs, such as administrative expenses, and a provision for profit or contribution to surplus are then added to the expected claims costs. A health plan also considers several other items in the process of calculating premium rates. Note that all items will not be applicable in every situation. Figure 9B-2 lists some critical items that health 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 health plan must be able to effectively price traditional indemnity benefits. The estimation of claims costs is also a key element in pricing traditional indemnity benefits. Cost Sharing1 Cost sharing features in a traditional indemnity plan often include deductibles, coinsurance, outof-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 maximum benefit. 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 plans actuaries incorporate the effects of a health plans cost sharing features into the plans price by developing a claims probability distribution, from which the value of the plan deductible can be derived. Factors that are considered in developing a claims probability distribution include the range of charges, the frequency of charges, the average charge, annual claims costs, and the accumulated frequency of those costs. Cost sharing features are more complex in determining family deductibles and out-of-pocket maximums. Typically, a health plans actuaries develop family claims probability distributions from available claims data or by adjusting individual claims probability distributions to derive family deductibles and out-of-pocket maximums. A complete discussion of this derivation is beyond the scope of this course. Besides calculating the value of the deductible and coinsurance from a claims probability distribution, a health plans actuaries also consider adjusting for utilization. Suppose a health plans 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% coinsurance plan).

In this case, the actuaries would most likely adjust downward for utilization because Plan B has a higher deductible (higher cost sharing feature). Although it may be difficult to determine how much a utilization adjustment is a result of cost sharing, a health plan can monitor the claims probability distribution of each block of business and adjust rates when necessary. Pricing PPOs 2 Pricing a PPO plan is typically based on pricing techniques of traditional indemnity plans. To price an indemnity plan, actuaries would start with the claims experience of an existing indemnity plan. 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 resulting claims. The first step in pricing a PPO would be to develop a base indemnity claims cost , which results from adjusting the indemnity plan as though the entire eligible group of employees had been enrolled in the indemnity plan. Once actuaries have developed the base indemnity claims cost, the claims 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 plans actuaries adjust the 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 outof-area plan in a similar manner. After developing these expected claims costs, actuaries then consider 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 plans actuaries must first determine which employees are in the network service area. For these employees, actuaries estimate what percentage of employee utilization will be in-network utilization. This percentage may be broken down 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, the percentage calculation is often based on how many employees will use the network and assumes that these employees will use in-network providers 100% of the time. Other assumptions about employee in-network utilization include the number of in-network providers, benefit differences among plans offered, employee contribution levels, the ease of provider 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 providers according to the likelihood of utilization, the relative contribution cost, and their out-of-pocket expenses. Sometimes this selection takes the form of choosing an in-network provider for a perceived less serious illness or for new medical services, and a non-network provider for ongoing care or perceived life-threatening illnesses. This phenomenon will usually adversely affect the claims experience of the indemnity plan.

Next, the health plans actuaries will use risk adjustment factors to adjust the existing claims costs for selection issues. Once that has been done, the actuaries then weight the in-network and out-ofnetwork 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 environmentfor example, an HMO, a PPO, and an indemnity plancombines many of the techniques described above. The first step is to develop a base indemnity claims cost, then the in-network and out-of-network PPO claims costs. The health plans 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 develop claims costs for each plan component after actual plan selection is known, before developing the actual premium for each plan.

AHM Health Plan Finance and Risk Management: Principles for Maintaining Accounts Course Goals and Objectives After completing this lesson you should be able to Discuss the main points in the cost concept, the measuring-unit concept, the fulldisclosure concept, and the time-period concept with respect to financial reporting in health plans Discuss the realization principle and the matching principle with respect to revenue and expense 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 characteristics discussed in the previous lesson, the accounting profession has developed specified concepts, principles, and guidelines that all companies should follow. Among these ideas are the cost concept, the measuring-unit concept, the full-disclosure concept, the time-period concept, the realization principle, the matching principle, and the various accounting bases. We discuss each of these in the following sections. Cost Concept An extension of the going-concern concept is the cost concept, also called the historical-cost concept, initial-recording concept, or the acquisition-cost concept, which states that companies should report items on their financial statements according to the actual cost of those items at the time of purchase. For example, the value of an asset that a company will report in its accounting records is the actual amount paid for an assetits historical costnot the asset's current market value. The current market value, also called fair market value or simply market value, is the price at which an asset can be sold under current economic conditions. On the date of purchase, an asset's historical cost is equal to the assets book value. An asset's book value is the value at which the asset is "booked," recorded, or carried in the company's accounting records, specifically its general ledger. Periodically and systematically, an assets book value may be adjusted under specified circumstances. An underlying assumption of the cost concept is that the original acquisition cost represents the asset's market value at the time of purchase. The basis for this assumption is the concept of reliability, because a company's acquisition cost of an asset is more objective and reliable, for example, than is an appraisal of the asset's current market value or a manager's opinion of the asset's value. Also, a company can objectively verify the asset's historical cost through source documents such as sales invoices or property deeds. Conversely, while the historical cost of an asset offers objectivity and reliability, it may lack relevance, particularly for assets held for a long period of time. When investors and other interested parties consider the value of a company's assets, they are usually less interested in the value 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 other methods of determining current market value are only estimates, and estimates can be misleading. Appraisals, management influence, and constant market fluctuations make it difficult to assign current market values to many assets. Further, the cost and time required to determine the current market 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 generally outweighs the loss of relevance. Measuring-Unit Concept The measuring-unit concept, also called the stable-monetary-unit concept, the unit-ofmeasurement concept, or the stable-dollar concept, states that a company should record the amounts associated with its business transactions in monetary terms, such as U.S. dollars. There are two assumptions regarding the measuring-unit concept: (1) that the appropriate unit of measure for business transactions is money and (2) that the measuring unit's value is stable over time. Recall that a company includes in its financial statements only those transactions that it can represent 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 of a company's common stock is not a dollar amount. Similarly, verbal descriptions of a company's accounts as well as supplementary information and notes to the financial statements provide valuable 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 not have a precise, measurable monetary value are not quantified or included in a health plans financial statements. These items include, for example, a health plan's effectiveness in providing customer service, the morale of its employees, its intellectual capital, its goodwill (in effect, the value of the health plans brand name), and the condition of the health plan's property, plant, and equipment. 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 dollar changes over time. The amount of office supplies that a dollar will buy this year may not be the same amount it will buy next year. Therefore, if the purchasing power of a measuring unit changes significantly, then the measuring-unit concept can limit our ability to analyze and compare 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 real estate for $100,000. The company then reports a $50,000 capital gain (the excess of sale price over purchase price) on the sale of the real estate. However, if the purchasing power of the dollar has declined by half during the 10-year period, the company is no better off in terms of purchasing power than it was 10 years before. That is, because $50,000 ten years ago could buy the same amount as $100,000 today, the company has made no real "gain" in purchasing power because 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 a valuable tool. Like the cost concept, the measuring-unit concept provides objectivity and reliability, even though its relevance may fluctuate as the value of the measuring unit itself

fluctuates. Accounting authorities prefer that companies avoid the subjectivity involved in continually estimating the changing value of a measuring unit. They do, however, recognize that when significant changes occur in a measuring unit's value, users of a companys financial information should become aware of the fact. For example, during periods of high inflation (a general increase in the price level of goods and services), the FASB has required U.S. companies to disclose in their annual reports the potential impact that high inflation has on the dollar values listed in their financial statements. Full-Disclosure Concept The full-disclosure concept, also called the adequate-disclosure concept, states that financial statements must contain all material information about a company and that the company must disclose any additional information or fact that, by its omission, could mislead an interested user of the accounting information. The full disclosure concept implies the inclusion of every item that is material, relevant, reliable, and comparable, as well as understandable, to provide to an interested user a fair presentation of a company's financial statements. The full-disclosure concept points to the critical role of notes, schedules, and supplementary information that accompany financial statements. The full-disclosure concept does not require the inclusion of excessive details, however. For example, an independent financial analyst is no better informed about a company's financial strength if the company clutters its balance sheet with detailed descriptions of every government security that the company owns. In this case, summary information is more useful. Typical disclosures are notes and supplementary information regarding the nature and substance of contingent liabilities (to provide a cushion against various special risks), other commitments, significant lawsuits, potential losses, and the accounting methods and policies used in preparing the financial statements. Beyond these points, other information requiring disclosure is open to professional judgment. Decisions rendered in recent U.S. court cases have broadened the definition of the types of information that must be disclosed, so company management has tended to disclose supplementary information as a matter of course. The Securities and Exchange Commission (SEC), the FASB, and other sources of accounting standards have also reinforced the 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 financial statements should report the company's business operations during a specified time period. This time period, called an accounting period, is a specified length of time during which a company's business transactions are recorded, summarized, and reported. Typical accounting periods are one month, one quarter, and one year. Any specific accounting period is in itself arbitrary, given the assumed indefinite life associated with the going-concern concept. However, the alternative to artificially imposed accounting periods is to postpone a company's financial statements until the end of the company's life, when all debts are paid and all investor claims are settled. Because many individuals need financial information periodically during 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 a suitable 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. Most companies also produce financial statements or reports more frequently. These statements, such as monthly budgets and quarterly statements, are known as interim financial statements or interim reports to distinguish them from annual accounting period statements and reports. Nearly two-thirds of all companies use the calendar yearthat is, from January through Decemberas a standard accounting period. Most health plans select an accounting period based on the calendar year because this is the accounting period required for tax reporting and Annual Statement purposes. Other companies choose to operate on a fiscal-year basis. A fiscal year is simply a 12-month accounting period chosen by a company. A fiscal year may or may not coincide with the calendar year. The drawback to the time-period concept is that a company does not complete all of its transactions within one accounting period. A company continues doing business and making transactions without regard to the artificial constraints of periodicity. This is an extremely important issue for health plans because of the variable nature of the many liabilities stemming from enrollees ongoing illnesses. First, many illnesses or accidents occur in one accounting period but are not reported until subsequent accounting periods. Second, the treatment of many illnesses and accidental injuries, as well as the length of provider contracts, often extend beyond one accounting period. Because not all transactions are easily identified with a single accounting period, a company's management 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 principle and the matching principle, to match revenues and expenses to each other and to the appropriate accounting period. Much of the rest of this lesson describes the principles behind the accounting process that answers this question. We will begin by discussing some of the intricacies of two terms that we will 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 cost may be classified either as an expense or an asset. If a cost represents resources that are consumed during the current accounting period, then the cost is considered an expense. An expense is a reduction in a company's assets that applies to the current accounting period. As a very simple example, if a health plan buys office supplies today and uses them all today, the cost of the supplies is an expense for the health plan. Because expenses represent resources consumed during the 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 resources consumed during the current accounting period. If, however, a cost represents a resource that can provide benefits for future periods, then that cost may be considered an asset. Suppose a health plan buys a computer system that the health plan assumes will provide it with benefits for the next five years. Because the cost of the computer system will provide benefits in future accounting periods, this cost is accounted for as an asset of the health plan.

Recognition of Revenues and Expenses We have seen that costs eventually become, or are recognized as, expenses. Both expense recognition and revenue recognition are critical in determining the amount of a companys net income for an accounting period. In accounting terminology, recognition refers to the process of classifying 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 are defined in Figure 10B-1. Generally, a company recognizes revenue when a product is sold and delivered, when a service is completed, or when cash changes hands as part of a business transaction. For an item to be recognized, the item must be one of the accounting elements. In addition, the item must be measurable, relevant, and reliable. Although revenue recognition (the realization principle) and expense recognition (the matching principle) are interrelated, we describe them separately.

The Realization Principle Just as a health plans costs do not always become expenses in the same period the costs were incurred (for example, IBNR claims), a health plan does not necessarily receive all of its revenues in the same accounting period in which it earned them (for example, premium revenues). As a result, the health plan follows certain guidelines to match the revenue with its proper accounting period, that is, the period in which the health plan has earned the revenue. Under GAAP, the realization principle, also known as the revenue principle or revenue recognition principle, states that a company should recognize revenue when it is earned. Generally, revenue is earned at the time a service is rendered or when a good passes from the legal ownership of a company to the legal ownership of the customer.

The realization principle requires a company to recognize revenues during the accounting period in which they have been earned, regardless of when cash changes hands. If the company does not receive immediate payment in cash, a legal and reasonable expectation should exist that the client or customer will remit payment in full. A clothing store earns revenue when it sells a sweater, an auto repair shop earns revenue when it repairs a car.

The realization principle applies primarily to the receipt of a health plans premiums or government program payments such as Medicare. A health plan earns revenue when it provides promised healthcare coverage. However, health plans typically receive premiums in advance of the period during which healthcare services are provided. Suppose a health plan receives an employers premiums in advance of when the premiums are earned (for example, at the beginning of the month of coverage). In this
case, 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, such as a claims liability account. The Matching Principle While the realization principle governs revenue recognition, the matching principle governs expense recognition. The matching principle states that a company should recognize expenses when the company earns the revenues related to those expenses, regardless of when the company receives cash for the revenues earned. A company also matches losses with revenues during the appropriate accounting period. The realization principle and the matching principle work in tandem. First, a company reports revenues according to the realization principle. Next, the company identifies, quantifies, and matches the expenses required to earn those revenues. Then the company records the expenses according to the matching principle. The match between revenues and related expenses does not mean that the amounts for revenues and expenses must be equal. However, this process ensures that a companys net income for an accounting period does not appear artificially or misleadingly high or low due to a mismatch in the timing of expense and revenue recognition. Figure 10B-2 summarizes the principles, concepts, and guidelines that all companies should follow for maintaining accounts. By following the guidelines set forth in the matching principle, a company can prepare its statement 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) associating cause 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 in accounting 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 specific elements of revenue are charged to earnings of future accounting periods instead of being charged to the current accounting period. The process of deferring the recognition of expenses until future accounting periods is known as capitalization . For example, a health plan that uses agents for small group business or individual healthcare coverage would spread agent commissions over the premium-paying period of healthcare coverage. Industry experience, and, in some cases, regulations, determine what items can 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 clearly recognizable or measurable. In such cases, a company uses another method to match revenues and expenses known as systematic and rational allocation. Systematic and rational allocation is an 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 of spreading (allocating) the cost of an asset over the asset's estimated useful life. As with the method of associating cause and effect, a company capitalizes costs under systematic and rational allocation. Assume that a health plan spends $1,000,000 one year to buy and install a new computer system. The health plans management cannot know for certain how long the system will provide financial benefits or what its financial benefits will be. Without a recognizable and measurable association between cause and effect, the health plans management uses the expense recognition approach to capitalize the cost in the present accounting period, recognize the cost as an 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 systems life) for the system, and uses the straight-line method of depreciation (which applies an equal dollar amount of depreciation for each year of the computer systems 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 the computer system. Immediate Recognition Sometimes a company cannot match its incurred expenses with earned revenues within an accounting period, nor can it match the expenses with revenues that it expects to generate in the future. Under GAAP, sometimes expenses cannot be matched with revenues, and incurred costs provide no objectively recognizable future benefits. Neither associating cause and effect nor systematic and rational allocation is an applicable approach for expense recognition. In such cases, the company uses the immediate recognition approach. Under immediate recognition, a company recognizes all applicable costs as expenses during the current accounting period. Immediate expense recognition is common under SAP. The fees that a company pays to lawyers and consultants are typically reported as expenses under the immediate recognition approach under both GAAP and SAP. Some expenses, such as utility bills, cannot be attributed to one particular type of revenue earned. In such cases, a health plan reports these expenses in the accounting period in which they occur, whether or not the health plan can match these costs directly with revenues earned. A company can change its approach for recognizing expenses if the nature of a cost changes over time. For example, suppose a health plan capitalizes the cost of computer equipment. The company recognizes the cost associated with the equipment over several accounting periods. But before the end of its estimated useful life (and before its total cost has been recognized and expensed), the equipment becomes obsolete and is discarded. At this point, the health plan can use the immediate recognition approach to recognize the remainder of the cost as an expense and write this amount off as a lump sum in the current accounting period. Figure 10B-3 summarizes these approaches to expense recognition.

Accounting Bases The realization principle and the matching principle are both central concepts for a manner of accounting called accrual-basis accounting. Another base of accounting that health insurers and some health plans use in certain circumstances is cash-basis accounting. In the remainder of this lesson, 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 expenses when they are incurred, even if cash has not actually changed hands. Accrual-basis accounting records revenue according to the realization principle and expenses according to the matching principle. The purpose of the accrual basis of accounting is to record a transaction when the company incurs a financial obligation either as the payor or payee. Thus, accrual-basis accounting enables an interested party to view the consequences of obligations incurred by a company whether 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 a primary focus of GAAP. For this reason, accrual-basis accounting is a central concept in financial accounting conservatism. The FASB mandates the use of accrual-basis accounting in financial statements. Both GAAP and SAP require companies to record their financial transactions on an accrual basis. Accrual-basis accounting provides information on the consequences of transactions, including a company's earnings potential and financial performance. Companies that use accrual-basis accounting must make adjusting entries to their accounting records at the end of each accounting year 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 only when it receives or disburses cash. Thus, neither the realization principle nor the matching principle applies under cash-basis accounting. Instead, cash receipts and cash disbursements are two 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 a company as some form of payment. A company records a cash receipt in the same accounting period in which it receives the cash. A cash disbursement is the payment of cash by a company to a recipient. Under cash-basis accounting, a company records a cash disbursement in the same accounting period in which it remits payment. In a pure cash-basis system, a company makes no entries to record unpaid bills or pending income. Also, the company calculates net income by subtracting paid expenses from revenues received. In addition, health insurance companies and health plans that fall under the jurisdictions of state insurance commissioners must report some items on a cash basis for statutory reporting purposes. Accrual-basis accounting helps to match expenses with revenues, a process that typically enables companies to develop more relevant, reliable, and comparable financial statements. Because cashbasis accounting does not apply the realization principle or the matching principle, misleading financial statements can result. For this reason, few companies use a pure cash-basis accounting system. Further, under GAAP, financial statements must report the results of noncash transactions, such as depreciation, as well as cash transactions that occur during an accounting period. 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 may not be legally collectible (such as certain premiums for individual healthcare coverage), it can only be recorded on a health plans books when it is received. On the other hand, a health plans investment income is legally collectible and earned as of the due date. A health plan therefore typically recognizes investment income when it comes due rather than waiting until the income is received. Many medical groups use modified cash-basis accounting. Many hospitals use accrual-basis accounting, except for large capital expenditures. Also, the nature of health plans may lend itself to modified cash-basis accounting if its use would not result in misleading results concerning IBNR claims, for example. These and other factors are considered before a health plan determines whether to use a particular base of accounting. Endnotes 1. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life and Health Insurance Companies (Atlanta: LOMA, 1997), 141. 2. Ibid., 67.

AHM Health Plan Finance and Risk Management: Financial Statements Course Goals and Objectives After completing this lesson you should be able to Describe the components and purposes of a health plans balance sheet, income statement, 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 plans 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 so that they can develop appropriate strategies for improving performance in problem areas. Similarly, by studying a company's financial statements, external parties such as investors, rating agencies, and regulators learn about the companys financial activities. They gain insight into its financial soundness and its profitability. As a result, they are better able to make informed decisions about the company's financial prospects. In this lesson, we introduce you to the primary financial statements and reports used to communicate accounting information to external users. General-purpose financial statements prepared according to GAAP comprise a health plan's annual report. Health plans that are regulated by state insurance departments also prepare an Annual Statement, which must conform to 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 the previous year. By law, for-profit, publicly owned health plans must provide an annual report to stockholders. Generally, the financial statements included in the annual report must be prepared according to GAAP. 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 are not required by law to provide interested parties with an annual report. However, some not-forprofit health plans may send an annual report to their policyholders and to other interested parties as part of communicating their service strength, for example. Most companies regard the annual report as an important document, not only from an accounting point of view, but also from a promotional point of view. An annual report is an opportunity for a company 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 numerous illustrations 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 notes and supplementary information. These financial statements contain the information that accounting specialists believe is essential for an external user to gain a general understanding of the financial condition, activities, and prospects of the company providing the report. This lesson focuses on these four financial statements and their accompanying notes and supplementary information. The preparation of financial statements is the end product of financial accounting. The dollar amounts in a health plan's financial statements represent thousands, millions, and even billions of dollars. Companies usually round these amounts off to the nearest thousand or million. The heading of every financial statement generally includes three pieces of information: (1) the name of 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 appears on a company's financial statements is generally the last day of the company's fiscal year or other applicable accounting period. A company that owns more than 50% of the stock of a subsidiary company will usually compile its financial statements for the annual report on a consolidated basis. Consolidated financial statements 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 parent company controls the subsidiary company, the parent and its subsidiary are considered a single operation, despite being separate legal entities. Parent companies usually provide separate financial information for each subsidiary or line of business in the annual report. Maintaining separate financial information is particularly useful in management decision making. Separate financial information on subsidiaries and lines of business is also useful for external parties in situations in which a parent company is considering the sale of a particular subsidiary. Balance Sheet The balance sheet is a snapshot of a company's financial position as of a specified date and summarizes what a company owns (assets), owes (liabilities), and its owners investments in the company (owners equity or net worth). We defined assets, liabilities, and owners equity in Principles for Maintaining Accounts. The amounts listed on the balance sheet represent the companys summarized account balances on the date shown at the top of the balance sheet. In this context, a balance sheet is a static measure of a companys 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 balance sheet. The main purpose of the balance sheet is to measure the owners' wealthtypically this means what remains after subtracting what a company owes from what it owns on a specified date. 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-profit stock company.

Figure 10C-2. Example of Consolidated Consolidated, , GAAP GAAP--Based Balance Sheets. Sheridan Health Networks, Inc. Consolidated Balance Sheets as of December 31, 1998 ($000s) ASSETS Current Assets: Cash and cash equivalents $ 290,963 Investment securities, at market value 775,652 Receivables, net 234,363 Other current assets 13,001 Total Current Assets $1,313,979 Property and equipment, net 28,798 Intangible assets 174,627 Long-term investments 25,705 Other noncurrent assets 12,148 Total Assets $1,555,257 LIABILITIES AND STOCKHOLDERS EQUITY Current Liabilities: Medical claims payable $ 330,665 Reserves for future policy benefits 120,000 Unearned premiums 52,584 Accounts payable and accrued expenses 93,110 Experience rated and other refunds 63,906 Other current liabilities 77,428 Total Current Liabilities $ 737,693 Reserves for future policy benefits, noncurrent 83,008 Long-term debt 217,000 Other noncurrent liabilities 11,771 Total Liabilities $1,049,472 Stockholders Equity: Common stock $ 175 Treasury stock, at cost (26) Additional paid-in capital 220,578 Net unrealized gains (losses) (1,271)

Retained earnings 286,329 Total Stockholders Equity $ 505,785 Total 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 the balance sheet depicted here. For example, within the three balance sheet account categories, some balance sheet accounts are unique to health plans, such as the liability account Medical Claims Payable. A detailed discussion of each item that appears on a health plans balance sheet is beyond the scope of this course. A balance sheet is fundamental to accounting because it demonstrates a company's fulfillment of the basic accounting equation: Not-for-profit health plans typically used the term net worth in place of owners equity. Consider the basic accounting equation as follows:
The left side of the equation (Assets) represents what a health plan, as a separate legal The right side of the equation (Liabilities and Owners' Equity) represents what the health

entity, owns.

plan owes to its creditors and stockholders or policyowners. Similarly, on the account form of the simplified balance sheet, the left side reports on the health plan's assets, and the right side reports on the health plan's liabilities and owners' equity. The total of the left side of the balance sheet must equal the right sidethey must balancejust as in the basic accounting equation. Remember that the annual report presents GAAP-prepared financial statements that focus on the company as a going concern. Thus, a balance sheet answers the following general question: As of a certain date, what and how much does a company own, what and how much does it owe, and what 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 other equity securities, provider networks, premiums receivable, and goodwill. Most of health plans obligations (liabilities) are medical claims payable and ongoing healthcare benefits to plan members and individual policyowners. When you review a list of a health plans assets, you see, in summary form, what the health plan's managers purchased with the funds provided 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 of asset and its purpose. For example, a company generally lists its holdings of common stock at their current market value as of the balance sheet date. Besides current market value, other balance sheet accounts may be valued according to historical cost, amortized cost (book value), or the lower of cost or market. The lower-of-cost-or-market rule values certain assets at historical cost or current market value, whichever is lower.

The rules for valuing each balance sheet account classification may differ between GAAP and SAP. You should be aware that the GAAP-prepared balance sheet that a health plan presents in its 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 a GAAP-prepared balance sheet. Admitted assets are those assets that state insurance law permits to 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. By comparing several years of the company's balance sheets, it is possible to form some conclusions about the dollar amounts associated with each account classification. It is also possible to discern certain company performance trends, such as whether the company is increasing its assets or its liabilities over time. However, to fully understand the balance sheet in the annual report, you must study the accompanying 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 of the annual report, are an integral part of the balance sheet. We discuss these notes later in the lesson. Income Statement An income statement shows how much money a company has realized from its operations during an accounting period, and, ultimately, to what extent the company's general operations during that period resulted in an increase or decrease in its assets. A company's income statement answers the question: Do revenues exceed expenses? If so, the company earns net income. Net income is the excess of an entitys total revenues over its total expenses. A net loss results when an entitys total expenses exceed its total revenues. We defined revenues and expenses in Principles for Maintaining 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 a specific date. A balance sheet is in essence a static measure of a companys financial position on a particular date. In contrast, the income statement is a moving picture of a company's financial performance over a specific accounting period. In this context, an income statement can be described as a dynamic measure of a companys operations over time. Figure 10C-3 shows the general form of a health plan's income statement. Figure 10C-4 depicts the consolidated income statements for Sheridan Health Networks, Inc. As you can see in Figure 10C-4, Sheridan first lists its sources of revenues. Next, Sheridan subtracts its expenses from its revenues to obtain its earnings before income taxes. Then, Sheridan subtracts income taxes to obtain its net income or net loss for the accounting period.

While the balance sheet measures a company's financial condition, the income statement measures profitability, which is one key to survival for all health plans. Profit is the extra income above that needed to pay for all costs associated with providing benefits, and this profit contributes to the health plan's retained earnings, an owners' equity account. We discuss retained earnings later in this lesson. A company must disclose in its GAAP-based income statement any gains or losses that result from transactions involving (1) the disposition of a business segment called discontinued operations or (2) any extraordinary items that are not likely to occur in the future. In addition, the company must disclose the impact of any changes in accounting policies on income statement accounts. Figure 10C-5 defines gains, losses, and extraordinary items.

Because they occur independent of a company's normal business operations, gains and losses appear separately on a companys income statement to avoid distorting the companys income from continuing operations. Suppose a health plan suffered a $1,000,000 extraordinary loss as a result of a fire at its home office. The health plan would separate this $1,000,000 extraordinary loss from its income from continuing operations. Proceeds that a health plan receives from the sale of its home office furniture represent a gain or a loss, not revenue, because the health plan's primary business involves providing healthcare benefits, not selling furniture. A retail furniture store, however, includes the proceeds from the sale of furniture from its inventory in a revenue account because selling furniture is part of its primary business operations. Thus, the account classification of a company's gains and losses depends 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 and whether a publicly traded health plan will be able to pay cash dividends to stockholders. Net income increases owners' equity while a net loss decreases owners' equity. Generally, this bottom line figureso called because net income is usually found on the last line of the income statementindicates whether a company is profitable and is likely to remain in business, at least for another year.

Cash Flow Statement The third major financial statement presented in a companys annual report is the cash flow statement. The cash flow statement, also called the statement of cash flows, provides information about a company's cash receipts (inflows) and cash disbursements (outflows) during a given accounting period. The cash flow statement reconciles the cash the company has on hand at the beginning and at the end of the accounting period. In providing information about a company's cash flows, this statement also provides insight into a company's operating, investing, and financing activities. It answers 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 companys cash flow statement. Figure 10C-7 illustrates Sheridans consolidated, GAAP-based cash flow statements. Like the income statement, the cash flow statement is a dynamic measure that shows a change over time. In essence, the cash flow statement is a rearrangement of the changes that occurred between the current and previous balance sheet, which as we noted earlier, is a static measure of a company'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 on hand to cover current expenses, then it may be insolventthat is, unable to pay bills and obligations as they come due. Many health plans are cash rich because premiums are received in advance of the provision of healthcare services. If a health plan does not accurately estimate its IBNR claims, the health plan may be unable to pay those claims as they come due. On the other hand, having too much available cash may result in idle cash that is not being put to more productive use. As you might expect, managing cash effectively is one of a companys most important tasks.

Figure 10C-7. Example of Consolidated Consolidated, , GAAP GAAP--Based Cash Flow Statements. Sheridan Health Networks, Inc. Consolidated Cash Flow Statements for the year ended December 31, 1998 ($000s) CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 56,851 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 7,100 Gains (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 719 Increase (decrease) in certain liabilities, net of acquisitions: Medical claims payable 70,728 Reserves for future policy benefits 7 Unearned premiums 5,798 Accounts payable and accrued expenses 6,926 Experience rated and other refunds 954 Other noncurrent liabilities (6,421) Net cash provided by (used in) operating activities $ 124,283 CASH FLOWS FROM INVESTING ACTIVITIES: Investments purchased $(686,801) Proceeds from investments sold 463,746 Property 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 $ 60,000 Repayment of long-term debt (47,000) Proceeds from the issuance of common stock 60,126 Common stock repurchased (53)

Net cash provided by (used in) financing activities $ 73,073 Net increase (decrease) in cash and cash equivalents $ (54,141) Cash and cash equivalents at beginning of year 354,104 Cash 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 and its income statement. The cash flow statement is similar to a check register in that both show the amount 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 received by a health plan when it sells an asset becomes a source of funds. A cash outflow is a use of funds. A cash payment to purchase a bond is a use of funds. With respect to balance sheet and income statement accounts, a company's cash inflowsits sources of cashincrease as a result of:

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 statement accounts. A company's cash outflowsits uses of fundsincrease 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 companys own common stock (a decrease in a stockholders' equity Paying expenses (a decrease in an expense account)

account)

You can calculate a company's net cash flow for an accounting period by using the following formula:

The net cash inflow or outflow represents the net increase or decrease in cash for the accounting period. Net increase or decrease is also known as the net change in cash. Theoretically, the net change in cash equals the difference between the cash balance (as shown on the balance sheet) at the 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 the difference in the cash balance between the company's December 31, 1999, balance sheet and its December 31, 2000, balance sheet. Changes in a company's cash flow occur as a result of three activities:

 Operating activities are transactions associated with a companys major lines of

business; these transactions directly determine a companys net income. A health plans operating activities are generally associated with the sale and maintenance of healthcare services. These activities include (1)selling healthcare benefit contracts and providing administrative services, (2)administering and adjudicating claims payments, (3)paying expenses associated with healthcare services, (4)developing and maintaining provider networks, and, to a lesser extent, (5)receiving investment income (such as bond interest and dividend income on stocks Investing activities are transactions that involve the purchase or sale of assets and the lending of funds to another entity. A health plans 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 or from owners of a stock company. Financing activities include transactions associated with (1) issuing, repurchasing, or retiring common stock and (2) borrowing and repaying funds loaned by creditors. Financing activities for not-for-profit health plans include transactions 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 cash inflow from or provided by that activity. If the reverse is true, then the result is a net cash outflow used 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 cash inflow provided by operating activities. Further, under investing activities, if the company sells $150,000 worth of bonds and purchases $160,000 of another corporations common stock, the cash 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 is important when a company prepares its cash flow statement. Companies use one of two methodsthe direct method or the indirect methodto prepare this statement. The only difference 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 cash flow from operating activities by taking its major types of operating cash receipts and then subtracting each major type of cash disbursement. The difference between cash receipts and cash disbursements is the net cash for the period. Although this method seems straightforward, it can be quite expensive and time consuming to track every cash transaction. Therefore, many companies uses the indirect method, which begins with the net income figure as reported on the income statement, then reconciles this amount to operating cash flows through a series of adjustments (additions and subtractions). Cash flows from investing and financing activities are calculated the same under either method. The cash flow statement depicted in Figure 10C-7 was prepared using the indirect method. The final financial statement we discuss is the statement of owners' equity, which shows the changes that occurred in the Owners Equity portion of the balance sheet. Stock companies typically call this statement the statement of shareholders equity or the statement of stockholders 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 similar statement 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 in equity accounts that occur from one balance sheet to the next. This reconciliation is similar to the reconciliation 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 on stock. Figure 10C-8 lists and describes the typical components of a stock health plans statement of 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 to financial statements are an integral part of a company's annual report. Therefore, analysts do not review 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 behind some of the amounts presented in the financial statements, usually accompany or immediately follow the financial statements in a company's annual report. These notes enable users to understand some of the more complex items in the published financial statements. Notes also appear on the financial statement pages themselves, either in footnote form or as parenthetical comments beside a particular line on the financial statement. Supplementary information usually follows the notes in an annual report. An explanatory note for a company's fixed assets, such as company-occupied real estate, is one example of the additional information that you may obtain from notes to the financial statements. The balance sheet generally lists one total for Property, Plant, and Equipment. An accompanying note or supplemental information will disclose the depreciation method and itemize each component of this particular asset. The notes to the financial statements often take up a significant amount of space in a company's annual report. Financial Statement Integration A company's financial statements are integrativethat is, they relate to, explain, and complement each other. The income statement and the cash flow statement are dynamic measures and provide the critical links between the changes in two consecutive balance sheets, which are static measures. Recall that net income in the cash flow statement minus cash dividends paid to stockholders equals the change in retained earnings on the balance sheet between two accounting periods. Another relationship between the balance sheet and the income statement is that an increase in various expenses (income statement accounts) decreases cash or increases short-term or longterm liabilities (balance sheet accounts), depending on the nature of the expense. Note also that

 The $56,851 of net income on Sheridan Health Networks income statement appears in the 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 on the cash flow statement The owners equity section of the balance sheet is a summary of the figures obtained from 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 of owners' equity. A net loss is also a cash outflow generated by operating activities on the cash flow statement. Net income is thus the balancing figure between retained earnings on the statement of owners' equity and retained earnings on the balance sheet. The indirect method of preparing the cash flow statement demonstrates the interrelationship between the income statement, the balance sheet, and the cash flow statement. Recall that, under the indirect method, the cash flow statement begins with net income, which is taken directly from the income statement. This figure is then adjusted up or down according to changes on the balance sheet, such as increases or decreases to claims liabilities, and expenses due and accrued. Endnotes 1. Nicholas L. Desoutter and Kenneth Huggins, eds., LOMAs Glossary of Insurance Terms, 3rd ed. (Atlanta: LOMA, 1997). 2. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life and Health Insurance Companies (Atlanta: LOMA, 1997), 143.

AHM Health Plan Finance and Risk Management: The Strategic Plan Course Goals and Objectives After completing this lesson you should be able to Define strategic planning, mission statement, and vision statement Explain the steps in a health plans typical strategic planning framework Describe the purpose of a SWOT analysis and list some attributes that health plans evaluate to determine their strengths, weaknesses, opportunities, and threats Like the practice of medicine, strategic planning is both an art and a science. Key personnel must buy into a health plans strategic planning process and commit to the health plans strategic plan. The strategic plan itself must be reality-based and operate according to sound finance and accounting principles. The execution of the plan by personnel is the art, and the operation of sound accounting principles is the science. Besides developing an overall strategic plan, a health plan must develop a strategic financial plan to support the financial aspects of the health plans strategic plan. We discuss the development of a health plans strategic financial plan in the next lesson. Strategic Planning Strategic planning is the process of identifying an organizations long-term objectives and the broad, overall courses of action that the organization will take to achieve those objectives.1 In the context of health plans, strategic planning is the development of a roadmap of how a health plan will achieve success. Before developing this roadmap, however, it is essential that a health plan first 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 we discuss a simplified strategic planning process, as illustrated in Figure 11A-1. The first step in the strategic planning process is to define an organizations mission and vision statements. Then the organization conducts both an internal analysis and an external analysis of its current position. Next, the organization develops its strategic plan, followed by its strategic financial plan. Implementation and ongoing monitoring of the organizations strategic plan follows.

Admittedly, Figure 11A-1 oversimplifies the strategic planning process. The vertical two-way arrow that runs to the right of the description of the steps in the strategic planning process illustrates that strategic planning is neither linear nor static. Organizations constantly adjust some of their strategies in response to changing conditions and occasionally revise their mission and vision statements as a result of such adjustments. For example, a health plan may alter its strategic plan as a result of changes in state solvency requirements that require the health plan to maintain a higher amount of capital and surplus. Although this change in the health plans external environment would not change its mission or vision statements, greater capital and surplus requirements could significantly impact the health plans strategy for entering certain markets. In the following sections, we describe each of the steps in the strategic planning process Define Mission and Vision Statements A health plan defines its purpose and direction by defining its mission and vision. A mission statement is a statement that succinctly sums up an organizations reason for existence and overall purpose. 2 It is essentially the reason for the organizations existence. One example

of a health plans mission statement is A vision statement, also called a vision, is a statement of an ideal that an organization would like to achieve; it is intended to inspire enthusiasm and commitment in the organizations employees. 3 The vision statement defines whether or not the organization is successful in fulfilling its mission. An example of one health plans vision statement is Conduct an Environmental Analysis Figure 11A-1 shows that once a health plan has determined where it wants to go by defining its mission and vision statements, the health plan must then perform an assessment of the current internal and external environment it which it operates. One way of performing this assessment is by 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 current playing field and determine possible changes in the environment and options for internal adjustments in response to those changes. 4 An assessment of a health plans strengths and weaknesses looks at the health plans internal capabilities relative to the strengths and weaknesses of its competitors. Similarly, an assessment of a health plans opportunities and threats is a view of external market attractiveness from the health plans perspective. Conduct an Environmental Analysis Ideally, a health plan would be the strongest competitor in an attractive market, and the health plans strategic plan would focus on exploiting the health plans strengths to sustain its competitive advantage. If the health plan were a strong competitor in an unattractive market, then the 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 an unattractive market. In this case, the health plan would probably develop a quick exit strategy. If the market is attractive, but the health plan is a weak player in that market, the health plan will either focus its strategy on improving its market position or exiting that market to use its resources to become stronger in other attractive markets. Because local market share is critical to a health plan, a national health plan needs to develop strategic plans that are appropriate to the local markets in which they compete and in their national operations. Besides market share, a health plan may perform a SWOT analysis to analyze its relationships with the major providers in each market in which it conducts business. Strengths and Weaknesses In the process of developing a strategic plan, the health plan first prepares an objective assessment of its internal strengths and weaknesses relative to its competitors. Over time, these strengths and weaknesses will change. For example, if a previous SWOT analysis had identified as a weakness the benefit design of the health plans key product, and the current SWOT analysis may 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 the healthcare industry. Note that many of these attributes are linked. For example, distribution, quality, and service are closely related in that convenient access to healthcare is usually perceived as a positive component of service and quality. Opportunities and Threats Threats and opportunities are external factors that could impact the future business of the health plan. It is critical that a health plan constantly evaluate these external factors and take appropriate action to defend against the threats and seize the opportunities. In some cases, threats can be turned into opportunities. For example, legislation that increases expenses for one type of health plan, such as an HMO, is certainly a threat to a health plan that has a high market penetration of HMO membership. On the other hand, such legislation can also be an opportunity for the health plan to increase the market share of its PPO business. Similarly, changing medical practice patterns can be both a threat and an opportunity, depending on whether or not a health plan has at least anticipated the changes and adjusted its plan benefits and price appropriately. The most difficult part of determining a health plans threats and opportunities for a SWOT analysis is evaluating whether or not current trends in external factors will continue. Figure 11A-3 describes some changes which are typical threats to, and opportunities for, a health plan.

Develop the Strategic Plan A health plan that has developed its mission and vision statements and evaluated its current position using the SWOT analysis, is ready to develop its strategic plan. The health plans strategic plan must take advantage of the health plans strengths and opportunities and defend against its weaknesses and threats. One framework for developing an health plans strategic plan involves using the marketing variablesproduct, price, place (also called distribution), and promotionin combination with human resources and information technology. A health plan can manipulate these four marketing variables as needed in the strategic planning process to help the health plan achieve its goals. Human resources are a critical component of a health plans strategic plan because, in health plans, often the product is less important than the size and the quality of the products provider network. Another critical element of a health plans strategic plan is information technology, which is essential to provide healthcare services and to comply with financial reporting requirements. Lets examine these marketing variables in more detail. Product, Price, Place, and Promotion A health plans 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 health plan can differentiate its products by offering a wide variety of benefit choices or achieving a superior brand name for quality and service. Alternatively, the health plan can choose to differentiate itself on price alone. The provider network is among the most important parts of a health plans product because the provider network directly affects the health plans ability to deliver quality care at a competitive price. A health plan can also differentiate its products through the use of alternate distribution channels or advertising formats that its competitors are not using. The strategic plan also addresses the geographic service areas in which the health plan chooses to compete. Expansion strategies may be called for if the health plan feels it can obtain a competitive advantage in an attractive market. In this context, expansion can be achieved either by (1) entering the market and building a market share, or (2) acquiring an existing market share from a health plan that has been operating in that market. In addition, a health plans 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 through brokers and agents. Most health plans use both. Human Resources Investments in technology, brand, distribution systems, and the like are important, but to achieve its strategic goals, a health plan will also have to hire and retain highly committed employees who tend to outperform their competitors. Perhaps this is the area where a sustainable competitive advantage is most viable for many health plans. For this reason, a health plans strategic plan also typically includes a plan for attracting and retaining the right employees, who are critical to achieving the health plans 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 plans strategic plan. A health plan faces risks and benefits in adopting new IT systems, whether it develops the systems internally or purchases them externally. Being the first health plan in a particular market to implement 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 cost increases and extensive service problems. Consequently, a health plan should consciously decide whether to be a leader or fast follower in the use of new IT systems. This decision should be a part of the health plans strategic plan. Because acquiring a new IT system is a considerable expense, a health plan typically conducts a financial evaluation of potential IT capital expenditures, and monitors promised results, as a critical part of its IT strategy. If the health plan chooses the right IT systemfor example, an excellent call center management system or medical management systemthen the health plan will enjoy a competitive advantage until competitors 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 SWOT analysis, and developed its strategic plan, it must identify the specific actions that it will take to implement the strategic plan. For example, a statement like we will achieve a sustainable cost advantage does not describe how the cost advantage will be accomplished. An example of a more specific action item to achieve a cost advantage is a statement like we will renegotiate our hospital 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 plans managers should also have the authority and support necessary to undertake their assigned action items. The implementation of a health plans strategic plan is a complex process. As a result, some parts of the health plans strategic plan will not go exactly as expected. Adjustments to the original strategic plan may become necessary. For this reason, health plans typically also develop contingency plans, which are plans designed to minimize the possible negative impacts and take advantage of opportunities that changes in the health plans operational environment may present. Contingency plans are typically used only if the health plans strategic plan is not working. Most contingency plans contain corrective actions. We discuss in the nesxt lesson 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 plans mission 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 stands in relation to its goals. These measures, called metrics, are developed around key dimensions, such as
Qualityfor example, the National Committee for Quality Assurances (NCQAs) Servicefor example, average telephone wait time Financefor example, cash flow or net income

Health Plan Employer Data and Information Set (HEDIS)

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 plans include the health plans market share and growth rate. To measure progress toward achieving a health plans stated vision of being the recognized industry leader, the health plan may measure its 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), 98100. 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), 6768. 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 Objectives After completing this lesson you should be able to: Distinguish between a health plans strategic financial plan and operational budget Describe the purpose of the financial planning function in for-profit and not-for-profit health plans Define debt and equity with respect to a health plans capital structure Define cost of capital and the capital asset pricing model Calculate a health plans weighted average cost of capital Explain the purpose of a health plans pro forma financial statements List some key drivers of a health plans pro forma income statements and balance sheet Define sensitivity analysis and describe how a health plan uses the optimistic, most likely, pessimistic scenario modeling and Monte Carlo simulation After a health plan has developed a draft of its overall strategic plan, the health plan can begin developing its strategic financial plan. One of the main goals of a health plans strategic financial plan is to assess the long-term financial feasibility of the health plans overall strategy. The focus on long-term goals distinguishes a strategic financial plan from an operational budget, which is a component 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 how an organization will achieve the goals established in the overall strategic plan. An operational budget is a short-term budget that covers all or part of an organizations operations.1 Figure 11B1 presents a comparison of a health plans strategic financial plan and its operational budget. We discuss budgets and other short-term financial management tools in Management Control. A health plans strategic financial plan must be consistent with the health plans financial policy and realistically project the desired financial results with an acceptable level of risk. Before we discuss the development of a health plans strategic financial plan, we examine the role of financial planners in a health plan and the development of a health plans financial policy.

The Financial Planning Function A health plan must be financially sound to fulfill its mission and meet its vision. The financial planning function in a health plan ensures that the health plan remains financially healthy and complies with all external and internal financial reporting requirements. This statement is true whether 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 core business functions to ensure ongoing operations. The tasks associated with the financial planning function are typically performed by a health plans employees in the finance, accounting, investments, and/or contracting areas. The difference in the finance role between for-profit and not-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 the health plan is willing to accept. Typically, there is a tradeoff between the possibility of faster growth and the assumption of higher financial risk.

Although a health plan should establish adequate internal controls to ensure that its assets are not being misused, some health plans may want to, or even have to, tolerate more financial risk with respect to their assets than other health plans tolerate. However, there can be negative consequences if a health plan assumes too much risk. The following scenarios show the potential consequences 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 of

relaxing its underwriting guidelines to enter a new market. This scenario could cause the health plans 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 plans activity ratios to fall below levels set forth in debt covenants, which stipulate the conditions with which the health plan must comply for the health plan to continue to borrow money. (We discuss activity ratios in Financial Statement Analysis in health plans.) If a health plan invests in long-term assets such as real estate, which generally cannot be sold quickly for cash. This scenario could cause a temporary cash shortage for the health plan, 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 plans insolvency if not quickly corrected. Health plans, therefore, must set policies to minimize the exposure to these financial risks, 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. Equity is a form of ownership in an organization. In an existing organization, equity can typically be generated through (1) surplus or retained earnings or (2) a stock issue. Equity owners of a forprofit organization expect a return on their investment and eventually hope to receive future profits, 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 organizations debt holders are also investing in the organization and expecting periodic interest payments and the eventual return of their principal (the borrowed amount). Depending on the amount of debt and equity an organization has, the organization may have either a debt structure or an equity structure. From an organizations perspective, debt is obviously more risky than equity, but is almost always less expensive than equity. Debt is less expensive than equity for the following two reasons: 1. Compared to an organizations equity holders, its debt holders have a prior legal claim to the organizations 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-profit organization), the tax shield (or savings) lowers the total cost of the organizations debt. Although not-for-profit organizations typically do not pay income taxes or receive the benefit of the tax shield, they can sometimes issue debt and pay tax-free interest to the investor, who in turn accepts a lower interest rate.

To manage the financial risks associated with conducting its business, a health plan needs to determine what it costs the health plan to obtain capital by each of the different capital financing methods. An organizations cost of capital is the overall rate of interest or dollar amount that the organization pays for the long-term funds that it employs.5 Calculating a health plans cost of debt is relatively easy. It is essentially the same as the average interest rate the health plan is paying to debt holders, adjusted for the tax shield. Estimating a health plans cost of equity is a bit more complicated, however. The cost of equity is usually calculated using the capital asset pricing model (CAPM), which uses beta and the market return to help investors evaluate risk-return tradeoffs in making investment decisions. According to the CAPM, the cost of equity is equal to an investors risk-free ratefor example, the interest rate on a U.S. Treasury bondplus an adjustment that considers the market rate, at a given level of 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 equity since it has no investors expecting a return. Because not-for-profit health planlth plans obtain their equity primarily from retained earnings, their cost of capital is typically related to operating costs. Also, a not-for-profit health plans customers, which can be thought of as its owners, value their cash and will want it used in such a way that will generate value for them. Therefore, a notfor-profit health plan might reasonably apply a beta from a similar publicly held company in calculating its cost of equity. After a company determines its cost of debt and its cost of equity, then the company can calculate its weighted average cost of capital. The weighted average cost of capital (WACC) is the overall cost that a company pays to obtain new funds from all sources. 7 Suppose a health plans capital structure consists of 25% debt and 75% equity and that the health plans average after-tax cost of debt is 5% and its cost of equity is 11%. Using WACC, the health plan has a weighted average cost of capital of 9.5% [(5% 25% debt) + (11% 75% equity)], as shown in Figure 11B-3. The 9.5% rate calculated using WACC can be used as a hurdle rate for setting the health plans financial policy. In our example, if the health plan establishes 9.5% as the hurdle rate for capital investments, any investment that is expected to earn a return of more than 9.5% should add value to the health plan. Ultimately, establishing a policy for capital structure involves a tradeoff between 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 in which healthcare services are provided, while it often pays providers several months after they have performed healthcare services for plan members. Between the time a health plan collects its premium and pays all of the associated claims or medical expenses, it holds cash, which is managed by the health plans treasury function. For many health plans, investment income is significant in dollar amount, even if it is not significant in percentage terms of the health plans total income. In many cases, regulators provide some parameters on the type and amount of investments a health plan can make, but a health plan also has some latitude in its choice of investments. Stocks have historically yielded the highest returns, followed by long-term bonds (those with maturities of 10 years or longer), with short-term bonds (those with maturities of one year or less) yielding the lowest returns. A health plan develops an investment policy that guides the health plans mix of debt and equity investments. A health plans investment policy typically must be approved by the health plans board of directors. Such a policy usually establishes guidelines for matching the expected cash flows from investment income to the expected cash outflows for provider reimbursement expenses, for example. A health plans investment policy also establishes risk and return targets for the health plans investments. Developing the Strategic Financial Plan Once a health plan develops its financial policy, including the debt and equity targets it needs to fund its business, and determines the policy it will follow in making investments, the health plan can develop its strategic financial plan. The core of the strategic financial plan is the development of 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 companys financial condition will be at the end of an accounting period, assuming that the company achieves its objectives.14 Because the pro forma financial statements are a forecast (projection), a company has to create, review, and revise pro forma statements several times to make them useful in the strategic financial plan. After developing a few iterations of pro forma financial statements, a health plan reviews its strategic financial plan to see if the plan produces acceptable and reasonable financial results. If it does, the health plan then conducts sensitivity analysis, discussed later in this lesson, to determine if the assumptions made in the health plans strategic plan are likely to occur. A health plan also typically develops contingency plans for use in the event of changes in the market environment or in the health plans underlying assumptions. After the strategic financial plan is developed and reviewed, the health plan can begin implementing its plan. As part of the implementation 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

plans strategic financial plan in the following sections. After the strategic financial plan is developed and reviewed, the health plan can begin implementing its plan. As part of the implementation 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 actively participates with the finance function in developing and evaluating the pro forma financial statements. Key assumptions that are used in developing a health plans pro forma financial statements must be aligned with both the health plans SWOT analysis and its overall strategic plan. Minor, or more predictable, assumptions can be made by the finance function with little or no outside help. Before developing the pro forma financial statements, it is useful for a health plans senior management to agree on some global assumptions. For example, in developing the pro forma financial 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 begin developing its pro forma financial statements. Typically, health plans spend most of their time on the key assumptions that will drive the projected financial results. The first pro forma financial statement that we examine is the pro forma income statement. Forecasting the income statement is the most critical of the three financial statements, as it also drives the development of the balance sheet and cash flow statement. As a result, errors in forecasting 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 a health plans senior management. In forecasting the income statement, a health plan starts with the key drivers of revenues and expenses. Figure 11B-4 shows some high-level drivers and the impact strategic decisions will have on making these forecasts. The health plans management forecasts premium revenues and medical expenses by product type (for example: HMO, PPO, POS, etc.), estimating price and unit costs (for example, PMPM) and then multiplying by volume (membership). It is critical that the assumptions used in developing the pro forma income statement be consistently linked to the overall strategic plan. For example, if a health plans strategy calls for a 15% annual increase in premium revenues, then the health plans prices and membership assumptions must realistically support this. If the assumptions cannot support this, the strategy must be revisited. Health plans that have allowed the desired financial results to drive the assumptions, instead of having the assumptions drive financial results, risk developing unrealistic strategic financial plans. Therefore, a health plans senior management attempts to resist any pressure to use unrealistic 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 forecasted net 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 plan made in developing the pro forma income statement. As a result, a realistic pro forma income statement will usually result in a realistic pro forma balance sheet. Recall that a health plans balance sheet lists the health plans 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 and liabilities portions of a health plans balance sheet. This figure also provides examples of some strategic 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 plans current assets and current liabilities. For example, a health plan whose product mix contains an HMO, rather than a PPO, may experience a lower IBNR liability if more providers are paid on a capitated basis. In creating a health plans pro forma balance sheet, financial assumptions, such as the assumption that the health plan will issue debt or equity, must be supported by the health plans overall strategic plan. Also, the health plan must ensure that it will have the needed cash available to implement 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, because this review provides insight into whether the health plan can achieve the forecasted income statement and balance sheet. Another key use of the pro forma cash flow statement is that it can be used to calculate the net present value of the health plans strategic plan. In other words, the pro forma cash flow statement shows, in terms of cash inflows and cash outflows, the impact of a health plans strategic plan on the health plans cash. Reviewing the Strategic Financial Plan Because the development of a health plans pro forma financial statements is an iterative process, it requires a number of revisions until the health plan has a set of workable (reasonable) financial statements. In reviewing the pro forma financial statements, the health plan may want to seek answers to the following questions in determining if desired results are to be reflected in these financial statements:

 Do results reflect a historical performance trend? Have predicted growth rates and earnings ever been sustained in the health plan industry in this market? Although changes in the market and changes in the health plans strategic plan will produce different results from the past, it is especially important to look for forecasts that resemble hockey sticksthat is, flat in the beginning with steep improvements projectedwithout a reasonable explanation for the performance improvement. If the forecasted results look outstanding, wouldnt they invite a competitor response, such as a new market entrant? Has this prospect been accounted for in the pro forma financial statements? Are the forecasted operating ratios and financial ratios within the limits of the health plans financial policy and investment policy? Do they meet the external requirements of regulators and lenders? Are measures such as net income growth and return on equity acceptable to the health plan and its owners? (We discuss financial 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 its strategy. Changing the assumptions so that they produce the desired financial outcome completely defeats the purpose of preparing both the strategic plan and the strategic financial plan. Sensitivity Analysis The strategic financial plan we have so far developed is based on a single set of assumptions and results in a single outcome. The probability of that single set of assumptions occurring is essentially zero because there is uncertainty concerning the assumptions used in developing the strategic financial plan. Because of this uncertainty, sensitivity analysis is recommended as part of the strategic financial planning process. Sensitivity analysis is a process of taking the key assumptions made in the strategic plan and estimating a range of uncertainty concerning these assumptions. In this way, sensitivity analysis measures the downside risk and upside potential of the strategic financial plan, and it allows for the development of contingency plans for use when the plans implementation does not go as intended. Sensitivity Analysis In performing sensitivity analysis, a health plan typically models only the key assumptions that are likely to make a significant financial impact on the health plan. These key assumptions might include market growth, pricing and cost assumptions, and new market entrants. Predicting market trends and competitor actions is a necessary, though imprecise, activity. There are several recommended methods of performing a sensitivity analysis. A common technique 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 range of 0% to 10% to see how a percent change in the assumed medical inflation rate would affect the potential outcome of its strategic financial plan. In the following sections, we discuss the use of optimistic, most likely, pessimistic scenario modeling and a Monte Carlo simulation. Figure 11B6 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 preparing two more sets of pro forma financial statements, in which key assumptions are revised to project a 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 its probability (likelihood) of occurring. Some health plans use a 10% probability that the outcomes will be optimistic and a 10% probability that the outcomes will be pessimistic, with respect to the strategic financial plan, which represents the most likely scenario. In this example, the health plan expects 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 the financial outcomes will be higher than expected. Monte Carlo Simulation Although optimistic, most likely, pessimistic scenario modeling is useful, it yields only three possible outcomes out of a distribution of infinite possibilities. To obtain a distribution of possible outcomes, a health plan may conduct a Monte Carlo simulation.

A Monte Carlo simulation is a risk analysis technique in which probable future events are simulated on a computer, using a random number generator, to produce a distribution of possible outcomes.17 A Monte Carlo simulation defines the strategic financial plans key assumptions such as medical inflation rates and utilization ratesin terms of mathematical formulas that can be correlated to each other or analyzed independently. A health plan might use a Monte Carlo simulation to predict the distribution of expected claims. This information would be useful in negotiating risk-sharing arrangements with the health plans providers. A Monte Carlo simulation results in more robust insights about the potential outcomes of a health plans strategic financial plan, as illustrated in Figure 11B-6. In our example, the Monte Carlo simulation shows that there is a 6.7% probability (calculated by adding all the probabilities of net income below zero: 2.6% + 4.1%) that the health plan will have a net loss in the year 2003. The optimistic, most likely, pessimistic scenario model cannot address this possibility.

Contingency Planning After performing a sensitivity analysis, a health plan then prepares contingency plans to minimize the downside risk that changes in the market environment can exert on the health plan. In addition, contingency plans enable the health plan to take advantage of opportunities that such changes 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 contingency plans 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 a health plan to have plans drafted and ready to implement when critical assumptions do not go as planned. Implementing and Monitoring the Strategic Financial Plan After a health plans senior management has approved the strategic plan and the strategic financial plan, management may present these plans to the board of directors to obtain formal approval. In such cases, the health plans board of directors periodically reviews management reports on the health plans 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 plans mission and vision, as well as the supporting goals and values. Communicating the health plans mission and vision statements and its strategic goals to employees and other interested parties helps focus the efforts of the health plan to achieve its mission. The strategic financial plan, however, is a document that should be closely guarded, because the health plan would not want it to end up in the hands of competitors. A health plans strategic financial plan is a working document that the health plan uses to manage its progress toward achieving strategic goals. This means that health plans need to compare their actual performance with their forecasted performance to determine the amount of any variance (difference). These variances, which include not only financial performance, but also quality and service 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 of an accounting period to determine whether or not its strategy is working. Therefore, a health plan should develop a short list of early indicators of key success factors and closely monitor the achievement of these factors. A health plan must constantly monitor early indicators of key success factors and make the appropriate adjustments to the strategic financial plan as changes occur. For this reason, the early indicators of key success factors must be performance measures that a health plan can use to track progress toward achieving its strategic goals. Early Indicators of Key Success Factors Assume that a health plans 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 to 4% 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 plans 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 plans administrative expenses could increase significantly without an accompanying increase in premium revenues. In this case, the health plan would have to make the necessary adjustments in its strategic financial plan, perhaps through developing alternative means of achieving the plan membership increase or otherwise offsetting the increased administrative expenses that would result from hiring additional employees. Management Incentives and the Strategic Plan Assume that a health plans 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 to 4% 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 plans 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 plans administrative expenses could increase significantly without an accompanying increase in premium revenues. In this case, the health plan would have to make the necessary adjustments in its strategic financial plan, perhaps through developing alternative means of achieving the plan membership increase or otherwise offsetting the increased administrative expenses that would result from hiring additional employees. For publicly held health plans, stock options provide a vehicle for linking incentives to achieving the 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 its executives at an identified price on a specified date. It is in the executives interest for the company to do well, so the stocks value will rise. If the stocks value does rise, the executive may, by exercising the stock options, be able to buy the companys stock at a price below the stocks market value. 18 Privately held health plans can use management incentives such as long-term bonuses, which are typically based on obtaining three-year results, or they can issue phantom stock. A phantom stock is an incentive, issued to a privately held companys employees, that is similar to a publicly traded stock, but its price is set by a formula. The formula is typically described in the companys strategic plan, and the value of the phantom stock is dependent on the companys achievement of its strategic goals. Endnotes 1. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life and Health Insurance Companies (Atlanta: LOMA, 1997), 535. 2. Thomas Reichmann, Controlling: Concepts of Management Control, Controllership, and Ratios (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), 160161. 7. Conant et al., 497.

8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

Gitman and Joehnk, 157. Ibid., 141. Ibid., 336. Ibid., 154. Ibid. Conant et al., 386. Mulligan and Stone, 525. Conant et al., 167. Ibid., 133. 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., LOMAs 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 a case study environment

In this lesson, we present a simplified case study to illustrate the development of a strategic financial plan, including sensitivity analysis techniques and the development of contingency plans. The case study begins with a brief overview of the market and competitive situation facing a fictitious health plan, Lifelong Health, Inc. (Lifelong). We examine the development of Lifelongs pro forma income statement, balance sheet, and cash flow statement. Next, we see how assumptions made on Lifelongs pro forma income statement flow through to its pro forma balance sheet and cash flow statement. In Financial Statement analysis in health plans, we will return to Lifelong in our discussion of ratio analysis. Although Lifelongs pro forma financial statements are in the form of high-level summaries, they contain enough information so that you may conduct an internal analysis. Note that there are many other ways to present internal statements. For example, many health plans do not include investment income as part of operating income, but group it with other income or in a separate net of investment expenses category. Background Information Lifelong is the largest provider of healthcare in Major City, a large, midwestern city. Lifelong is a health plan that has two products: an HMO and a PPO. Lifelong, along with its three key competitorsGlobal Health, Graymount HMO, and Sage Healthcare has a 75% share of the market in their city. Figure 11C-1 provides a Summary SWOT analysis that includes a description of Lifelong and its competitors, as well as an analysis of the competitive playing field. Lifelongs Strategic Plan Lifelongs mission statement is to provide superior healthcare at a reasonable cost to employers and plan members. Lifelongs CEO, Dr. Susan Chandler, believes that Lifelong can compete as the health plan leader in price, quality, and service. Dr. Chandler notes that, in this business, you can 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 healthcare benefits. Dr. Chandler believes that the practice of medicine must become more of a science, particularly through using statistically proven medical protocols. Dr. Chandler has identified the following key actions in Lifelongs strategic plan . Lifelongs vision is to dominate health plans in Major City and to be recognized as one of the most 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 from Lifelongs 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 achieving Lifelongs strategic goals. Current Financial Situation Lifelongs finance department has prepared financial statements to reflect Lifelongs historical financial performance in 1997 and 1998 and has prepared pro forma statements (forecasts) for the next five years. (Note that, in practice, the transition between the last year of a companys historical performance and the first year of its forecasted performance does not always neatly coincide with the end of an accounting period. For example, forecasting 1999 results typically occurs before a companys 1998 accounting period is over. As a result, the companys 1998 year usually reflects eight or nine months of actual results, combined with forecasted results for the rest of 1998. For the purposes of this simplified case study, we assume that Lifelong had access to actual results for the entire 1998 accounting period.) Figure 11C-2 shows Lifelongs 1997 and 1998 summary income statements and some data on plan membership and the average prices for its products. In their review of Lifelongs financial performance for 1998, Dr. Chandler and senior management agree that 1998 has been a disappointing 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 net loss of nearly $7 millionquite a change from the previous year. This net loss is Lifelongs first unprofitable 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 was 507,500, 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 in 1998, as can be seen in the Average Price and Average Price Increase lines in Figure 11C-2. Recall that Lifelongs fourth strategy action item was to increase HMO membership, in part by migration from its PPO product. This strategy obviously did not occur as planned, so Lifelong must examine the price relationship between its HMO and PPO products. Dr. Chandler, in a meeting with Lifelongs board of directors, pointed to the following areas as contributing to Lifelongs poor performance in 1998:
Lifelongs inability to control costs, particularly pharmacy costs, which were growing at Competitors Graymount, Global, and Sage Healthcare reduced their prices in 1998,

a much faster rate than forecasted

leading to lower-than-planned membership growth for Lifelong. Dr. Chandler noted that Lifelongs key competitors also experienced losses in 1998. Anti-HMO sentiment sweeping the nation, combined with Lifelongs low PPO price increase, caused HMO membership to grow less than planned. Dr. Chandler told Lifelongs board of directors that the good news is that the price war is over. Lifelongs competitor analysis points to average price increases in the 6% to 8% range for HMO products and 10% to 15% range for PPO products. Lifelongs strategic plan calls for greater

price increases for its PPO product than for its HMO product, but price increases are expected to be lower than those of its competitors. Development and Review of Lifelongs Pro Forma Financial Statements As mentioned earlier, Lifelongs finance department, working closely with its strategic planning team and senior management, has produced a set of pro forma financial statements for the years 19992003. The finance department is about to present these pro forma financial statements to Dr. Chandler for her initial review. As with any pro forma financial statement, Lifelongs statements were prepared using certain assumptions. In the following sections, the finance department explains to Dr. Chandler the underlying assumptions on which the pro forma financial statements were based. Also presented are an analysis of Lifelongs current financial situation and recommendations for changes to Lifelongs strategic 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 assumptions that Lifelong used in developing its pro forma financial statements. Lifelongs 1997 and 1998 historical financial performance are repeated here for convenience. Note that the assumptions were built around each of Lifelongs productsthe HMO and the PPO. It is impossible to develop a pro forma income statement without looking at an organizations revenue drivers and cost (expense) drivers. Revenue drivers and cost drivers can best be determined by estimating membership and price and costs per member per month. As you can see from Figure 11C-3, Lifelong assumes very different membership growth rates and prices for each product over the next five years. In the more complex real world, the assumptions would have to be built around several different products with different funding mechanisms in several different geographic areas. The Finance Department explained the following points concerning their assumptions to Dr. Chandler:
Pricing will be consistent with Lifelongs strategy for PPO members to migrate to the

HMO.
HMO membership is projected to pass PPO membership by 2001, and will represent Margin, as a percent of revenue, deteriorated most rapidly in the PPO product in 1998,

more than 60% of Lifelongs total membership by 2003.

and even with 12 % annual price increases will never reach 1997 levels. HMO product margins 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, because utilization rates are expected to decrease as a result of improvements in medical management techniques. As a result, only the sickest HMO patients will be hospitalized. Pharmacy cost increases will slow down, although they will still significantly outpace inflation. Lifelong has the following immediate concerns:

 Membership increases will not materialize because of premium rate increases that are

much higher than the previous year. Early indicators by Lifelongs sales department, however, suggest Lifelong will be well on its way to achieving its 1999 membership target upon completion of the January 1, 1999, open enrollment period. Medical costs will again increase faster than forecasted, rendering Lifelongs price increases inadequate to cover medical costs. For example, medical costs that rise only 1.5% faster than Lifelongs forecast will cause 1999 to be another year in which lifelong records a net loss. Lifelongs key long-term risk is that public sentiment and regulations will continue to be unfavorable to the HMO product. In response, Dr. Chandler requested that a contingency plan be developed for possible mid-year price changes and that an early indicator system be developed as well 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 that address an unfavorable market, so that Lifelong can develop an alternate pricing strategy to use in adverse market conditions. Finally, Dr. Chandler recommended that the finance department, along with the sales department, explore the possibility that Lifelong develop a POS product within 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), Lifelongs premium revenue (membership price PMPM 12 months per year) and its medical expenses flow from the assumptions depicted in Figure 11C-3. Lifelongs Other Revenue, shown in Figure 11C-4, consists mostly of investment income from its cash and marketable securities. The finance departments analysis of Lifelongs 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 Lifelongs gross margins (revenues minus expenses before interest and taxes) as a percent of revenue are expected to be below 1997 levels. The projected net income increase is a result of administrative cost projections falling from 10.4% 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 and achieving benchmarking levels. (Note that Lifelongs administrative cost percentages would be more realistic if each years percentage were increased by 5%for example: 15.4% of premium in 1998 and 11.7% of premium in 2003. Note also that Lifelong needs to address the work force reduction, given its expected plan membership increases over the next five years.) Dr. Chandlers response was, Im committed to both holding 1999 administrative costs flat and addressing our employee morale problem. She pointed out that the strategic financial plan allows a 4% average pay increase per year. In addition, Dr. Chandler asked the finance department to run a 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 midyear price change.

Figure 11C-5 depicts Lifelongs pro forma balance sheet. Lifelongs assumptions and its pro forma income statement indicate an optimistic five-year period for Lifelong. The finance department, however, pointed out the following two concerns on the balance sheet:
Equity as a percentage of Lifelongs annual premium is projected to fall from more than

36% in 1997 to less than 29% in the year 2003. This decrease is expected to occur, in spite of a record net income margin, because fast membership growth outpaced the need for 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. In other words, Lifelong had cash on hand and investments that total more than nine months worth of premium in 1997, but by the year 2003, Lifelongs cash and investments are projected to drop to less than six months worth of premium. The projected decrease in the ratio of cash and investments to Lifelongs premium is being caused in part by the
Repayment of $100 million bond in the year 2001, as shown in the Long-Term Debt line

of Figure 11C-5
Decline in claims, including IBNR claims, from 30% (1997) to only 20% (2003) of

annual medical expenses The decrease in the ratio of claims to annual medical expenses is a result of the higher mix of HMO plan membership, for which Lifelong compensates a greater proportion of its providers through capitation. Recall that, under capitation, a health plan pays its providers at the beginning of the service period, before services are rendered. Therefore, Lifelong has less cash on hand to invest from premiums received at the beginning of the month if it also has to pay its providers at the beginning of the month. Dr. Chandler is uncomfortable with the expected direction of these two ratios because these ratios would begin to violate Lifelongs existing financial policy, which specified a minimum 70% ratio of cash to annual premium. In other words, Lifelongs cash on hand needs to be at least 70% of Lifelongs annual premium. Dr. Chandler also expressed concern that the direction of the relationship between Lifelongs equity and its percentage of annual premium eventually might approach regulator thresholds. She requested the following scenarios be run:
Assume that Lifelong refinances, rather than pays off, the $100 million in bond debt that

matures in the year 2000. Assume that Lifelong raises its premium, which in turn would slow Lifelongs growth in plan membership (Note that increasing the forecasted price without decreasing plan membership 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 balance sheet together, thus providing some interesting insights about a companys financial condition and performance. Figure 11C-6 depicts Lifelongs 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 flow

from operations was projected to be a positive $6.5 million. The $13.4 million difference primarily results from the increased claims, including IBNR claims. Establishing realistic targets for provider contract negotiations will be critical. The trend of cash from operations being higher than net income is projected to reverse itself by the end of the forecast period, because Lifelong will pay a greater proportion of its providers in advance. Dr. Chandler commented that she felt confident about being close to having a solid forecast. She asked that the next review incorporate the changes discussed. She then handed out copies of a page entitled The Seven Keys to a Sound Strategic Financial Plan, shown in Figure 11C-7. Dr. Chandler noted that Lifelongs strategic financial plan has assumptions that are consistent with its strategic plan. She also acknowledged that the projected results would stretch the team, but were achievable. Dr. Chandler asked that more sensitivity analysis be performed and scheduled a separate meeting to develop contingency plans. She noted that early indicators, including PMPM targets, seemed like a good way to stay on top of achieving Lifelongs strategic goals. Dr. Chandler asked that Lifelongs vice president of human resources be invited to the next meeting so that he could start thinking about linking incentive compensation to the plan. Dr. Chandler concluded her comments by stating that the strategic plan and the strategic financial plan are working documents and should 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 Objectives After completing this lesson you should be able to: Differentiate between a health plans external analysts and internal analysts and describe the types of financial information each one seeks Distinguish between horizontal analysis and vertical analysis of an health plans financial statements 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 reveal financial information that is not immediately apparent from a health plans balance sheet and income statement Financial statements provide glimpses of a health plans past performance and current condition, and they can be one of the tools used to predict its future success. Financial statements are also a primary means for a health plan to communicate information to various audiences, including internal managers, creditors, regulators, stockholders or policyholders, employers and other plan sponsors, and plan members. But financial statements require interpretation; otherwise, they are nothing more than columns of numbers. Financial analysis, also called financial statement analysis , is a process that assesses a companys financial performance and position and compares the company with other companies within and outside its industry. The balance sheet, the income statement, and the cash flow statement 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 of financial information are interested in a health plans financial statements. Many of these people and organizations analyze the health plans financial statements. Each party has different goals and 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 (including trend analysis), vertical analysis (including common-size financial statement analysis), ratio analysis, and benchmarking. External analysis is financial analysis performed by someone outside of the company being analyzed. Most external users of a health plans financial information conduct financial analysis themselves, but some also rely on analysis conducted by other external parties. Examples of external parties that typically conduct their own analysis include investment firms, public accounting firms, regulatory authorities, and independent organizations such as the National Committee for Quality Assurance (NCQA), A.M. Best, Standard & Poors, and Moodys.

Employers and other plan sponsors, plan members, and individual stockholders usually rely on published analytical materials. Note that most external analysts, whether they conduct financial analysis themselves or rely on analyses conducted by others, want comparative datathat is, they want to note a health plans financial condition and performance in comparison with that of other health plans. Internal Analysis Internal analysis is financial analysis undertaken by employees of the company being analyzed. Usually, a health plans managers conduct internal analysis (1) to maintain awareness of the needs and interests of all external parties and (2) to determine where to allocate health plan resources to support growth and ongoing business operations. Although external analysts usually have available to them only published reports and financial statements, internal analysts may access additional financial information that is typically not released to the public. As a result, internal analysis can be more detailed and more specific than external analysis. Some types of internal analysis compare two or more accounting periods to determine trends in financial performance. For example, in the case study in Case Study: Lifelong Health, Inc., the senior management team at Lifelong Health, Inc. reviewed Lifelongs historical financial performance for strategic planning purposes. Other types of internal analysis compare one health plans performance with the performances of other health plans, or even other companies, to evaluate the performance of specific management personnel and individual departments or functions within the health plan. Comparative Financial Statements A health plans financial statements are an important source of financial information for both external analysis and internal analysis. However, numbers on a financial statement, when viewed in isolation, usually do not tell a complete story about the health plans financial condition or performance. Suppose a health plan made $120 million in claims payments in 2003. The relative importance of this amount would depend on the relationship between the amount of claims payments and the amount of premium income the health plan earned in 2003, the number of plan members in the health plans 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 of numbers 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 the historical relationship between the health plans premium revenues and IBNR claims. Then the health plan can determine an estimated percentage of premiums that will be necessary to meet its IBNR claims liabilities. One approach to addressing the limitations of analyzing a health plans financial statements out of context is to use comparative financial statements. Comparative financial statements are financial statements that present a companys financial information for two or more accounting periods side by side. In other words, comparative financial statements enable a financial analyst to review any changes in a health plans financial statement items from one year (or any other

accounting period) to the next. Both internal and external analysts use some or all of the following techniques: horizontal analysis (including trend analysis), vertical analysis (including common size financial statement analysis), ratio analysis, and benchmarking. Horizontal Analysis Comparative financial statements are useful in conducting horizontal analysis. Horizontal analysis measures the numerical amount that corresponding items change from one financial statement to another over consecutive accounting periods. Horizontal analysis shows the absolute amount of the increase or decrease in an item, along with the percentage increase or decrease. The earliest period being used in the analysis is known as the base period, because all comparisons are made with the amounts and percentage relationships of items in the base period. Horizontal analysis is fairly straightforward. To compute the percentage change using horizontal analysis, subtract the base period amount from the amount of the period being studied. Next, divide that result by the base period amount. Finally, multiply the total by 100 to put the answer in percent form, as indicated in the following equation: Figure 12A-1 shows Sheridan Health Networks (Sheridans) 1997 and 1998 consolidated balance sheets. We will use the information in this figure to conduct a horizontal analysis of Sheridans balance 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 is the percentage change between the two periods. In our example, assume that 1997 is the base period and that 1998 is the period under study. The percentage change in 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 Sheridans income statements from the same two years. To perform a horizontal analysis of Sheridans selling expenses in 1997 and 1998, look at the selling expense totals in Figure 12A-2 for each year. Next, notice that Sheridan incurred $65,131 (in $000s) in selling expense in 1997 and $68,259 (in $000s) in selling expense in 1998. Once again, the base period is 1997. The percentage change in selling expense is This information indicates that Sheridans selling expense increased nearly 5% from 1997 to 1998. A health plans annual report may contain up to five years of financial statements. A health plans Annual Statementwhich is required if the health plan is regulated under state insurance requirementsincludes at least two years of financial statements. Therefore, similar calculations

can be made for every category on two or more of a health plans financial statements, whether they were prepared under GAAP or under SAP. Trend Analysis Although our example compares just two consecutive accounting periods, health plans frequently prepare comparative balance sheets, income statements, and cash flow statements across several accounting periods. One form of horizontal analysis used to address changes across multiple accounting periods is trend analysis. Recall from Pricing and Rating that trend analysis involves the calculation of percentage changes in financial statement items over several consecutive accounting periods, they were prepared under GAAP or under rather than over just two accounting periods. Trend analysis is useful in developing a health plans premium rates to charge for a given level of healthcare benefits. Trend analysis is also useful in constructing an health plans strategic plan. Both the direction and the velocity of trends are important factors that can be determined from analyzing a health plans comparative financial statements. The term direction refers to whether a trend displays an increase or decrease in account amounts. The term velocity refers to whether the increase or decrease in an account is gradual or rapid. Examining the direction and velocity of trends enables an analyst to compare trends in relative items. Analysts may describe the direction of a trend as positive (an increase in total revenues) or negative (an increase in total expenses). Likewise, the velocity of a trend may be described as gradual, stable, or rapid. For example, a financial analyst may describe the velocity of Sheridans increasing 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 assign the base period an index number of 100. The use of an index number provides a statistical method for measuring the change in a variable. The next step in this process is to calculate a series of index 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 resulting index number will be greater than 100. If the amount of the period being studied is lower than that of the base period, then the resulting index number will be lower than 100. For example, an index number of 120 indicates a 20% increase between the base period and the period being studied. An index number of 80 indicates a 20% decrease between the base period and the period being studied. After determining the index number for the base period, apply the equation for calculating percentage changes used in horizontal analysis to determine the percentage increase or decrease for each period under study. Then, apply the percentage change to the base periods index number of 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 the direction and velocity of trend, as applied to the Wholesome health plans comparative income statements. Note that, for our simplified example, premium income is Wholesomes only cash inflow; claims payments and selling expenses are Wholesomes only cash outflows. Also note that both premium income and claims payment expenses increased during the three-year period under study, but selling expenses remained stable for two years, then declined in 1998.

Lets apply the equation from horizontal analysis for calculating the percentage changes in income 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 these income statement items. In this case, Wholesomes net income decreased 50% in 1997 from the base year 1996 and 80% in 1998 from the base year 1996. Lets focus on analyzing the changes in these four income statement itemspremium income, claims payment expenses, selling expenses, and net incomefor 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 decrease in selling expenses (0% in 1997 and 5% in 1998). The result is a significant decrease in net income (50% in 1997 and 80% in 1998). Keep in mind that, whenever the base period amount is greater than the amount of the period under study, the resulting percentage change is a decrease. In our example, the direction of trend for Wholesomes net income is a decrease for both years (a 50% decrease in 1997 and an 80% decrease in 1998). The velocity of trend for Wholesomes net income is rapida 50% decrease in 1997 and an 80% in 1998given the same criteria that were given for the Sheridan example earlier in this lesson. The disparity between cash flows into and out of a health plan, which is indicated through an analysis of the health plans comparative financial statements, would trigger an investigation by the health plans management. Both the direction of trend and the velocity of trend in premium income are positive for Wholesome because this represents an increase in cash inflows. Although the direction of trend in selling expenses is positive for Wholesome, it is not enough to offset the direction of trend in claim payments expenses. Also, the velocity of trend is worthy of serious consideration because the flow of money out of Wholesome is increasing each year. This example depicts an extreme trend in net income. In practice, Wholesomes management should have addressed this disturbing trend long before 1998.

Comparative financial statements often present the year-to-year (or other accounting period-toaccounting period) changes in absolute amounts as well as percentages. An analyst should consider both the amount and the percentage change. A large percentage change, either in a negative or a positive direction, is significant only if the item being analyzed is consequential. For example, a 50% decrease in a health plans petty cash may be deemed insignificant, but a 50% decrease in the health plans premium income is cause for alarm. External financial analysts and health plan managers generally use trend analysis to identify financial statement accounts or other items that appear unusual. However, trend analysis cannot be used to express fluctuations between negative amounts and positive amounts as index numbers. For example, index numbers cannot describe the change in net income from -$1,000 (a net loss) in one period to $1,000 (net income) in the next period. Also worth noting is that percentage changes are relevant only when compared with the base period amount. To compare percentage changes between the amounts of two other accounting periods, one of those periods must 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 financial statement item to another financial statement item. Usually the item to which all other items are compared is critical to a health plans financial performance. For example, to conduct vertical analysis of a health plans balance sheet, an analyst divides each asset item by total assets, and divides each liability or stockholders' equity item by total liabilities and stockholders' equity (or total liabilities and capital and surplus on a SAP-based balance sheet). The combined percentage totals of all asset accounts or liabilities and stockholders' equity accounts should equal 100. On a health plans income statement, each item is typically stated as a percentage of total revenues, which equals 100%. In other words, an analyst divides each item by the health plans total revenues. Figure 12A-5 shows a vertical analysis of Sheridans consolidated balance sheets for 1997 and 1998. The analysis in Figure 12A-5 uses total assets for each respective year as the denominator for performing a vertical analysis of Sheridans assets. Sheridans balance sheets show that, for 1997, current assets represent 84.5% of Sheridans total assets. Note also that investment securities represent a large percentage of Sheridans total assets: 49.9% in 1997 and 48.7% in 1998. Sheridans percentage of net receivables increased slightly in 1998 from 1997. On the liabilities and stockholders' equity side of the balance sheet, Sheridans current liabilities were 47.4% in 1997 and 48% in 1998 of total liabilities and stockholders equity. Remember that the 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 and stockholders equity for both years.

Care should be taken when determining the significance of vertical analysis percentages of different years. Sometimes a percentage change may seem unimportant, but the dollar amount of that change may be critical to a health plan. For example, although the percentage increase in Sheridans net receivables was relatively smallfrom 15.1% in 1997 to 16.5% in 1998the dollar amount ($40,573,000) was significant. Recall that net receivables are primarily premium receivables that are amounts owed to a health plan for services that have already been provided. In this case, Sheridans management would most likely review its collections procedures and other factors to determine the cause of an increase in net receivables, then take the appropriate action to reduce the amount of receivables. Common-Size Financial Statement Analysis Vertical analysis uses percentages to relate different financial statement items to a specified, total amount on the statement. Vertical analysis can also be used to compile a common-size financial statement, which is a financial statement that displays only percentage relationships to a specified item; there are no dollar figures for each item. Balance sheets and income statements are often exhibited 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 Sheridans total revenues for each respective year. In other words, total revenues is the common size to which all other income statement items are compared. Analysts use a common-size financial statement to compare the percentages associated with a health plans current and previous accounting periods. In addition, common-size statements allow a health plan to compare itself to another health plan or to published industry averages. The use of common-size statements also somewhat facilitates the comparison of companies in different industries, which is especially valuable to potential investors. Because all amounts are stated in relative terms rather than absolutes, common-size financial statements facilitate the comparison of companies of different sizes in the same industry. For example, a staff model HMO may compare its PMPM rates to those of other staff model HMOs in its geographic area. Assume that health plan As net income on its 1998 income statement was $450 million and that health plan B's net income for 1998 was $150 million. It would be easy to conclude that health plan A is more profitable because it had a greater net income that health plan B. However, a review of each health plans 1998 common-size income statement reveals additional information. Suppose health plan As common-size income statement indicates that health plan As net income is 3% of its total revenues. Health plan Bs common-size income statement shows that health plan Bs net income represents 5% of its total revenues. From another perspective, expenses are 97% of health plan As total revenues, whereas expenses are 95% of health plan Bs total revenues. The information provided by common-size income statements suggests that, although health plan B's net income is lower, all other factors being equal, health plan B appears to be operating more efficiently than health plan A. In the above example, health plan A and health plan B obtain most of their revenues from premium income. Suppose health plan C receives most of its revenues from administrative services 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 premium income that is a smaller percentage of its total revenues, as compared with health plan A and health plan B, which have few or no ASO contracts. In order to compare the efficiency of health plan C with that of health plan A and health plan B, some analysts recognize premium equivalents, 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 a company compares its own performance, products, and services with those of other companies or organizations that are recognized as the best in a particular category. Benchmarking measures a health plans performance and practices and helps identify those practices that will lead to superior 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 of benchmarking. Some examples of healthcare practices or financial performance measures that health plans typically benchmark with other health plans include wait time in a doctors office, independent quality ratings, inpatient length of stay, claims payment turnaround time, and key financial ratios. Figure 12A-7 lists some additional examples of practices that health plans typically benchmark in the health plan industry. Note that it is critical for a health plan to benchmark against the same line of business. For example, when benchmarking its employer group plan, a health plan would not typically compare its results with those of a Medicare plan. Suppose that, in our earlier example, health plan As management discovered that its expenses were significantly higher than those of health plan B and most other health plans. A next step for health plan As management probably would involve a review of internal operations and related factors in an effort to decrease expenses so they are within the industry range. This attention to expenses would ultimately enable health plan A to increase the percentage relationship between net income and total revenues.

Health plans and providers can also benchmark against companies in other industries. For example, to improve inpatient service, a hospital may benchmark against other hospitals, but it may also want to benchmark against the hotel industry or the restaurant industry. A health plan may benchmark the quality of its nurse advice line against best practices available through customer service lines and call centers provided for customers in the catalog sales industry or in the mutual funds industry. Alternatively, a health plan may compare its call wait times and lost call percentages to those of the airline industry. The ideal benchmarking candidates are those health plans or other companies with a high level of performance in the area being studied, and with similar asset size, business mix, market, and ownership structure. A health plans benchmarking goals should be as explicit as possible. For example, instead of setting the general goal of reducing operating expenses, a health plan would typically select as a benchmark a similar-sized health plan that is known as an industry leader in operating expense cost control. Using vertical analysis, the health plan could then set the goal of equaling the benchmarked health plans percentage of operating expenses to revenues by the end of the following accounting period. In this case, the health plan could establish a goal of reducing operating 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 plans balance sheet and income statement. However, a health plan should also analyze its cash flow statement to gain a complete understanding of the health plans financial condition. The cash flow statement can be a valuable aid in determining the health plans future direction. Recall that the cash flow statement details the sources and uses of cash by segregating the statement into cash flows from operating activities, investing activities, and financing activities.

Analyzing a health plans 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 obtain cash from operating activities because this indicates that a health plans core business operations are healthy and active. Consider the following three circumstances in which a health plan can acquire 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 with a health plan? You would probably prefer the health plan that obtained most of its net cash inflow from operating activities, rather than from investing activities or financing activities. High dollar amounts of net cash inflows from operating activities usually indicate soundness in the health plans core business operations. This financial strength in turn enables a health plan to finance and deliver healthcare services to members of your sponsored group. Similarly, if you were a potential creditor, under which circumstance would you prefer to lend money to a health plan, all other factors remaining equal? As a creditor, you would probably prefer that the health plan obtain most of its revenues from core business operations, because this increases the likelihood that the health plan will be able to repay any loans provided by the health plans current and future creditors. Selling a line of business or issuing stock are one-time activities that are not likely to be repeated in subsequent years. However, it is possible that a health 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 increasing sales 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, particularly one that might have been profitable, or a health plan that has incurred additional debt or diluted the 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 activity would be more attractive to a plan sponsor, creditor, or investor than a health plan that generated the majority of its net cash flows (that is, cash inflows minus cash outflows) from financing or investing activities. Generally, the larger the cash inflows from operating activities, the better able a company will be to pay its obligations and to weather unfavorable changes in the economy. Given this information, a health plans management could decide to sell an unprofitable line of business, then use the proceeds from this sale to expand its relatively strong lines of business against competing health plans. This brief analysis is admittedly simplistic. The point of this illustration is to provide you with a preview of how you might begin to use financial analysis to make rational decisions about a health plans financial strength or performance. In this example, the health plans interested parties would go beyond this one scenario to consider other factors. Suppose the health plan obtained higher sales volume, but at significantly higher expenses. In this case, the operating activity could be interpreted as a negative factor. What if the health plan obtained $250,000 from the sale of an unprofitable line of business? In this case, the investing activity could be perceived as a positive factor. Likewise, if the health plan issued stock to raise funds to finance a potentially profitable expansion or acquisition, interested parties could interpret

this factor as a positive one. Figure 12A-8 summarizes a health plans 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, and profitability Recognize and apply the ratios that are most important to health plans Managers use the information contained in a health plans financial statements and other documents to measure the efficiency with which the health plan is achieving the strategic financial plan. Recall that a health plans strategic financial plan typically includes goals related not only to its current financial performance, but also to its growth rate. Financial statement analysis is an objective technique for measuring a health plans performance and its progress toward a sustainable rate of growth. One of the most widely used methods of financial statement analysis is ratio analysis. Ratio analysis consists of comparing various financial statement values for the purpose of assessing a health plans financial performance or condition. A ratio is a comparison of two or more numbers in fraction form. A ratio may be stated as a fraction; for example, one-half may be written as either 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 ratios are applicable to all types of businesses. For example, acceptable ratio results for a health plan are going to be quite different from the acceptable ratio results for a clothing manufacturer or a public accounting firm. Ratio analysis should also be conducted with a general understanding of the health plan being studied and its environment. Because healthcare costs, benefits, demographics, and forms of business typically differ regionallyand sometimes across health plans within a specified regionit is important to compare a health plans ratios with similar health plans in terms of these and other factors. Published ratios are available for health plans to use in benchmarking specified performance areas. Also, health plans that are subject to statutory solvency requirements must comply with the established ranges of acceptable ratios for risk-based capital (RBC) requirements, which we discussed in Risk Management in health plans lesson. Ratio analysis can answer a health plans direct (yes or no) questions, such as: Can short-term liabilities 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 claims or reimburse providers within 30 days? Meaningful ratio analysis serves best only to point out changes or trends in operating performance and help illuminate the hazards or opportunities associated with normal business operations.

The relationships created by ratio analysis help to highlight a health plan's strengths and weaknesses, thus revealing areas that need attention or additional research. For example, a health plans current assets may seem adequate on the balance sheet, but only when they are applied in the current ratio can their adequacy be confirmed or contradicted. For this reason, ratio analysis is an important part of a SWOT analysis, which we discussed in The Strategics Planning Process In health plans. Before proceeding further, a few words of caution. First, other than regulatory mandates for calculating specified ratios, there are few standards for calculating financial ratios. For example, sometimes the formula for calculating a health plans return on assets ratio and its return on investment ratio yield the same results; sometimes there is a slightly different formula for each ratio. Consequently, this assignment cannot provide an exact description for every financial ratio used in every analysis. Instead, we review some commonly used ratios and indicate the type of information 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 are applicable to all health plans. For example, health plans do not typically have inventories, make purchases 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 to health plans. As we noted in Accounting and Financial Reporting, health plans often prepare financial statements under two different bases of accounting: generally accepted accounting principles (GAAP) and statutory accounting practices (SAP). Recall that statutory accounting is required for the Annual Statement, which must be submitted by any health plan that must comply with state insurance requirements. Note, however, that ratio analysis is also conducted for taxation purposes and that a health plans management team may develop specific financial ratios to use in monitoring the health plans progress toward achieving its strategic goals. GAAP Ratios This section describes traditional financial ratios that analysts use to study a health plans GAAPbased financial statements. It is important for a health plans managers to be familiar with these ratios because they should be able to analyze the health plans financial statements, as well as those of other health plans. In this section we categorize ratios as liquidity ratios, activity ratios, leverage ratios, and profitability ratios. We apply each ratio to the 1998 balance sheet and income statement from Lifelong Health, Inc. (Lifelong), which are presented in Figures 12B-1 and 12B-2. Recall that we discussed Lifelong in a case study in The Strategic Planning Process In Health Plans. Liquidity Ratios Liquidity ratios measure a companys ability to meet its current liabilities. Current liabilities , also called short-term liabilities or short-term obligations, are those debts that a company must pay within one year. For a health plan, liquidity is critical because a sufficient amount of current assetsfor example, cash and other liquid assetsmust be available when needed to pay medical expensesparticularly IBNR claimsand 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 the current accounting period, typically one year. 1 Because a health plan receives premium income in advance of the provision of healthcare services, liquidity is typically not a problem, unless the health plan capitates its providers. In such cases, at the beginning of each month, a health plan may receive cash inflows (from premium income), which immediately become cash outflows (for provider reimbursement). Having sufficient cash on hand is important to meet the obligations to pay IBNR claims when a health plan becomes aware of them. For this reason, liquidity is particularly important for health plans that capitate most or all of their providers. Current assets produce little, if any, return on investment. As a result, health plans try to maintain as low a level of liquidity and as high a level of invested cash as possible, while ensuring that their current liabilities can be met. Lets look at some key liquidity ratios as they apply to Lifelongs balance sheet. Current Ratios The current ratio is the ratio of a health plans current assets to its current liabilities. We calculate this ratio as current assets (the numerator) divided by current liabilities (the denominator). In our example, Lifelongs 1998 balance sheet has current assets of $588,028,000 and 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 of its current liabilities. Lifelongs current ratio is 2.26; this means that Lifelong has more than twice the amount of current assets necessary to fulfill its current obligations. There is no standard current ratio result for all companies in all industries. An average current ratio in the health plan industry is 1.2 to 1.4. The higher a health plans current ratio, the greater its liquidity and the greater the ease with which the health plan can cover its short-term obligations. A current ratio that falls below 1.0 generally indicates that a health plans liquidity may be too low. In this case, the health plan could be forced to sell long-term assets to cover current liabilities if an unexpected event, such as several multiple births or an epidemic, occurred. On the other hand, if a health plan experiences predictable 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 quick ratio is similar to the current ratio, but excludes the dollar amount of a health plans inventory from the health plans current assets. A health plan calculates the quick ratio by subtracting inventory 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 our example, Lifelong has no inventory, so its quick ratio and its current ratio are equal.

The cash ratio is the ratio of a health plans cash to its current liabilities. In other words, the amount included in the numerator excludes all other current assets. In our example, Lifelongs cash ratio is

Lifelongs cash ratio indicates that Cash is a relatively small percentage of Lifelongs current assets. In this case, it appears that Lifelongs management has chosen to maintain as little cash as possible and to invest the remainder. Days in Accounts Receivables The days in accounts receivable, also called the average collection period, is calculated by dividing a health plans accounts receivable by its average daily revenues. Suppose a health plan had $20 million in premiums receivable and $365 million in annual revenues. In this example, the health plan would have an average collection period of 20 days:

Because most of a health plans accounts receivable are premiums receivables, the average collection period is the number of days that the health plan takes to collect premium income from plan sponsors and others. In the event that healthcare benefit services are rendered by a health plan before the health plan receives premiums for those services, the average collection period will increase. The longer it takes for a health plan to collect premium income, the higher the risk that a health plan has a collection problem. Should premium income become uncollectable, the health plan may have to write off the amount of uncollectable premium income as a bad debt. In this case, the health plan would have to report lower premium incomeand, ultimately, lower net income than it otherwise expected.

Again, because plan sponsors typically pay premiums a month in advance of receiving healthcare benefits, a health plan usually has a sufficient amount of cash on hand to pay its ongoing obligations, such as claims obligations and provider reimbursement. A typical circumstance in which a health plan may not receive premium income prior to providing healthcare benefits occurs when increases in the number of eligible plan members have not been reported to the health plan in time for that months premium payment. Net Working Capital Another common method of measuring a health plans liquidity is to calculate its net working capital. Net working capital is obtained by using the elements of the current ratio, but in subtraction form: Current Assets Current Liabilities. The amount of a health plans net working capital indicates the amount of excess cash (sometimes called free cash available for long-term investments) that the health plan may consider using for investment purposes. We discuss the investment of excess liquid assets in Management Control. In our example, Lifelongs net working capital is: Lifelong appears to have excess cash available for investment. Upon calculating the liquidity ratios, we see that Lifelongs 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 a health plan converts specified financial statement items into premium income or cash. Activity ratios gauge a health plans productivity and efficiency. In other words, activity ratios measure how well a health plan utilizes its assets to generate revenues. Below is a discussion of several key activity ratios for health plans.

Total Asset Turnover Ratio One activity ratio, asset turnover, is a standard activity measure in most industries, including the health plan industry. There are several versions of the asset turnover ratio, each of which is found by dividing a health plans total revenues by some measure of assets, such as cash, invested assets, or fixed (long-term) assets. An important asset turnover ratio for health plans is the total asset turnover ratio, which is a health plans total revenues divided by its total assets. Below is the calculation for the total asset turnover ratio and Lifelongs 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 income statement (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 period as the denominator. For the purposes of our discussion, the denominator is the amount of total assets on a health plans balance sheet. In the numerator, we use total revenues because, for a health plan, generating investment income is part of its core business operations. Generally, the higher a health plans total asset turnover, the more efficiently it has used its assets. For example, assume that the total asset turnover for health plan A is 1.0 and the total asset turnover for health plan B is 2.0. This information indicates that health plan B has generated $2 for each dollar invested in total assets, while health plan A has generated only $1 for each dollar invested in total assets. Thus, we could infer that health plan B has used its assets more efficiently. Note that health plans that own their medical facilities may have a lower total asset turnover tha health plans that do not own their own facilities. In this case, a health plan that owns its 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) divided by all fixed-charge obligations, which include interest payments, taxes, principal payments, and preferred stock dividends. Unlike dividends on common stock, preferred stock dividends are a fixed obligation that must be paid to preferred stockholders, regardless of a health plans earnings level. The fixed-charge coverage ratio indicates a health plans 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 or preferred stock. The more fixed-charge obligations that a health plan has, the higher the risk it has assumed, 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-charge obligations. 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 the other hand, a health plan with a fixed-charge coverage ratio of less than 1.0 does not have sufficient 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 plans contractual fixed charges such as interest payments. Variations of the fixed-charge coverage ratio include the times interest earned ratio and the debt-service coverage ratio. Times Interest Earned Ratio The times interest earned ratio is calculated by dividing a health plans EBIT by its contractual interest payments only. This ratio directly relates a health plans interest payments to its EBIT, as follows:

Debt Service Coverage Ratio The debt service coverage ratio relates a health plans EBIT, not only to all its inter-est payment obligations, but also to all its principal and lease payment obligations, as specified in the following equation:

Again, the higher the times interest earned ratio and the debt service coverage ratio, the more likely 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 a financial effect in which the use of fixed-cost funds magnifies both risks and returns to a health plans owners. A health plans total leverage consists of two types of leverage: operating leverage and financial leverage. Operating leverage is the effect whereby incurring fixed operating costs automatically magnifies a companys 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 plans borrowed funds are invested earn a rate of return greater than the fixed rate of return required by the health plans creditors (i.e., suppliers of borrowed funds), the result is positive financial leverage. This positive difference boosts overall returns for the health plans owners. On the other hand, if the assets in which the borrowed funds are invested earn a rate of return lower than the fixed rate required by lenders, the result is negative financial leverage. Recall from Pricing and Rating our discussion of margins in the context of pricing a managed healthcare product. In the context of financial leverage, the difference between the cost of borrowing the funds and the return earned using these funds is called the margin, also called the profit margin or the spread. Suppose a health plan borrows money at a 9% interest rate. If the health plan earns an 11% return on those borrowed funds, it has realized positive financial leverage with a 2% margin. On the other hand, if the health plan earned only 6% on those borrowed funds, it would have realized negative financial leverage with a 3% margin. The preceding examples illustrate the leverage effect, or the effect that fixed costs have on magnifying a health plans risk and return. The leverage effect applies to all companies. The more money a health plan borrows, the more debt the health plan has, and the greater the fixed costs associated with making payments on the debt. Thus, financial leverage exposes the health plan to risk. But financial leverage also provides funds that the health plan can use to increase net income. Increasing financial leverage by borrowing money simultaneously increases a health plan's risk and potential return." The leverage effect is an illustration of the risk-return tradeoff that we discussed in Risk Management in health plans. Traditional leverage ratios compare some measure of a health plans liabilities to some indicator of the firm's financial strength. For many non-health plans, liabilities on the balance sheet consist largely of accounts payable and long-term debt (bonds payable or notes payable). For health plans, most liabilities are for claims payments, including IBNR claims, and other contractual obligations such as provider reimbursements. Because financial leverage ratios measure a health plans debt burden in relation to the assets it owns to cover its debts, these ratios are sometimes called solvency ratios . Two important GAAP ratios that apply to all companies, including health plans, are the debt ratio and the debt-to-equity ratio.

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 which plan contractors and others have legal claims, such as healthcare benefits, including IBNR claims. The higher the debt ratio, the greater the health plans financial leverage. The debt ratio is a balance sheet ratio that is found by dividing a health plans total liabilities by its total assets. Lifelongs debt ratio is:

A debt ratio of about 85% is considered average for a health plan, so Lifelongs debt ratio is well below the industry average. For most non-health plans, the debt-to-equity ratio measures the relationship between the amount of assets provided by the health plans creditors and the amount of assets provided by its stockholders. For a stock health plan, the debt-to-equity ratio measures the relationship between the amount of liabilities to plan sponsors, providers, and creditors and the amount of equity provided by the health plans stockholders. The higher a health plans debt-to-equity ratio, the more the health plans relies on borrowed funds to cover future and current benefit payments, to pay for ongoing business operations, and to finance growth. The debt-to-equity ratio is calculated as total liabilities divided by stockholders' equity. Lifelongs debt-toequity ratio is: The healthcare industry average for this ratio is about 0.83, so Lifelong has a significantly higher debt-to-equity ratio than does its peers. Health plans usually have high debt-to-equity ratios because of pending claims payments. A health plans current liabilities typically represent a large portion of its liabilities, which in turn must be supported by the health plans 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 to its sales, total revenues, assets, stockholders' equity, capital, surplus (if applicable), or stock share price. Profitability ratios enable a health plans interested parties to
Determine if management has operated the health plan efficiently to cover its costs Calculate the return that compensates the health plans owners for the risk of their Measure the efficiency with which management has used the health plans assets and

investment

stockholders' equity to generate revenues For these reasons, both internal and external users of a health plans financial information pay close attention to the health plans profitability ratios. Relating a health plans net income to its revenues is one way to determine how efficiently health plan costs are managed. Common-size financial statements, described in previous lesson, are a handy tool for evaluating health plan profitability in relation to revenues. For example, a frequently cited profitability ratio that can be found in the common-size income statement is net profit margin, which is explained later. Comparing a health plans net income to its assets or stockholders' equity used in generating that income 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 following sections, we also describe several other measures of profitability: earnings per share, the price/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 much after-tax profit is generated by each dollar of total revenue. This ratio is found by dividing net income, sometimes called net gain from operations, by total revenues. Lifelongs net profit margin is:

The average net profit margin for a health plan is 2.8%. Lifelong's net profit margin is negative because Lifelong had a net loss in 1998. Lifelongs management will likely take steps to improve its operating efficiency in the next accounting period. Return on (Total) Assets The return on assets (ROA) ratio measures a health plans success in using its assets to earn a profit. This ratio indicates the productive use of business resources and is often used to rank companies within the same industry. A health plans ROA is a strong indicator of management's

efficiency and is one of the most widely used measures of a health plans overall success. Generally, the higher a health plans ROA, the better. There are several variations of the ROA ratio, such as return on total assets (ROTA) and return on invested assets (ROIA). Alternatively, a health plan may use the average of the current years total assets and the previous years total assets as the denominator to obtain the return on average total assets ratio. Many health plans also calculate the ratio using different assets to compare the efficiency of various asset categories. In addition, different health plans may employ different valuations of assets to make these calculations. For the purposes of our discussion, we calculate ROTA using the end-of-period value for assets on the health plans balance sheet. Using these criteria, Lifelongs ROTA is

The managed healthcare industry average for return on assets is 2.1%. In this case, Lifelong is lower 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, measures the rate of return on the book value of the stockholders' investment in the firm. Alternatively, a health plan could calculate its ROE by using the average stockholders equity for the current and previous years in the denominator. For the purposes of our discussion, we calculate ROE by dividing a health plans 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 plans stock to realize a return in the form of cash dividends and capital gains (capital appreciation). In this context, a capital gain is the amount by which the selling price of an asset exceeds its purchase price. A health plans net income forms the basis for stockholder dividend payments and any future increases in stock values that will provide for capital gains. Therefore, a health plans reported earnings per share on stock is one of the most important ratios to investors. Earnings per share (EPS) , also called earnings per share of common stock , is the amount of net income per share of a companys common stock. To calculate EPS, divide the amount of net income 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 income to determine the amount of income available to common stockholders. In our example, Lifelongs equity consists of retained earnings, but no common stock, so we will use another company to calculate EPS. If health plan A has a net income of $10 million, no preferred stock, and 6,000,000 shares of common stock outstanding, then health plan As EPS is

Because health plans generally do not issue preferred stock, the numerator of this ratio is the health plans net income. Earnings per share is the only ratio that all companies that have common stock must include in their financial statements. Not-for-profit health plans do not calculate EPS because they do not have common stock. This ratio appears on the income statement in a health plans annual report. Most health plans strive to increase EPS by 10% to 20% annually. health plans EPS can be affected by several factors, including extraordinary items. For this reason, these factors must be considered when calculating a health plans EPS or when comparing the EPS of several health plans. Recall from Assignment 10 that an extraordinary item, also called an extraordinary gain (loss), is an item that is unusual or infrequent, such as damage caused by fire at a health plans home office. A health plan that reports an extraordinary item on its income statement also reports two EPS figures. The first EPS is calculated using earnings before the extraordinary item, and the second is calculated using earnings after the extraordinary item. For example, assume that a health plan had earnings after interest and taxes of $1,560,000, a $600,000 (net) extraordinary gain, and 1,200,000 shares of common stock outstanding. Figure 12B-6 demonstrates the way to report the earnings per share before and after the extraordinary gain. By computing the EPS both ways, the company avoids artificially inflating its EPS, which would have overstated its normal incomeproducing ability.

Price/Earnings (P/E) Ratio An often-quoted relationship between a health plans earnings per share and the current market price of its stock is the price/earnings ratio. The price-earnings (P/E) ratio, also called the earnings multiple, represents the amount of money that investors are willing to pay for each dollar of a health plans earnings. Recall that health plan A's EPS was $1.67. If we assume that the market price of health plan As stock is $35 per share, then health plan As P/E ratio is

There is a wide range of interpretations of the P/E ratio. Generally, the higher the P/E ratio, the greater the investor confidence in a company. In our example, health plan As common stock price 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 As earnings. Investors use the P/E ratio as a guideline in evaluating whether to buy stock or acquire a company. Price/earnings ratios vary widely among companies and industries and are most meaningful when compared to selected industry groups or market averages so that comparisons of relative performance can be made. An average P/E ratio for a health plan is between 10 and 15. In our example, health plan As 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 form of cash dividends and (2) to realize appreciation in stock market values. One function of a stock health plans board of directors is to determine the portion of net income, if any, to pay out in dividends to stockholders. To make this decision, the board must balance stockholders' expectation of dividends with the health plans need for capital.

The dividend payout ratio represents the proportion of earnings (net income) paid out to stockholders in the form of cash dividends. This ratio, which is presented in percentage terms, is calculated by dividing dividends per share by earnings per share. Because the numerator and denominator are in per share terms, we can simplify the dividend payout ratio to dividends divided by earnings (net income). The dividend payout ratio is not applicable to stock health plans that do not pay dividends to their stockholders. Dividend Payout Ratio Suppose health plan A had net income of $10,000,000 and that health plan As board of directors decided to pay $2,729,511 in dividends to stockholders. Below is the general formula for the dividend payout ratio, followed by health plan As calculation of its dividend payment ratio. Generally, investors who seek growth in a company want the dividend payout ratio to remain small, because a low dividend payout ratio means that the company has retained most of its earnings to fund future growth. Investors who seek current income prefer the dividend payout ratio to be larger. The dividend payout ratio tends to be somewhat similar for many firms within a particular 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 and Health Insurance Companies (Atlanta: LOMA, 1997), 38, 40. 2. Susan Conant et al., Managing for Solvency and Profitability in Life and Health Insurance 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, financial leverage, and profitability (for health plans that must comply with state insurance regulations) 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 insurance requirements must file the Annual Statement in every state in which they conduct business. The financial statements contained in the Annual Statement include a balance sheet, an income statement, and a cash flow statement. However, the calculations for items listed in the financial statements contained in the Annual Statement follow statutory formulas, rather than traditional GAAP-based formulas. As a result, many traditional financial ratios cannot be applied directly to the statutory financial statements that appear in the Annual Statement. The result has been a modification of these traditional ratios for statutory purposes. In some cases, new ratios were created specifically for analysis of statutory health plan statements. These "statutory ratios" are commonly divided into four categories: liquidity ratios, capital and surplus ratios, financial leverage ratios, and profitability ratios. Liquidity Ratios Two primary liquidity ratios for statutory purposes are (1) the quick liquidity ratio and (2) the current liquidity ratio. Quick Liquidity Ratio The quick liquidity ratio compares a health plans liquid assets to the health plans contractual reserves. Liquid assets include a health plans cash and other readily marketable assets such as short-term investments. Recall from Fully Funded and Self-Funded Health Plans that reserves are estimates of money that a health plan or insurer sets aside to pay future business obligations. Contractual reserves typically include a health plans claims liabilities and IBNR claims liabilities. To calculate a health plans quick liquidity ratio, divide the health plans liquid assets by its contractual reserves:

The usual range for this ratio is between 10% and 20%. The quick liquidity ratio provides regulators with information about a health plans solvency.

Current Liquidity Ratio The current liquidity ratio compares all of a health plans total assets not invested in its affiliates to all the health plans total liabilities, not just its claim liabilities and IBNR claims liabilities. The current liquidity ratio is calculated as follows:

The average range for this ratio is 95% to 120%. A ratio lower than 95% is considered below the accepted norm. Capital and Surplus Ratios Health plans measure their financial strength using capital and surplus ratios, which are sometimes referred to as capital ratios for stock companies. Both capital and surplus are owners equity accounts on a health plans 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 accounting practices (SAP), surplus is the amount that remains when an insurer subtracts its liabilities and capital from its assets.1 Recall from Accounting and Financial Reporting that retained earnings is the cumulative amount of a companys earnings that has been kept (retained) in the company over time. In this context, Surplus on a SAP-prepared balance sheet is similar to Retained Earnings on a GAAP-prepared balance sheet. Not-for-profit health plans and certain insurers that do not issue stock do not have capital accounts. As a result, their owners equity accounts typically consist of Retained Earnings (GAAP) or Surplus (SAP).

The basic capital and surplus ratio for a health plan is calculated by dividing a health plans capital and surplus by its total liabilities, as follows:

Generally, the greater the value of this ratio, the stronger the health plans financial position. The average industry range is between 4% and 12%. A health plans capital and surplus position can weaken because of
Poor profitability Payment of excessive dividends relative to the health plans actual profit Excessive capital losses from investments

 Reserve valuation changes that increase the health plans reserves (Increases in a health

plans reserve valuation may result from changes in statutory requirements or from a decision by a health plans managers to increase its reserves, including IBNR claims liabilities.) One weakness of the basic capital and surplus ratio is that it is an unweighted ratio that fails to recognize the factors that can cause significant changes to a health plans capital position. To obtain a more accurate measure of a health plans solvency and financial strength, many internal and external financial analysts use a specified set of capital ratios. These capital ratios, which are called risk-based capital (RBC) requirements, are weight-adjusted to account for different levels and types of risk as well as different practices of determining the appropriate amount of claims liabilities that are unique to each health plan. The formula for determining a health plans RBC requirements considers five different kinds of risk: affiliate risk, asset risk, underwriting risk, credit risk, and business risk. We discussed RBC requirements in Risk Management in Health Plans. Independent rating agencies also apply various capital ratios to determine a health plans financial strength. Insight 12C-1 summarizes how one rating agency assigns a value to the financial security of health plans.

Financial Leverage Ratios As noted earlier, financial leverage ratios compare a health plans obligations to its ability to meet those obligations. In the context of healthcare benefits, such obligations can be measured in terms of claims liabilities or in terms of claims liabilities in combination with other miscellaneous liabilities. Financial leverage ratios typically relate a health plans liabilities to its capital. A key financial 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 plans contractual 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 liabilities to total equity. A low result for this ratio is more desirable than a high result, within a normal range. However, there is no absolute standard for determining what is too low and what is too high 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 health plans profitability. Some of these ratios evaluate a health plans 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 sections discuss 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 the growth of a health plans capital and surplus. The gross profit ratio compares a health plans gross gain from operations before interest expenses and taxes with its beginning capital and surplus for a specified accounting period. To calculate the gross profit ratio, a health plan divides its gross gain from operations by its beginning capital and surplus amount for a specified accounting period, as follows: Return on Capital Ratio To determine a health plans overall success in generating returns to stockholders, an analyst calculates the health plans return on capital ratio. The return on capital ratio is similar to the GAAP-based return on equity (ROE) ratio. Whereas ROE is stated as the ratio of net income to stockholders' equity, the return on capital ratio is the ratio of net gain from operations to beginning capital and surplus. A health plan calculates the return on capital ratio by dividing its net 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 at the beginning of the specified accounting period. The result of the return on capital ratio indicates how efficiently management is using a health plans capital and surplus to earn a return for the health plans 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 plans net gain from operations to its average invested assets. The statutory ROA ratio shows the efficiency of a health plans managers in using the health plans investments to earn a return for stockholders. This ratio is similar to the GAAP-based ROTA, which is the ratio of a health plans net income to its total assets. However, statutory ROA considers only gains from an health plans normal business operations, like premium income and investment income, rather than net income, and only the health plans average invested assets, rather than its total assets, as follows: To determine a health plans average invested assets, the health plan adds its beginning-of-year invested assets balance to the end-of-year balance from the same accounting period and divides the sum by two. Investment Yield Ratio The investment yield ratio, also called the net yield ratio, measures how effectively a health plan can earn adequate or higher returns on the health plans investment portfolio. The calculation for this ratio is a version of the traditional ROA ratio, as follows:

Note that the investment yield ratio uses a health plans investment income in the numerator and invested assets in the denominator, rather than net income divided by total assets, as does the basic ROTA ratio. The investment yield ratio is an important indicator of a health plans potential returns. Health plans prefer an investment yield that is neither too high nor too low, although a definition of these extremes varies among health plans. How well a health plan manages the cash it receives from plan sponsors is critical to the health plans solvency and profitability. An unusually high investment yield could indicate excessively risky investments, while a very low yield probably indicates inadequate returns. Net Gain to Total Income Ratio Another performance indicator of interest to regulators is the net gain to total income ratio. The net gain to total income ratio is calculated by dividing a health plans net gain from operations by 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 any dividends to stockholders and federal income taxes. This ratio also highlights the share of the health plans income that is not used to cover expenses. A result of less than zero for this ratio usually indicates that a health plan has experienced a net loss from operations. The usual industry range is 1.5% to 6.0%. Figure 12C-1 summarizes the GAAP-based financial statement ratios with the ratios used to analyze SAP-prepared statements. Additional Financial Analysis Besides the financial ratios discussed above, health plans track other ratios and financial data relating specifically to health business written. Among the most important ratios for health plans are 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 expense ratio, the cash and investments to premium income ratio, the cash to claims payable ratio, and the equity to premium income ratio. Medical Loss Ratio The medical loss ratio (MLR) , also called the loss ratio, is the percentage of a health plans incurred claims to its earned premiums. For the purposes of calculating the MLR, incurred claims include those that have been paid as well as those that have not yet been reported. A health plans earned premiums consist of both collected and uncollected premiums. The MLR is a measurement of a health plans overall claims levels. Monitoring the MLR is critical to a health plan. Health plans use the MLR to determine if their healthcare benefits are in line with the premiums charged. Because the denominator of the MLR is earned premiums, MLR automatically adjusts for growth in a health plans business. The industry average for the MLR is 83%. To calculate the MLR, divide a health plans incurred claims by its earned premiums. Assume that health plan Q had $82 million in incurred claims and $100 million in earned premiums. The calculation of health plan Qs MLR is as follows:

There are several variations of the MLR. One variation is the paid loss ratio, which is based on paid claims rather than incurred claims. Keep in mind that a health plans MLR should be based not only on the health plans paid claims, but also on the best estimate of its IBNR claims for the accounting period being evaluated. Calculating the paid loss ratio is easier because the data for paid claims are readily available and do not have to be estimated. However, using the paid loss ratio instead of the MLR can result in an inaccurate assessment of the magnitude and trend of a health plan over time. Also, paid loss ratios can be unusually low for new or rapidly growing blocks of business. It is therefore difficult to determine with certainty the profitable and unprofitable blocks of business using only paid loss ratios. Another variation of the MLR is the tolerable loss ratio (TLR), also called the acceptable loss ratio. The TLR indicates the ratio of losses that a health plan can tolerate without losing money on a particular block of business. If a health plans medical loss ratio exceeds its tolerable loss ratio, then profits may disappear. In addition, health plans that must comply with state insurance regulations are required under certain circumstances to calculate the lifetime loss ratio, which measures the ratio of losses for the entire lifetime of each product. Circumstances under which a health plan must calculate the lifetime loss ratio occur when a health plan applies for a premium rate increase on an existing product. State regulations stipulate the minimum percentage requirement for a health plans lifetime loss ratio. Expense Ratio The second component of the combined ratio is the expense ratio. The expense ratio measures the percentage of health plan expenses, other than medical expenses, paid for each dollar of the health plans premium income. Suppose Green HMO has health plan expenses of $15 million and earned premiums of $100 million. In our example, Green HMOs 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 plans expense ratio may be somewhat misleading if the health plan has a new or growing block of business, because expenses are generally higher in the first year of a sale. A health plans expense ratio can also be misleading if the health plan has a lot of administrative services only (ASO) business, small group business, or individual business. It is therefore necessary to track the expense ratio over a number of years if the 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 to pay both its claims obligations and its operating expenses. The combined ratio, which is a profitability 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 for health plan Q), and its expense ratio (0.15 for health plan Q), as follows:

If a health plans combined ratio is less than 100%, then the health plans premium income contains a margin for profit or for managing adverse conditions. In our example, health plan Q has a 3% potential profit margin. To the extent that a health plans combined ratio exceeds 100%, the health plan must rely on investment income to avoid losses. In such cases, investment income is 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 solely on funds in its surplus account. To answer this question, a health plan calculates its months of surplus. A health plans months of surplus is calculated by dividing the health plans end-ofperiod surplus by the average underwriting deduction. The average underwriting deduction is the sum of claims incurred and operating expenses incurred divided by the number of months. The formula for calculating a health plans months of surplus is

The more months of surplus that a health plan has, the lower the risk that the health plan cannot meet the obligations that it has incurred. The average months of surplus for a health plan is 2.3 months. When a health plan establishes a claims reserve, it does so under the assumption that there are enough assets available to match claims liabilities. If applicable, statutory requirements may also mandate the amount of a health plans claims reserve. The months of claims reserve is obtained by dividing the sum of a health plans adjusted, unpaid claims liabilities by its average claims expense. A health plan adjusts its unpaid claims liabilities to reflect changes in its business and in inflation. The average claims expense is the sum of claims and the adjustment for claims expenses incurred, divided by the number of months in the period being evaluated. The formula to calculate a health plans months of claims reserve is as follows:

The more months of claims reserve that a health plan has, the stronger its financial position. The industry average for the months of claims reserve is 1.67 months.

IBNR Claims Ratio Knowing the ratio of a health plans IBNR claims to total claims is useful in estimating future claims obligations. The IBNR claims ratio is obtained by dividing the estimate of IBNR claims by total claims liabilities:

Selling, General, and Administrative Expense Ratios Earlier we discussed the expense ratio with respect to a health plans combined ratio. To control operating expenses, a health plans managers often find it useful to break down the expense ratio into its components according to selling expenses, general expenses, and administrative expenses. In this way, a health plan can identify what percent of the overall expense ratio comprises selling expenses, general expenses, and administrative expenses. To isolate a particular type of expense, a health plan divides that expense by the health plans earned premiums Cash and Investments to Premium Income Ratio A health plan is also interested in the relationship between the amount of cash and investments it has and its premium income, in part because the health plan needs to manage its cash inflows and cash outflows carefully. Premium income results in a cash inflow for a health plan and investment purchases result in a cash outflow for the health plan. Remember that premium income consists of earned premiums, which include both collected premiums and uncollected premiums. The investments in this case are primarily marketable securities that can be readily sold if necessary. Suppose health plan Q has $42 million in cash, $500 million in investments, and $700 million in premium income. The formula for the cash and investments to premium income ratio, and health plan Qs ratio calculation, is: The amount of health plan Qs cash and investments is about 77% of the amount of health plan Qs premium income. This information indicates that health plan Q has the equivalent of 77% of its premium income in current assetsthat is cash and readily marketable investments. The industry average for 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, which indicates the relationship between a health plans cash and its claims payable. Assume that health plan Q has $42 million in cash and $192 million in claims payable. The formula for this ratio, along with health plan Qs ratio calculation, is as follows:

A health plans 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 the health plans 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 becomes part of the health plans retained earnings or surplus, which ultimately increases the health plans equity. The equity to premium income ratio is obtained by dividing a health plans equity by its premium income. Suppose health plan Q has $250 million in owners equity and $700 million in premium income. This ratio, and health plan Qs calculation, is This information indicates that the amount of health plan Qs equity is approximately 36% of the amount of its premium income. The industry average is 30%.

Endnotes 1. Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life and Health Insurance Companies (Atlanta: LOMA, 1997), 41.

AHM Health Plan Finance and Risk Management: Management Accounting Course Goals and Objectives After 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 distinct characteristics, they are interrelated and often difficult to distinguish in practice. Implicit within the four management functions is decision making, in which a companys management selects a course of action. To make effective decisions about a company, a manager needs financial information. For example, a health plan manager might need to know how much money the health plan paid in provider 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 making decisions. With the information provided through management accounting, a health plans managers 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 of the most important purposes of management accounting. Feedback allows managers to locate the sources of its financially successful and unsuccessful operations and to analyze why certain areas of the company perform well while others do not. Management accounting information is most useful 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 plan include the study of costs, budgeting for short-term and long-term expenditures, and evaluating potential acquisitions or divestitures. Generally, we can divide a company's planning activities into two major segments: strategic planning and tactical planning. Recall from The Strategic Planning Process in health plans that strategic planning is the process of identifying an organizations long-term objectives and the broad, overall courses of action that the company will take to achieve those objectives. Strategic planning 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 the strategic plan. Planning Tactical planning, also called operational planning , is the process of determining how to accomplish specific tasks with available resources. Tactical planning is primarily concerned with the short-term, day-to-day activities of a company. In tactical planning, each functional area within the health plan develops specific plans based on the health plans overall strategic goals and business objectives. Figure 13A-1 (save in AHM 520 as z13a-1) lists some areas that are often 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 plans cash flow planning (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 Process lesson. Organizing During the organizing function, a health plans management takes explicit actions to ensure that the necessary resources are available to achieve the health plans strategic plan. Suppose a health plans management has projected what it will cost the health plan to enter a new market with its HMO product. In this case, management can use the cost projection to decide which employees and how many employees will be involved, and the role that each employee will take if the health plan enters a new market. Controlling The control function of management involves ensuring that a companys performance results in the achievement of the companys strategic plan. Management control activities involve the (1) establishment of standards of performance, (2) measurement and evaluation of actual performance against the standards, (3) detection of deviations from the standards, and (4) the determination of appropriate action to correct deviations. The most complete managerial control would consist of close physical supervision of each employee. However, this type of control is not usually practical or desirable. Therefore, managers rely on the concept of management by exception, which states that managers should focus on operational results or activities that differ from expected norms by a certain amount or percentage. Such information comes from management accounting reports that indicate deviations or exceptions. A manager can then investigate these exceptions to learn the causes behind them. For example, one management accounting report could show the projected costs and actual costs for a health plans claims department. Instances where the actual costs differ from the projected costs are known as variances. One way to gauge the performance of the health plans claims department is to examine these variances. A report of variances is an example of feedback that informs management how well the organization is achieving its plan. We discuss variance analysis later in this lesson.

Decision Making To make sound decisions, a manager needs financial information that is relevant, reliable, and comparable across accounting periods and departments. Management accounting provides this information, as well as analytical techniques that help managers understand the implications of a decision. Suppose a health plan decides to launch a new product. In this case, management accounting analysis can indicate the number of members that must be enrolled, at a specified PMPM rate, to generate enough premium income to achieve the health plans strategic plan. Management accounting analysis can also indicate the cost savings and useful life required of a new piece of equipment for a health plan to recover the cost of the equipment. Although the information provided by management accounting does not itself solve the problems that a health plan faces, the use of management accounting reports enables the health plans managers to weigh the consequences of various actions so that the managers can make well-informed decisions. Responsibility Accounting Responsibility accounting is a form of management accounting that is used primarily to prepare and monitor a companys budgets and to analyze the companys performance. Responsibility accounting , sometimes called profitability accounting, is a people-oriented system of policies and procedures that assigns revenues and costs to individual employees or to the organizational units that are accountable for these revenues and costs. Responsibility accounting focuses on the status of a companys internal operations and on specific areas of managerial responsibility. In responsibility accounting, the person who has the most influence over an areathe manager of a department, function, activity, or productis held accountable for the operations and financial outcomes of that area. This means that only those items, such as investments, revenues, and costs that can be directly attributable to a particular area are the responsibility of that areas manager. A direct cost, also known as a traceable cost, is a cost incurred for or traceable to one specific product, line of business, or department or function. A cost that is not incurred for or cannot be traced to one specific product, line of business, or department or function is called an indirect cost, also called a common cost or a shared cost. For example, the salary of the manager of a health plans accounting function is a direct cost of that function. However, the salary of the health plans 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 the company's business, the area or unit is commonly known as a responsibility center. A responsibility center defines the sphere of its manager's responsibility. In other words, only those items, such as investments, revenues, and costs, that can be directly attributable to a responsibility center 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 are divided into three types: cost centers, profit centers, and investment centers, which are listed in Figure 13A-2.

One way we can differentiate these centers is based on the extent of overall operational control accorded 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 an investment center is blurred. Therefore, some companies use the term profit center to refer to both investment centers and profit centers. In this course, we maintain the distinction between the two.

The manager of a responsibility center, called a responsibility manager, is evaluated according to the responsibility center's performance. The responsibility manager should have (1) objectives that are consistent with the company's objectives, (2) a clear understanding of the responsibility center's objectives, and (3) the necessary authority to establish formal reporting and budgeting control over the resources required to meet those objectives. By assigning responsibility to specific individuals, a health plans senior management has a tool for controlling revenues and costs and an objective means of evaluating its managers and supervisors. The basic tenet of responsibility accounting is that responsibility managers should be held 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 the next section. Then we describe methods of measuring and evaluating the performance of

responsibility centers and responsibility managers. Last, we discuss various factors that can impact performance evaluation. Goal Congruence Successful health plans are those that create an operational condition called goal congruence, in which the goals of a company and the goals of its managers are mutually supportive. When the business 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. The managers 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; in other words, the goals are not mutually achievable. Suppose a health plans strategic plan includes a goal of rapid growth in market share, even at the expense of short-term profitability. At the same time, the health plans underwriting department manager decides to establish more conservative (that is, more stringent) underwriting guidelines. In this case, the more conservative the health plans underwriting guidelines, the less likely that the health plan will achieve its strategic 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 as management by objectives (MBO). A typical goal for a responsibility manager is to meet a budget. Management by objectives also includes the establishment and achievement of nonfinancial goals, such as improved customer service or more favorable responses on an opinion survey of the responsibility center's employees. In successful MBO programs, senior management and responsibility managers collaborate on developing 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 are less likely to be attained. Note, however, that in recent years, health plans have devoted a significant amount of their resources to attaining quality standards established by external organizations. When the objectives of responsibility center managers conflict, goal incongruence may result. A health plans senior management would typically review such conflicts and resolve them. Suppose a health plans product development manager establishes a goal to reach a certain level of new product sales. The health plans actuarial department manager may argue that the new product objective conflicts with the health plan's profit objectives because of the high first-year expenses that a new product typically incurs. In this case, the health plans senior management would 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 to establish and achieve the appropriate objectives. Efficiency (doing things right) is the extent to which a responsibility center is able to achieve objectives with a minimum of waste. 1 While effectiveness 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 support the company's goals. For example, a health plans investment department that executes investment transactions on time and at a low cost is efficient. But if the investments that the department makes result in a lower investment returns or significantly higher risks for the health plan, then the investments department has not met its goal of maximizing investment return and is therefore not effective. A companys responsibility accounting system should incorporate methods of simultaneously measuring both effectiveness and efficiency. The first step in implementing such a responsibility accounting 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 for and understand how their performance is judged. In theory, the characterization of success and failure is a two-step process: (1) measuring performance and (2) evaluating performance. Measuring performance involves quantifying the responsibility center's results. Evaluating performance involves assessing those results. Together, measuring and evaluating performance answer two questions: What did the responsibility manager achieve? and What do the achievements mean? Responsibility accounting requires the establishment of procedures for fairly and accurately measuring 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 responsibility center. 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 companys expected (projected, forecasted) results as a benchmark against which the companys 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 the corresponding variance for each item. Variance analysis is helpful for monitoring and evaluating performance because variances quantify the unexpected results under the control of a responsibility manager. The concept of management by exception, which we introduced earlier in this lesson, encompasses variance analysis. Budgets are often used to pinpoint variances. A budget is a financial plan of action, expressed in monetary terms, that covers a specified time period, such as one year. 2 Typical budgets that lend themselves 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 budgeted amounts and actual amounts are rarely equal. For example, if an amount budgeted for an expense item is $10,000, and the actual result for this item is $12,000, the budget variance is $2,000. We discuss budgets in The Budgeting Process.

Variance analysis normally studies budgeted and actual results, but managers can also use it to compare other data. Managers can analyze variances between numbers from different areas or reporting periods by comparing a responsibility center's operating results from a current accounting period with those from a prior period. Another version of variance analysis compares actual costs with standard costs. Standard costs are predetermined costs that a company expects to incur during normal business operations. Generally, positive variancesvariances in which actual amounts exceed expected amountsare unfavorable for expenses, because the responsibility center incurred more expenses than it had anticipated. In contrast, positive variances are considered favorable for revenues because the responsibility center earned more revenues than it had anticipated. Similarly, negative variances, in which actual amounts are less than expected amounts, are usually considered favorable for expense items and unfavorable for revenue items. An effective variance system focuses on matters that require management's attention. Variance analysis allows a manager to isolate the problem areas, but it does not suggest solutions to problems. Most companies conduct monthly or quarterly reviews of their operating expenses and compare actual expenses to budgeted expenses. Large variances are a matter of concern, or at least interest, to a health plans senior management because they can lead to revised budgets or changes in the health plans operations. An important aspect of responsibility accounting is that managers should be able to explain budget variances that are under their control. We can categorize variances as either price variances or volume variances. The sum of the two equals the total variance. The price variance, also known as the rate variance or cost-related variance , is the difference between a product's actual rate (or unit cost or price) and its budgeted rate, multiplied by the number of units sold or processed. The volume variance, also known as the usage variance or the volume-related variance, is the difference between the budgeted quantities to be sold or processed and the actual quantities sold or processed, multiplied by the budgeted amount. Figure 13A-3 highlights health plan As price variance and volume variance with respect to health plan As expected PMPM rates. This variance analysis indicates that the health plan A experienced lower membership than expected, which, in turn led to lower-than-expected revenues. The result is both an unfavorable price variance ($916,700) and an unfavorable volume variance ($83,500), which lead to an unfavorable total variance of $1,000,200. A responsibility center report often contains segmented information about a high organizational level responsibility center and the lower-level centers contained within it. The performance reports 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 following sections.

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 monitor profit centers is to prepare a document that functions as an internal income statement. Preparing statements of this type is sometimes referred to as segment reporting. A segment report for a cost center details the direct coststhose costs that are directly under the control of the cost centers responsibility manager. A segment report for a profit center includes the information contained in a cost center report, but it also includes revenues. Further, a segment report 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. One example of fixed costs are lease payments for a health plans office space because these payments stay the same regardless of the health plans volume of business or support activity. Variable costs 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 plan processes, 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 fixed costs incurred by each segment. After all variable costs have been assigned to the proper segments, we can calculate a contribution margin. The contribution margin for a product is the difference between its selling price and its variable costs. Similarly, the contribution margin for a segment is the difference between total revenues and total variable costs. We discuss the contribution margin in the context of cost-volume-profit analysis in the next lesson. Fixed costs are categorized as either direct costs or indirect costs to allow for the calculation of a segment margin for each segment of the company. A segment margin is the portion of the contribution margin that remains after a segment has covered its direct fixed costs. The segment margin 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, which is an indicator of a segment's profitability. A segment margin incorporates only those costs and revenues attributable to the segment. If the segment cannot cover its own costs, it is not profitable and should be investigated. Segment margins and contribution margins are also useful for performance evaluation when put in ratio form. The segment margin ratio is the segment margin divided by the segment's total revenues:

The segment margin ratio measures a segment's efficiency of operating performance. The contribution 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 use of assets employed to earn a profit. The simplest measure of an investment center's performance is the amount of net income listed on the investment center's income statement. Traditional thinking indicates that the best-run segment of the company is the one with the highest net income, but this is not necessarily true. Recall that a companys net income includes the effects of income taxes. Therefore, the use of net income violates the maxim of responsibility accounting, because taxes are beyond the control of an investment center manager. Also, a small, well-managed investment center may have lower net income than a large, poorly managed investment center. For these reasons, we should not compare two responsibility centers only by net income because such a comparison does not adequately interpret their respective performances. Comparing investment 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 entire company. To measure the performance of an investment center, many companies use return on investment (ROI) , which is the ratio of operating income to controllable investment. The ROI ratio is calculated as follows:

Operating income , which can also be called net gain from operations before taxes, is income before subtracting income taxes. Controllable investment includes all balance sheet items controlled by the manager of the investment center. Controllable investment is found by subtracting controllable liabilities from controllable assets. Sometimes health plans substitute controllable surplus for controllable investment in the denominator of the ROI ratio. All other factors 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 overcomes the problem of comparing investment centers of different sizes. Like the segment margin ratio and the contribution margin ratio, ROI presents a result in percentage terms rather than in absolute terms. This is not to suggest that absolutes are unimportant. Absolute size is still a consideration 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 investment center. Calculating ROI for each investment center helps level the playing field. Suppose Health Plan Q has two investment centers: Investment Center A and Investment Center B. Assume that Investment Center A earns $10,000,000 in operating income on controllable investments of $60,000,000. Investment Center As 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 on controllable investments. The ROI for Investment Center B is 25% ($1,000,000 ? $4,000,000). In absolute terms, Investment Center B's operating income is only one-tenth that of Investment Center A ($1,000,000 versus $10,000,000), yet Investment Center B achieves a much higher return on its available resources (25% versus 16.7%). Besides being valuable as an evaluation tool, ROI can assist company executives in searching for ways to improve an investment center's performance. Such assistance arises when the ROI formula is broken down into a return on revenue component and an investment turnover component. Return on revenue measures management's ability to control operating income in relation to total revenues, which includes premium income and investment income. Return on revenue 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 by the responsibility manager. We calculate investment turnover by dividing total revenues by controllable 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 investment centers ROI. Figure 13A-4, which helps to clarify ROI, presents data for the East and West regions of a health plan. Each region is considered to be an investment center. Total revenues for the West region are nearly twice those of the East region, yet West's ROI is much lower than East's. Why? Notice that East earned a much better return on revenue than West. East also had a significantly higher investment turnover. These two factors led to a much more impressive ROI which, all other factors being equal, could earn East's manager a better performance evaluation than West's manager.

How can the West region attain an ROI similar to that of the East region? As stated earlier, an increase in total revenues alone is not the answer. Generally, ROI increases in one or more of the following ways: (1) by reducing expenses to increase operating income, (2) by reducing controllable investment, or (3) by increasing total revenues, accompanied by a proportionate increase 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. In Column 1, we reduce the West regions administrative expenses from $3,900,000 to $3,140,000. This reduction in expenses increases operating income, which increases return on revenue and ultimately increases ROI to the target 23.5%.

In Column 2, we retain the current levels of total revenue and operating income and reduce the investment from $8,850,000 to $5,620,000 to generate an ROI of 23.5%. And in Column 3, an increase in total revenue from $10,395,000 to $11,155,000, along with a corresponding increase in operating income, increases ROI to 23.5%. Notice that the increase in operating income (the differences between Column 0 and Columns 1 and 3) required to raise ROI to 23.5% is only $760,000. But the decrease in controllable investment (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 be much easier for the West region to improve its ROI by either decreasing expenses or increasing revenues (and operating income) by a relatively small amount than it would be to operate at the current level using far fewer invested assets. In fact, a current trend in all industries is to cut expenses to improve operating results. Some health plans require that their investment centers earn a specified ROI. Incentive programs often encourage responsibility managers to strive for higher returns on investment. Managers of these 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. Residual income (RI) is the amount of income an investment center earns above a certain minimum required rate of return on investment. The minimum required rate of return reflects the company's cost of capital, which we discussed in The Strategic Planning Process in health plans.

To earn a positive ROI and to foster growth, companies establish a required rate of return that is higher than their cost of capital. Residual income is found by subtracting the product of (1) an investment center's minimum required rate of return and (2) its controllable investment from the center's operating income. The minimum required rate of return times controllable investment is sometimes called the capital charge. The entire residual income calculation is as follows: 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 residual income as follows:

The $150,000 in residual income represents the amount of income that the investment center manager is able to earn in excess of the companys minimum required rate of return. When using residual income to compare two or more investment centers, the investment center with the largest 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 measurement system for its investment centers. Performance measurement systems can affect the behavior of managers 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 on investment, but residual income encourages managers to accept investment opportunities that have rates of return greater than the cost of capital. One drawback of ROI is that managers being evaluated by ROI may be reluctant to accept new investments that might lower their center's current ROI, even though the investment would be in the best interest of the entire company. This practice defies goal congruence. Figure 13A-6 reveals these behavioral characteristics of ROI and RI. Assume that health plan Q requires its investment centers to achieve an ROI of 20%. The actual results of one investment center, 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 the investment center's manager has met health plan Qs 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 this investment is 15%. (Note that the minimum required return will be different for different projects to reflect the level of risk presented by each project.) It is in health plan Qs best interest for the manager to invest in this project because the project's return exceeds the health plans minimum required rate of return and the project will generate an additional $85,000 of operating income per year.

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 ROI from 20.3% to 19.9%, as is exhibited in the middle section of Figure 13A-6. This goal incongruence is induced by the use of ROI. What if the investment center is evaluated by residual income? The bottom portion of Figure 13A-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 increase residual income from $160,000 to $170,000. This additional residual income will not only improve 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 larger investment centers. A disadvantage of both ROI and RI is that, if emphasized too greatly, they can 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 is possible that a manager may forgo some important expenditures for the sake of a higher ROI or residual income. For example, a health plans member services division may need additional staff, but the division manager might not receive approval to hire the necessary employees because the extra salary expense would decrease the division's ROI or RI. However, overworked employees could make mistakes and cause delays in service, dissatisfying members and resulting in a high lapse rate at renewal. In the long run, this would be more costly to the health plan than hiring additional employees in the first place. Figure 13A-7 summarizes the main advantages and disadvantages of ROI and RI.

Issues Associated with Performance Evaluation In the previous section, we examined the ways in which a companys senior management measures and monitors the performance of its various responsibility centers. In practice, however, achieving an accurate summary of performance is rarely so straightforward as preparing one report or calculating a simple ratio. As we discussed earlier, a premise of responsibility accounting is that responsibility managers should be accountable for only the costs that they directly control. But few costs are clearly the responsibility of only one individual. Most costs have varying degrees of controllability. The purpose of responsibility management is to identify the individual most directly responsible for incurring each cost.

Several related issues must also be considered before giving a final grade to a responsibility center or its manager. Some of these issues are problems inherent in the evaluation process. Other issues may affect a responsibility centers performance, and, if not considered, may lead to an inaccurate appraisal of the center. In the following sections, we discuss potential problems surrounding performance evaluation criteria. The underlying motive behind responsibility accounting is measuring and evaluating the performance of responsibility centers and responsibility managers. These evaluations guide a health plans senior management in allocating future resources to each business segment, making decisions about segments, and compensating and promoting responsibility managers. But the evaluation criteria can be as important to the final evaluation as the actual performance that is being evaluated. Potential problem areas include (1) relying too heavily on variance analysis, (2) using only one evaluation criterion, (3) using inappropriate evaluation criteria, (4) setting unattainable goals, and (5) judging a responsibility managers performance solely on the basis of the responsibility centers 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, seemingly favorable variances should also receive close scrutiny to determine whether they are indeed favorable to the company. For example, a responsibility center may have been budgeted $38,000 for a given activity but spent only $29,000. On the surface, this variance appears to be favorable. Upon reviewing the figures, however, management attempts to determine the reason for the seemingly superior performance. The favorable variance may have resulted from overly pessimistic (or padded) projections, indicating that what at first appeared to be performance that exceeded expectations was actually an indication of the responsibility managers poor judgment in making budget estimates. Favorable variances can also occur as a result of overzealous or shortsighted actions that include lowering quality standards, disregarding training, or altering operating procedures to reduce expenses in ways that diminish a products or services quality or competitiveness. For example, a dramatic increase in new business that might appear to be a favorable budgetary variance could actually be the result of using more relaxed underwriting standards. Ultimately, the health plan could experience extensive losses from that new business. Variance analysis can also mislead when evaluators consider budget variances that are beyond the control of a responsibility manager. Such uncontrollability often arises when one variance causes a second variance. In the following example, an unfavorable variance (a significant increase in the volume of phone calls) in one area causes another unfavorable variance (a significant increase in departmental salary costs). Suppose a health plans budget for its member services department forecasts call volume similar to that of the previous year. However, this year, the health plans marketing department introduces a new product that generates a significant increase in phone calls to the member services department, which in turn has to hire several new employees to answer phones.

In this scenario, the member services department experiences an unfavorable varianceeven if the cost per phone call has actually decreasedbecause of the increase in wages paid to new employees 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 services department or its manager. Use of a Single Evaluation Criterion Another evaluation problem occurs when evaluators reduce a responsibility managers performance evaluation to a single, all-encompassing measure. This practice usually emphasizes only one goal and ignores all others. For example, if the member services manager in the preceding example were evaluated almost exclusively on budget variances, then this manager would 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 the health plans new product. To avoid this problem, responsibility managers are typically evaluated on a number of criteria. For example, the member services manager might also be evaluated on average call hold-times, call abandonment rates, and plan member survey results on the quality of member services for the new product. Use of Inappropriate Criteria A related evaluation criteria problem is using performance measures that fail to reflect a health plans objectives or its employees responsibilities. Again, emphasizing profits in the short run without consideration of long-term consequences can negatively affect a companys financial performance. Nonetheless, some companies base management evaluations only on short-term results, such as a quarterly target ROI. Therefore, managers can be tempted to forsake long-term goals and overuse resources to maximize short-term returns if it is the only way to earn a satisfactory performance evaluation. Such companies may find themselves with insufficient resources in the future. Unattainable Goals Evaluation problems can arise when performance standards are not attainable by responsibility managers. For example, a responsibility manager may be evaluated unfavorably for failing to achieve goals that are unrealistic. Evaluators can avoid this problem by becoming aware of how the budgets and other standards are determined and to what extent controllability is considered in the comparison of budgeted to actual amounts. A company can reduce the problem of unattainable 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. A manager 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 a declining market.

Conversely, a business segment in a growing market may be thriving through no special accomplishment of the manager. In either case, senior management determines whether the performance of the manager has affected the performance of the segment, or whether the results are a function of the segments environment. Transfer Pricing Evaluating the performance of a companys profit centers and investment centers can be difficult when transfer pricing is involved. A transfer price is the price of a good or service that one segment of a company charges another segment of the same company. Unlike intercompany transactions in which prices are determined by supply and demand factors, transfer pricing arrangements are established by a companys management. Transfer pricing is especially important 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 is critical because transfer prices directly influence the profits for which managers of profit or investment centers are held responsible. An inappropriate transfer price might provide a misleading picture of a responsibility centers true performance, and, even worse, might motivate the 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, and negotiated 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, provider reimbursement, products, and advertising carries a cost. Before a health plan can determine what products it can offer, how many plan members it can serve, and what it can charge for its products and 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 a given level of healthcare benefits by examining the costs it incurs in developing, distributing, and administering those benefits now and in the future. Generally, the selling price of a companys product must be at least high enough to cover all of the product's costs and provide a profit for the company. The gathering and interpretation of cost information is therefore critical for determining 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 the costs incurred by a company. Cost accounting enables a health plans managers to plan operations, organize employee work loads, develop provider networks, and evaluate current financial 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 cost accounting system may vary among individual health plans, and, sometimes, even between different divisions of the same health plan. Whether a health plan prepares its financial statements for management reporting purposes or to comply with regulatory requirements, the health plan can design its cost accounting system to provide cost information in a variety of different formats or to allocate expenses to a specified division, segment, product, or plan sponsor. Figure 13B-1 lists some of the uses of cost accounting for health plans.

One essential element of an effective cost accounting system is accurate and complete accounting data. Before a health plan can develop an effective cost accounting system, it must already have in place an accounting system that produces reliable financial data at the appropriate level of detail. The information provided by cost accounting is only as reliable as the historical and current 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 plans product line include its HMO, PPO, and POS products. A health plans 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 the cost information, the greater a health plans overall effectiveness in analyzing costs. The rest of this 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 course of conducting business. The process of classifying a health plans costs produces useful information for the health plans managers to make objective decisions based on cost. Costs can be classified by description, behavior, and measurement. Note that many costs fit into more than one classification. Where appropriate, we identify the classification of a cost in more than one category. Costs Classified by Description The most basic way to classify costs is by their descriptive characteristics. Because many cost classifications have an opposing classificationfor example, direct costs and indirect costs costs classified by description may be thought of in pairs. Figure 13B-2 summarizes the most common classifications for pairing costs by description.

In the context of cost accounting, a cost object is any purpose for which a company measures its costs. One way to determine whether a cost is a direct cost of a particular cost object is to decide if the cost would disappear if the cost object disappeared. For example, the salary (cost) of a health plans marketing manager for its managed dental product (cost object) is a direct cost of the managed dental product because the salary cost disappears if the health plan no longer markets that product. To establish and evaluate distinct responsibility centers, a company must be able to distinguish controllable 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, depreciation on a health plans home office facility is an indirect cost, so this same responsibility manager should not be held accountable for it. Differential costs and sunk costs usually are a direct result of management decisions. Suppose a health plan plans to design and implement a new automated system to track provider reimbursement and utilization of healthcare services. To complete this project, the health plan must add new computer equipment and software to existing equipment and it must hire consultants to design the system's software and train the health plans employees. In this case, all costs that are incurred as a result of deciding to proceed with this project are both direct costs and differential costs. All costs that are already committed costs, but that were not originally committed to this project, are direct costs and sunk costs. Thus, the costs of the new computer equipment and software and the costs of the consultants are differential costs. The costs associated with the health plans existing equipment will not change as a result of the decision to go 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 change as the amount of time needed to complete an activity changes. Other costs change as the volume of an activity changes. Many costs change with both time and volume, and some costs are not affected 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 segment reporting 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 especially helpful for management reports and for cost-volume-profit analysis, which we describe later in this lesson. Costs classified by measurement include unit costs, marginal costs, and opportunity costs, 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 costs include 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 plans managers in

Predicting future costs Evaluating the efficiency of personnel, operations, and equipment Setting premium and dividend rates Benchmarking the health plans operations with those of other health plans

Fixed costs and variable costs can be expressed in terms of unit costs. Normally, as production volume or the amount of activity increases, fixed unit costs decrease. As volume decreases, fixed unit costs increase. Suppose a health plan had 150,000 existing plan members in 2003 and 160,000 existing plan members in 2004. Assume that the health plans total fixed costs in each year were $2,500,000. In 2003, 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 that fixed unit costs decrease as volume increases. Unit costs are often used to express standard costs. Recall from the previous lesson that standard costs are predetermined costs that a health plan expects to incur for particular items during normal business operations. Many health plans establish a standard cost for each item against which they later compare the actual cost. For example, an important standard unit cost for PPOs is the unit cost of processing one claim. A PPO establishes a standard unit cost for processing one claim and then conducts variance analysis; in other words, the PPO compares that standard cost with the actual unit cost of processing the claim. We discussed variance analysis in Management Accounting. Marginal Costs Marginal cost information is essential for making production decisions because it helps managers to determine the monetary effect of a specific action, and, in certain cases, whether an action should or should not be taken. Once a certain sales volume has been reached, the decision whether to produce or sell additional units involves different cost considerations than the earlier decision to produce or sell the initial amount. Some of the costs involved in processing the initial amount 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 marginal cost of the 51st policy is $500 ($40,500 - $40,000). A similar marginal cost study could be performed on the costs of processing the 52nd and 53rd policy application, and so on. The health plans receipt of the 51st application would probably not cost as much as 1/50th of $40,000, because most of the health plans total expensessuch as advertising, office supplies, and office space rentare committed costs or sunk costs. Therefore, these expenses are unaffected by the processing of one additional application. In other words, the marginal cost of each additional unit is different from the unit cost of the initial amount produced. To help make production decisions, managers consider the marginal unit cost, which is the increase or decrease in the unit cost as a result of an additional unit of a good or service. As you may have guessed, marginal cost information is useful to managers when determining 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 groups tend to be less expensive to sell on a per member basis, in part because it is possible to spread the plans fixed costs over a larger number of plan members. In this case, the health plan would allocate proportionately more resources to individual or small group product sales than to large group sales. Opportunity Costs In making decisions about expenditures, a health plan must consider both its out-of-pocket costs and its opportunity costs. Suppose a health plan is considering the introduction of a new POS product. 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 reporting requirements. What are the health plans opportunity costs associated with this project? Instead of introducing the POS product, the health plan could use the $1 million to enhance its current information system. Alternatively, the health plan could use the $1 million to purchase assets to generate investment income. Efficiencies realized from an improved information system or from additional investment income may provide the health plan a return that equals or exceeds the return offered by the new POS product. Note that the health plan could also use the $1 million for a variety of other purposes. The difficulty with considering opportunity costs is that there is no definitive way to capture them in a health plans accounting system because there is no transaction involvedno exchange of money or value of service to record. A health plans managers should therefore analyze various business 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 would consider not only the out-of-pocket costs of undertaking this project, but also the opportunity costs 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 the marginal unit costs associated with other alternatives. Cost Perspective From the above discussion, we may conclude that there are many varieties of costs and that a single cost can be classified in several different ways. Cost classification depends on the point of view of the individual analyzing the cost and the point of view of the individual or department incurring 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 plans president and board of directors A committed cost that resulted from a prior management decision regarding the operation A sunk cost that has already been incurred and cannot be avoided

of the health plan

Similar multiple characterizations can be made for virtually every other cost incurred by a health plan. A function of management accounting is classifying costs in different ways to better analyze company operations. Useful cost classification also promotes proper cost accumulation and cost allocation, which we discuss in the following sections.

Cost Accumulation Ideally, a cost accounting system should provide each manager with sufficient information to make informed decisions about the operations for which he or she is accountable. But the information generated from the cost accounting system is only as useful as the information originally input. To be a valuable management tool, the cost accounting system should accumulate costs and allocate costs accurately and fairly. Cost accumulation is the process of capturing all of a companys costs and categorizing them in meaningful ways. Once the company accumulates the total amount of costs, it can allocate them to departments, products, and lines of business relative to management needs. Specifically, a health plans cost accounting system should ensure that each cost is charged to the area of the health 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 one of 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 the specified area of the health plan that incurs the expense. For example, all health plan costs relating to salaries can be accumulated in one "Salaries" classification instead of being associated with a particular department, function, product, or service. Accumulating costs by type enables health plans to satisfy financial reporting requirements for compiling financial statements and corporate tax returns. Also, accumulating costs by type assists a health plans 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 each cost 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 and administration of a particular line are charged to that line. A line of business (LOB) is a segment that differs from other segments with respect to sales approach or with respect to client or member service; in the context of cost accounting, a line of business is a segment of products that has a cost pattern distinct from that of other product segments. The product segments methods of sales and service usually determine its cost patterns. Examples of a health plans lines of business include individual, small group, large group, Medicare, and Medicaid. After entering a cost in the accounting system, such as under "Salaries," the health plan also 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 with individual 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 plans resources than the health plans other similar products. When it accumulates costs by line of business, the health plans management is better able to identify the problem and take appropriate action. Actions that the health plan may consider to address this problem include a product rate increase, product redesign, 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 in Management Accounting, is a department or other business segmentfor example, accounting, legal, or claimsto which costs can be charged. To provide accurate cost information, cost centers should accumulate their costs according to the various levels of accumulation, such as type and function. A health plan accumulates costs by cost centers to facilitate the budgeting process and to identify the total cost of operating various areas. When accumulating costs by cost center, the costs of departments at each level of a health plan can be "rolled into" the cost reports for departments at higher levels in the health plan. This type of accumulation enables management to judge the performance of individual cost centers. Accumulating Costs by Function When costs are accumulated by function, they are directed to the health plan operation that generates the costs. In the context of cost accumulation, a function consists of a series of tasks that serve a specific purpose. The accumulated costs of the activities involved within a certain function, without regard to departmental lines, are known as functional costs. Within each function are the costs of salaries, supplies, equipment, and so on. For example, a health plan can determine the cost of collecting renewal premiums by gathering cost data from all departments or areas that are involved in the collection process, not just from the cashiers' area that receives and records premiums. Other costs incurred in receiving premiums include 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 these operations 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 cost center. Functional cost accumulation involves identifying and measuring all the activities involved in a given function. If an activity is involved in more than one function, a health plan allots the correct portion of an activity's cost to each function that uses the activity. Suppose one of a health plans functions is to maintain current information on plan members in the health plans information system. In this case, all the costs associated with maintaining these recordsincluding costs associated with obtaining plan member information, inputting the information into the health plans information system, and obtaining and inputting updated plan member informationwould be charged to this function.

Assume that the health plans employees in the claims department spend 10% of their time updating plan member records. In this case, the health plan would allot 10% of total salaries in the 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 underwriting applications 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 line of business that was responsible for generating them. It is usually straightforward to charge direct costs to the appropriate cost object. For example, if the marketing department spends $300 for dedicated telephone lines for its department's fax machines, the cost of the lines is charged to the marketing department. Assigning indirect costs to the appropriate responsibility center is less straightforward. To address the problem of assigning indirect costs, health plans use cost allocation. Cost allocation is the accounting process of assigning or distributing an indirect cost or expense according to a method or formula. Examples of indirect costs that can be allocated include service department costs and the salaries of managers in charge of more than one responsibility center. Note that cost allocation is arbitrary to some degree. Therefore, a health plans management considers whether indirect costs are allocated and by what method they are allocated in evaluating a responsibility manager. Sometimes responsibility managers believe they are being allocated costs that do not apply to their centers. Problems with improper or unfair cost allocation can occur because of internal influences (company politics), insufficient data to properly allocate costs, or a flawed cost allocation system. Suppose a health plan serves markets in several metropolitan areas, with separate profit centers for each market. Each of these profit centers receives supportsuch as underwriting, contract issue, and claims processingfrom a regional home office. The health plan must determine an effective way to allocate the expenses for the support services to each profit center. Assume that Profit Center As market consists predominantly of large employer groups and that Profit Center B sells primarily to individuals. In this case, Profit Center A would expect to pay less per plan member for its underwriting, contract issue, and claims processing services than Profit Center B. Cost Allocation Bases To help ensure an equitable allocation of indirect costs, health plans seek an allocation base, or measure of use, that exhibits a proportional relationship between the indirect cost and the cost center 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. In addition to these allocation bases, health plans also use number of plan members as an allocation base.

Cost Allocation Methods Keep in mind that different allocation methods and allocation bases are typically appropriate for various types of costs. There are several general methods for allocating a health plans indirect salary costs and non salary expenses. In addition to these methods, health plans that have government business, including Medicare and Medicaid contracts, must comply with regulatory requirements concerning cost allocation. Most health plans allocate indirect salary costs by using time analysis, which determines the percentage of time a manager spends with different departments or activities. Three common methods of time analysis are estimated time, actual time, and standard time. A discussion of these methods 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 non salary expenses among cost centers depends on a health plan's size, cost control program, and the level of information that its management requires. Nevertheless, methods of allocating indirect expenses 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 were established to meet statutory reporting requirements, rather than the information needs of internal management. In recent years, however, changing factorsincluding new and complex products, declining profit margins, increased competition, and more knowledgeable and demanding purchasershave 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 internal management 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 analysis involves the comparison of costs in one period to the same costs in a different period, such as comparing this month's costs to last month's costs or this month's costs to the same costs six months ago, one year ago, or several years ago. Figure 13B-6 shows an example of a health plan's change analysis. This example compares operating costs for the current period with the same period in the previous year. Analyzing cost trends helps management spot fluctuations, peaks, and valleys in the health plans operations. It also helps predict future costs. However, change analysis does not indicate what causes the fluctuations. For example, if a health plans research and development costs increased by 130% in one year, resources may or may not have changed proportionately. Change analysis would not consider this alteration in product mix. Thus, change analysis is useful for identifying what costs have changed but not why they changed.

Functional Cost Analysis We discussed functional costs earlier in this lesson. Functional cost analysis enables a health plan's top management to analyze costs as they apply to workflow rather than to organizational structures. Through functional cost analysis, a health plans management can identify inefficient or unnecessary functions within a department and cut costs accordingly, without harming the more efficient, useful functions within the department. Developing an effective functional cost accounting system with an appropriate level of detail requires identifying and defining each business function within the health planmarketing, claims processing, data processing, underwriting, and so onas well as each line of business or

product offered. These functions, lines, or products may or may not coincide with the departmental units of the health plan. Functional cost analysis is especially helpful when health plans make pricing and staffing decisions. Using functional cost analysis, a health plans management can analyze relatively small functions (for example, file maintenance) by product line, all the way up to complex functions (for example, total selling costs). Having functional cost data in addition to departmental 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 unit cost is found by dividing the total functional cost by an appropriate base unit, such as number of plan members, number of claims, or amount of premiums collected. The ratio of expenses to premiums is an example of unit cost information in which a health plans management is keenly interested. The appropriate unit of measure to use in calculating unit costs depends on the function itself and the line of business being monitored. Units of measure may be monetary or nonmonetary. By comparing functional costs on a unit cost basis, a health plans management is able to monitor the productivity and profitability of departments and products. Suppose the functional unit cost of adding one new member to Green HMO's health plan is significantly greater than the functional unit cost of adding one new member to Blue HMO's health plan. As a result of functional cost analysis, Green HMO might explore several options to decrease its functional unit cost. Possible solutions include updating Green HMO's information system, 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 products according to the activities consumed in producing the products or services. In other words, ABC identifies units of activity, calculates the costs of performing each unit of activity, and then assigns 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 a group policy, sending a premium due notice, and investigating a claim. An activity driver is the output of an activity being performed. For example, if the activity is the preparation of member booklet-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. 2. 3. 4. Identify the activity Identify the activity drivers Match costs to each activity Trace activity costs to products or lines of business

Under traditional costing systems, the assumption is that products generate costs. Under ABC, the assumption 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 activities consume resourcessuch as labor, supplies, and computer timeand produce outputssuch as checks 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 its products and services and which do not. A value-added activity is one that makes a product or service more valuable to the customer. A non-value-added activity is an activity that does not make a product or service more valuable to the customer. Generally, non-value-added activities are wasteful and should be minimized. Figure 13B-7 presents a simple comparison of costs accumulated in a traditional way and costs accumulated by activity. Note that the total costs incurred do not change.

Cost-Volume-Profit Analysis Cost is a major area influencing the pricing of products and services. For each health plans product, the product's cost sets the lower limit for the product's price. In the long run, no health plan can expect to survive if it sells products below what it costs to produce and sell them. The pricing of health plan products is much more complicated than the pricing of most other products because 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 may decrease over time. Other costs may escalate, particularly in times of high inflation. Unmanaged costs can quickly reduce or even eliminate a health plans expected profit on a particular product or service. Cost accumulation data helps a health plans managers to project the costs associated with a product 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 adjusting pricing factors, such as morbidity charges, on current products. One tool that health plan managers use to help analyze the appropriateness of pricing decisions is cost-volume-profit analysis.

Three important elements in business decisions are cost, volume, and profit. Analysis of these elements 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 of changes 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 such questions 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 key components of CVP analysis: contribution margin and the break-even point. Contribution Margin Cost-volume-profit analysis makes use of costs that are classified by behaviorfixed costs, variable costs, and semi-variable costsand unit costs. Fundamental to CVP analysis is the concept of contribution margin, which, as we saw in Management Accounting, is the difference between a product's selling price and its variable costs. The contribution margin is important to CVP 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 plan suffers 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. We calculate these two variations

Determining unit price figures for health plan products is complicated and outside the scope of this text. In this discussion, we assume that the health plan has already calculated its unit price figures. Break-Even Point The break-even point is the point at which total revenues equal total costs, and fixed costs equal the contribution margin. If a health plan sells just enough units of a product to experience neither a net gain nor a net lossin other words, net income equals $0it will break even. Once it reaches the break-even level of sales, the health plan will begin to experience a net gain equal to the contribution margin for each additional unit of product sold. A products break-even point could be found by trial and error. However, it is much simpler to use a breakeven formula, in which fixed costs are divided by the unit contribution margin: Figure 13B-8 calculates the break-even point for a health plan's product.

Cost-Volume-Profit Graph A cost-volume-profit (CVP) graph, sometimes called a break-even chart, highlights cost-volumeprofit relationships over a wide range of sales levels. A CVP graph gives a health plans managers another way to see the point at which a products net gain begins. Figure 13B-9 shows the CVP graph for the product discussed in our previous example. Note that the total cost line and the sales revenue line intersect at the break-even pointthat is, when the volume of sales (enrolled plan members) is 1,000. This is the same break-even point that we calculated 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, the vertical distance between the sales revenue line and the total cost line is the amount of net gain realized at that volume. Likewise, to the left of the break-even point, the vertical distance between the 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 CVP analysis enables a health plans managers to test scenarios using different cost, volume, and price assumptions for each product so they can see what different inputs result in net gains for the health plan. Suppose a health plan currently has a membership of 2,000 and its management is looking for ways to increase its net gain from operations. One suggestion might be to change the product benefit design so that more members will enroll each month. The health plans management predicts that a change in benefit design worth an additional $2 in benefitsin other words, a $2 increase in the variable unit cost on a PMPM basiswill increase

membership by 100. The expectation is that the increase in membership will increase the health plans net gain. Before instituting this change, however, the health plans management decides to use 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 products contribution margin decreases to $38 ($100 unit sales price (PMPM) - $62 variable unit cost). Given that the increase in variable cost will increase sales volume from 2,000 to 2,100, the change in total contribution margin is found as follows:

As you can see, proceeding with the change in product benefit design would result in a $200 decrease in the products contribution margin. Because fixed costs remain unchanged, this change in contribution margin will decrease the health plans net gain by $200. The health plan should therefore not institute this new benefit design. The previous example is one of many possible applications of CVP analysis, in which a health plan seeks the most profitable combination of fixed cost, variable cost, sales volume, and product price. A health plans managers study changes in any or all of these variables to maximize the performance of the health plans products and product lines. Sometimes, a health plan can improve its overall net gain by reducing the contribution margin on a product, but only if it reduces its fixed costs by a greater amount. Otherwise, an increase in net gain comes through an increase in contribution margin. There are many ways to increase contribution margin, such as reducing selling price to increase sales volume, increasing fixed costs to increase sales volume, or trading off fixed and variable costs to achieve appropriate changes in volume. The process is more complex when health plans sell many products. In that case, improving net gain comes from finding the right mix and right amount 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-term budgets, 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, expressed in monetary terms, that covers a specified period of time, such as one year. A budget can be used to plan for something as minor as the office supplies the underwriting department will use in a given month, or as major as the premium income and medical expenses that a health plan expects for the entire year. Through budgeting, a health plan affirms its goals and establishes expected performance levels for its management team. Once a budget is in place, the health plan uses it to monitor 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 reflects management's expectations of performance and provides a plan that a health plan uses to guide it into the future. Although a budget cannot anticipate future conditions precisely, it does provide a health 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 individual departments and employees. Through such comparisons, a health plan gains insights that help it plan new courses of action. In this lesson, we present an overview of the budgeting environment for health plans. First, we describe the benefits and the drawbacks of budgeting, followed by a discussion of the budgeting process. We separate budgeting into operational budgeting, financial budgeting, and capital budgeting. (We discuss capital budgeting in the next lesson.) Then we discuss how a health plan combines these individual budgets into a master budget, which becomes the basis for the health plans pro forma financial statements. (Recall that we discussed pro forma financial statements in The 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 determine whether or not the health plan is achieving its mission, the health plan develops and applies means of measuring where it stands in relation to its objectives. Budgeting plays a key role in this process. Through budgeting, a health plan projects financial targets for a defined future periodtypically one yearand creates a financial plan of action that it believes will help it achieve its goals. In the cyclical management functions of planning, organizing, and controlling, budgeting is one of the 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 its objectives. In defining costs, the budget not only sets goals for management, but also provides a map of the types of expenses that will be incurred in meeting these goals. Thus, the budgeting process integrates the costs of the health plans business with the benefits. For this reason, all companies use budgets, however informally. A budget outlines a health plan's plans for the acquisition and allocation of financial and other resources. Further, a budget is one of many management accounting reports that a health plan uses to make decisions about its product 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 objective should be to systematically project for a given department, division, or line of business the anticipated expenses and income for a given period of time. Budgets indicate whether managers are meeting the financial goals set for the health plan. Managers are evaluated on the basis of their ability to control the costs, revenues, or investments that are under their supervision. For this reason, most managers review computer-generated reports on a regular basis to compare monthly and year-to-date actual operating expenses and compare them with the budgeted operating expenses. If an area's actual expenses vary significantly from its budgeted amounts, then the area's manager will 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 action plan. Typically, budget variances in which (1) expenses are higher than projected, or (2) revenues are lower 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 plans objectives between the time the budget was developed and the time the evaluation was made (for example, the health plan decides to enter a new market, to withdraw from an existing market, to develop a new product, to withdraw an existing product, or to increase spending on operating systems or training) Unanticipated changes in the external environment, such as changes in state laws regarding mandatory healthcare benefits. Although the drawbacks of budgeting are not important enough to keep companies from using budgets, you should be aware of what those drawbacks are. First, the budgeting process can be very time-consuming and can involve everyone from entry-level personnel to senior management.

During the budgeting process, a health plan forecastsby line of business or producta variety of items, including the: Number of new plan sponsors that the health plan anticipates contracting with in the coming year and the number of existing plan sponsors that the health plan anticipates it will retain Total number of new and existing plan members the health plan expects will be enrolled in the coming year Anticipated cost of providing medical benefits for all plan members covered under nonadministrative services only plans Staffing levels needed to fulfill the health plans objectives based on the projected number of plan sponsors and members Amount of money to be spent in salaries, overtime, and benefits for the health plans employees Level of resources the health plan should spend on technology, training, and compliance with regulatory requirements during the coming year The time that a health plan takes to make these estimates is time spent away from doing the actual work that generates the revenues needed to keep the health plan in business. Another drawback is that if the health plan makes a material change in its plan for the year, or if expected market conditions change considerably, the health plan has to revise its budget, which may involve considerable additional work. However, budgeting is work that must be done, because it imposes discipline in controlling costs and because it improves the health plans probability of achieving its revenue goals.
Number of new plan sponsors that the health plan anticipates contracting with in the

coming year and the number of existing plan sponsors that the health plan anticipates it will retain Total number of new and existing plan members the health plan expects will be enrolled in the coming year Anticipated cost of providing medical benefits for all plan members covered under nonadministrative services only plans Staffing levels needed to fulfill the health plans objectives based on the projected number of plan sponsors and members Amount of money to be spent in salaries, overtime, and benefits for the health plans employees Level of resources the health plan should spend on technology, training, and compliance with regulatory requirements during the coming year

The extent to which a health plan suffers from these drawbacks reflects the health plans own corporate culture. If the budgeting process is well monitored and if managers are not rewarded for underestimating revenues or for padding expense budgets, then these behaviors are less likely to occur. As reflected in Figure 13C-1, which summarizes the benefits and drawbacks associated with budgeting, the benefits of budgeting outweigh the drawbacks. Producing a thorough, accurate budget requires considerable cooperation among company managers and other employees. This cooperation between different departments and functional areas allows a health plan to prepare a comprehensive planning document known as a master budget.

The Master Budget Large companies usually draw up a network of separate budgets and schedules, each reflecting operating and financial plans for specific segments of the health plan. When integrated, this group of budgets becomes the master budget , which shows the overall operating and financing plans for the health plan during a specified period, often one year. Different companies refer to the master budget by many different names, such as operating budget, comprehensive budget, corporate budget, performance plan, or simply the budget. In this text, we use the term master budget. The master budget begins with a health plans revenue forecast, then shows the health plans budgeted expenses, cash flows, and investment activities. The master budget can be thought of as a profit plan, because the achievement of the health plans goals outlined in the budget typically will result in a profit for the health plan. Most companies compile the master budget annually and update it via "re-projections" semiannually. The master budget culminates in a set of pro forma financial statements. Recall from Assignment 11 that pro forma statements project what a health plan's financial condition will be at the end of a budgeting period, assuming that the health plan achieves all of its budgetary objectives. At the close of the budget cycle, most health plans draft a pro forma income statement, cash flow statement, 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 its pro forma financial statements to determine whether it has met its goals. Top management and the board of directors use the variances between the pro forma statements and the actual statements to evaluate 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 health plans functional areas oversees the budgeting and financial planning process. The budget committee reviews proposed plans for reasonableness and works toward integrating all supporting budgets into the master budget. Ultimately, the budget committee provides the overall guidance necessary to coordinate a health plan-wide budgeting process. Technically speaking, we can identify three distinct approaches to budgeting: (1) top-down budgeting, (2) bottom-up budgeting, and (3) zero-based budgeting. In practice, most health plans use a combination of these approaches in a manner that best suits the health plans culture and needs. Top-Down Budgeting and Bottom-Up Budgeting As the names imply, top-down budgeting is generated on the corporate level by upper management and is passed down to lower management, while bottom-up budgeting is generated at the department level by lower management and is presented in the form of recommendations to upper management. In both types of budgeting, a health plan typically uses the previous year's budget 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 plans strategic vision and objectives for the coming year and financial data from the health plans activities in prior years. The health plans top executives typically develop top-down budgets. Bottom-up budgeting, on the other hand, includes a much larger number of employees from all departments within the health plan. These characteristics give top-down budgeting the advantage of being less time consuming and less labor intensive than bottom-up budgeting. Also, because top-down budgeting is generated at the corporate level, it is more likely than bottom-up budgeting to reflect top management's intentions for the health plan. Further, top-down budgeting enables a health plan to incorporate key changes in regulatory requirements or the health plans strategic plan on a timely basis. On the other hand, because budgets developed from the bottom up usually reflect the input and participation of the employees who will be responsible for achieving the budgetary goals, bottomup budgeting is more likely to reflect the realities of day-to-day operations. In addition, bottomup budgeting often has more grassroots support among company employees than does top-down budgeting.

Zero-Based Budgeting Zero-based budgeting (ZBB) differs from other budgeting approaches in that, for every accounting period, each line of business within the health plan must justify its continued operation. Zero-based budgeting generally applies only to expense budgets. (Companies can apply 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 be allocated for the following period unless and until each dollar to be spent is justified and is shown to be in accord with departmental plans and corporate goals and objectives. Thus, ZBB treats each activity as though it is a new project under consideration and does not automatically assume that the current levels of spending are reasonable starting points for developing next year's budget. Many of the positive results of zero-based budgeting come from the financial analysis and planning required at all levels of management in carrying out this budgeting process. Management must evaluate every operation in terms of efficiency and need. Lower-level employees play a key role in ZBB because they often provide necessary details to accurately assess the importance and financial requirements of each activity. Other benefits of ZBB are the breadth and quality of information contained in the budgets and the training and education employees 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 work associated with ZBB involves collecting and analyzing data to justify each item and prepare contingency budgets. Thus, many companies do not really have pure ZBB, but instead use a modified ZBB. With a modified ZBB approach, either the budgetary approach is only partially zero-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 or flexible budget, (2) as a short-term budget or long-term budget, and (3) as a rolling budget or period budget. Static Budgets and Flexible Budgets When budgets are classified by the degree of variability inherent in them, they are often referred to either as static budgets or flexible budgets. A static budget , also known as a fixed budget or a fixed-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 revenues and expenses are uncertain. Static budgets provide no alternative financial predictions when actual 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. For example, if a health plan allocates $10,000,000 for expenses for the coming month, the health plan generally cannot spend more than this fixed amount on existing revenue-generating activities. Further, the health plan would probably not pursue new revenue-generating activities that would require it to incur additional expenses. The health plan, of course, could spend less than the budgeted amount. Figure 13C-4 presents an example of a monthly static expense budget for each functional area of the health plan.

One approach is for the health plan to develop a flexible budget that shows three columns of possible first-year selling expenses based on (1) a pessimistic sales figure of $22,000,000, (2) a most likely figure of $25,000,000, and (3) an optimistic figure of $28,000,000, of new premium income. In each case, the amount budgeted for selling expenses differs accordingly. Figure 13C-5 is an example of this health plans flexible budget. Recall that we discussed optimistic, pessimistic, most likely scenario modeling in The Strategic Planning Process in Health Plans in the context of pro forma financial statements.

Budgets can cover almost any time frame. A short-term budget generally addresses a period of one year or less and relates mainly to a health plan's operations during that period. Often, the budget 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 their strategic financial plans. Budgets projecting far into the future allow for income and expenses that correspond to a health plans strategic planning objectives. For example, long-term budgets are often used to plan for the large 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 are less accurate over multiple years. The most current year of a health plans long-term budget is the short-term budget for the current accounting period. Thus, a long-term budget incorporates a health plan's short-term budgets. Rolling Budgets and Period Budgets A rolling budget, also known as a continuous budget, allows a company to continually maintain projections for a certain time period into the future. For example, a health plan with a six-month rolling budget updates the budget at the end of each month so that the projections always apply to the coming six-month period. A rolling budget forces the health plans management to constantly consider 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. The numbers in a period budget do not change during the time frame covered by the budget. Because it is updated regularly based on the results of the most recent period, a rolling budget can maintain a higher measure of accuracy than a period budget. However, maintaining a rolling budget generally requires more resources than a period budget. Suppose a health plan creates a rolling budget for the six-month period from January 1 through June 30. If the health plan updates the budget monthly, then it presents a new budget on February 1 to reflect the six-month period from February 1 through July 31. The health plan repeats this procedure for the six-month period from March 1 through August 31, April 1 through September 30, 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, and capital budgets. In the following sections, we discuss operational budgets. We discuss cash budgets 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 a definite period of time. Operational budgets provide detail for the projections and objectives found 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 accommodate management's decision-making needs. The operational budget reflects the financial steps the health plan will take during the coming year to achieve its profitability objectives. Examples of a health plans 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: revenue budgets and expense budgets. Revenue Budgets A revenue budget indicates the amount of income from operationsnew business, renewal business, and investmentsthat a company expects in the coming budget period. The revenue budget determines the limits of the other budgets and must be prepared before them. Some health plans divide the revenue budget into the sales budget and the investment budget . A sales budget projects premium income from both new business and renewal business. The health plan bases its estimates on historical data, reviews of the marketplace, and premium rates charged by competitors, among other factors. An investment budget projects the types of investments the health plan will make and the expected amount of investment-related income for each type. Because cash flow can have a significant impact on investment strategy, the health plan does not complete the investment budget until after it completes its cash budget. All operational budgets begin with a forecast of sales revenue and investment income because a health plan cannot establish appropriate spending levels until it determines the funds it will have available. The sales forecast estimates new business and renewal business premiums for a particular 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, the regulatory climate, and the preferences of purchasers and consumers.

Investment forecasts also require analysis of specific types of investment vehicles and analysis of market conditions. Methods of projecting sales and investment performance can range from relatively simple estimates based on prior experience to more complex forecasts based on computer simulations. A few of the forecasting techniques that health plans use include qualitative methods, trend analysis, and regression analysis.
Qualitative methods rely on the judgment of managers, who use their own experience and

understanding 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 trends to 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, such as claims costs. Some health plans make several different forecasts that reflect different assumptions, such as fluctuations in interest rates, then use the different tentative sales or investment forecasts to devise a single composite forecast. Personnel in a health plan's sales and actuarial areas provide management with estimates of the amount of premium income the health plan can expect. Sales managers in the home office usually check the sales forecasts for reasonableness. The investment department estimates the amount of investment income the health plan expects to earn during the next period. The sales budget is often broken down by product type (such as individual or non-group, small group, large group, Medicare, and Medicaid). The investments budget is often broken down by investment 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 the health plans annual revenue budget, divided into its sales and investment components, and broken down by quarter.

Expense Budgets Following the revenue budget, the next step in completing the operational budget is preparing expense 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 a health plan expects to pay for medical benefits during the next period. Actuaries and medical management personnel are typically responsible for developing the medical expense budget. (2) the selling expense budget, The selling expense budget is based primarily on the costs incurred in selling health plan coverage. In addition to commission costs, these selling expenses may include the direct costs associated with advertising, promotion, travel, sales office operations, and salaries for sales and marketing personnel. The marketing and sales departments typically are responsible for developing the sales expense budget. (3) the administrative expense budget. The administrative expense budget includes the other expenses needed to operate a company. Usually, this budget is the sum of all departmental expense budgets. The administrative expense budget also includes such companywide expenses as depreciation on buildings, computer equipment costs, and administrative salaries. Each functional area of the health plan usually prepares its own expense budget. Some health plans have two expense budgets: a medical expense budget and a selling and administrative expense budget.

Expense budgets can describe variable as well as fixed expenses. Both the medical expense budget and the selling expense budget describe variable expenses because the amounts budgeted depend on the figures contained in the sales budget. Typically, the more plan contracts a health plan sells, the more selling expenses it incurs and the more medical expenses it incurs due to increased plan membership. The administrative expense budget contains most of the health plans fixed expenses, such as home office salaries, rent, and depreciation. However, the administrative expense budget also contains variable expenses because the services provided by administrative departments are often based on the number of plan members. Figure 13C-8 shows a health plans annual expense budget by quarter. This budget includes elements of the medical expense budget, the selling expense budget, and the administrative expense budget. Having prepared its revenue and expense budgets, a health plan can then draft its pro forma income statement, which estimates the net income for the entire health plan. If a health plans master budget is for a period of one year, the health plans pro forma income statement may show only the end-of-period data. However, some pro forma income statements can also be divided into 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 plans cash budget using the health plans cash receipts and cash disbursements Cash management , also called treasury management or working capital management, is the management of a companys short-term cash needs.1 In the near term, a health plan either has excess cash or a cash shortage. Excess cash can easily become idle cash if it is not invested to earn a return. On the other hand, a cash shortage may delay provider payments and other payments that must be made to satisfy a health plans current obligations. Further, a health plan may incur additional liabilities if it has to borrow short-term funds to meet these obligations. To manage its cash effectively, a health plan typically constructs a cash budget. Recall that a health plans working capital is the difference between the health plans current assets 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 plans current liabilities may be greater than its current assets. Negative working capital tends to occur whenever healthcare expenses generated by plan members exceed the premium income that the health plan receives. This situation can develop in the short run simply because healthcare expenses generated by plan members vary from month to month, but premium income tends to be a more stable cash flow. Earlier we discussed how health plans manage the volatility in claims payments through estimating its IBNR claims. In addition, some forms of provider reimbursementnotably capitation contractstend to stabilize a health plans expenses, because a provider will be paid the same PMPM rate every month of the contract period, even if the cost of providing medical care 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 subsidiary income. 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 come due. 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 to sell its investments at an inopportune time and incur a loss or perhaps borrow money at a higher interest rate to meet its obligations. But holding too much cash on hand presents another set of problems. Although it provides the health 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 health plan 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 budgeting anticipates the flows of cash into and out of a health plan during a given period. A cash budget shows all expected cash inflows, cash outflows, and ending cash during a period. Many health plans 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 cyclical events and seasonality affect its estimated cash inflows and cash outflows. Suppose a health plan learns that its IBNR claims liabilities typically become cash disbursements within 45 days of their occurrence. In this case, the health plans cash disbursements budget and cash budget would indicate a 45-day payment cycle for IBNR claims. In another example, a health plan may discover that its provider reimbursement payments peak around a specified time each year. The underwriting cycle is one example of the impact of a cyclical effect on health plans. Recall from The Relationship Between Rating and Underwriting that the underwriting cycle occurs when a health plan experiences a pattern of three years of underwriting profits, followed by three years of underwriting losses. In conjunction with, and sometimes instead of, a formal cash budget, some health plans have their internal accounting function submit a daily cash report to the health plans investment function. In turn, the investment function uses the daily cash report to determine the amount of excess cash available 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 general assumptions can be made about cash flows in the health plan industry. A health plan forecasts its expected cash receipts and cash disbursements using qualitative methods, trend analysis, and regression 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 investment income. Most group health premiums are due on a quarterly or monthly basis according to due dates specified in each contract. The majority of plan sponsors remit their premiums by the due date to avoid losing coverage, so a health plans cash inflows from premiums are relatively stable. Somewhat less predictable is a health plans investment income. However, even if some of a health plans investments are volatile by nature, most of a health plans investments are in relatively low-risk assets that provide a guaranteed, steady income stream. One example of such an investment is a U.S. Treasury bill that pays semiannual interest. Nevertheless, when forecasting for investments, health plans must consider the overall economic outlook, statutory requirements, tax factors, and the health plans investment strategy. A company plans for its cash inflows through a cash receipts budget, which is a schedule of cash receipts that the company expects to receive during the period. To predict both the timing and the amount of its cash receipts, a health plan constructs the cash receipts budget using data from its sales 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 the beginning of the month. Figure 14A-1 shows a sample health plans annual cash receipts budget broken down by quarter. Note that the sample health plan divides its cash receipts budget into receipts from the sales of health plans and healthcare products and receipts from investments. For simplicity, Figure 14A-1 assumes that there is no timing difference between income and cash receipts. In other words, the revenue forecast equals cash.

The Cash Disbursements Budget A company attempts to estimate the timing and amount of all of its cash disbursements in a cash disbursements budget . Unlike a health plans cash receipts, the health plan's cash disbursements take 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 nonrecurring cash disbursements, many of which result from its capital budgeting decisions. Also, a health plan must estimate its liability for IBNR claims as accurately as possible to manage cash effectively. If an health plan significantly underestimates the IBNR claims liabilities, the amount of these

liabilities will be understated on the health plans balance sheetthat is, the dollar amount of IBNR claims liabilities would be lower than it should be. The health plans income statement would similarly understate the amount of its healthcare benefit expenses, thereby making the health plan look more profitable than it really is, all other factors remaining equal. If a health plan significantly overestimates its IBNR claims liabilities during 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 high opportunity cost would result. Again, a health plan generally experiences heavy cash outflows in the first few working days of each month because most monthly payments are due on the first of the month. These payments include provider reimbursements and utility payments. The cash disbursements for fixed expenses such as salaries are made with relative ease and accuracy. However, estimating the cash disbursements for variable expenses such as claims payments and variable provider reimbursement contracts such as FFS contracts is less predictable. The accuracy of these predictions depends in large part on the accuracy of a health plans sales forecast. Figure 14A-2 shows a sample health plan cash disbursements budget. This figure shows that a sample health plan first divides its cash disbursements budget into two categories: healthcarerelated disbursementssuch as claims payments and provider reimbursementand investmentrelated disbursements. Note that a sample health plan subdivides its healthcare-related cash disbursements into a fixed component and a variable component and its investment-related cash disbursements into shortterm purchases and long-term purchases. Also, note that a sample health plan made a one-time purchase of computer equipment during the third quarter. The Cash Budget Once a health plan has prepared its cash receipts budget and cash disbursements budget, the health plan prepares its cash budget. Important pieces of information that are contained in a health plans cash budget include the health plans: 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 of a health plans minimum cash balance requires a great deal of research and estimation from a health plan's managers. Setting this figure too low raises the risk of running out of cash. Setting this 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 plans productive assets usually arranges for a line of credit from a bank. A line of credit, also called a bank line, is a pre-arranged agreement that allows a company to borrow money on demand up to a specified amount. This short-term borrowing becomes necessary whenever a health plan encounters a cash shortage. Some health plans make arrangements with banks that allow a health plan to keep funds in interest-bearing accounts and the bank automatically transfers money to the health plans checking (or other cash disbursements) account as needed. A health plan can use many methods to derive its minimum cash balance. For example, a health plan may set its minimum balance equal to that of its budgeted cash disbursements for a month. The health plans IBNR calculations, as well as planned-for capital improvements, may also figure into the determination of an appropriate cash balance for any given period. More sophisticated techniques involve computer spreadsheet simulations. Regardless of the method used to determine the minimum cash balance, this decision is a significant one with respect to a health plans solvency and profitability.

By examining its cash budget, a health plans management can estimate the timing and amount of a cash shortage, which will require additional financing, or excess cash, which will allow for investment in relatively liquid assets. Recall that an assets liquidity is the ease with which an asset can be converted into cash for an approximation of its true value. Generally, the more liquid an 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, government securities 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 XYZs cash 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 a cash shortage of $2,021,000. To address the expected cash shortage, health plan XYZ has planned for a short-term loan in the amount of $2,500,000. (Alternatively, health plan XYZ could sell some 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 noted in 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 plans cash receipts and cash disbursements budgets, the cash budget, and the pro forma income statement are transferred to the health plans pro forma cash flow statement. Then, the health plan prepares its pro forma balance sheet. Endnotes 1. Susan Conant et al., Managing for Solvency and Profitability in Life and Health Insurance 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 health plans capital budgeting decisions Describe factors that affect a health plans capital budgeting decisions Explain the function of sensitivity analysis in capital budgeting A health plans managers focus on ways to make the health plan grow or otherwise become more profitable. 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, a company undertakes capital budgeting , which is the analysis of decisions about investing in longterm assets. The capital expenditures made to obtain a health plans long-term assets are expected to 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 to hold 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 major capital project if the new product requires a large amount of up-front capital for development and marketing. The Capital Budgeting Process Because a capital budget is long-term in nature, it is used extensively in a health plans strategic planning. As a result, the health plans top management is closely involved in developing the health plans capital budget. A capital budget is a budget in which a company estimates its need for capital. Capital budgets generally incorporate new projects, major repairs to or remodeling of already-owned long-term assets, acquisitions of other companies, legislatively mandated safety and environmental improvements, cost reduction projects, and revenue expansion projects. The capital budgeting process often includes many steps. In this lesson, we identify four important steps: (1) generating capital budgeting ideas, (2) classifying each capital project proposal, (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 plans marketing function or actuarial function may suggest a new product idea for development. The claims administration function may recommend upgrading outdated equipment to enable more effective claims processing. A health plans investment function may request a new decision support system to generate a higher return on the health plans investments. Or the health plans president may decide that the organization plan is outgrowing its office space and propose investing in additional space or extensive remodeling.

Classifying Each Proposal In compiling the master budget, a health plan determines the resourcesmoney, staff time, equipment, and so onthat it can devote to proposed capital projects. Because there are often multiple functional areas requesting capital resources, it is helpful to classify each capital project proposal so that a health plans managers can better analyze each one and gauge its potential usefulness to the health plan. Although specific classifications vary among health plans, some typical classifications include New Projects such as new assets or new uses for existing assets. Examples of this category are new healthcare products or the purchase of another health plan or one or more of its product lines. Replacements such as new assets that will be used to replace old or defective assets. An example is the replacement of an outdated mainframe computer with a new computer system. Cost reduction programs such as assets that reduce the cost of a health plans operations. An example is the purchase of a printer to handle in-house print jobs that previously had been outsourced. Safety and regulatory expenditure programs such as those that address employee safety concerns or are required by legal regulations. An example is the purchase of a new fire alarm and sprinkler system for a health plans home office building. Estimating Cash Flows Once a health plan has generated and classified its capital project ideas, the health plan then estimates the cash flows associated with each project. Estimating each projects cash flows quantifies both its benefits and drawbacks and facilitates the evaluation of each project. Capital projects have both cash inflows and cash outflows. A health plans management should consider only each projects incremental cash flows, which are the additional costs or revenues that result from a capital project. We discussed incremental (differential, marginal) costs in Management Control. Suppose a health plans 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. In subsequent 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 a capital 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 that the project will increase revenues, decrease costs, or both. A projects cash inflows may be predictable in amount and timing; that is, the same cash inflow may be expected during each year of the assets useful life. Often a projects cash inflows are uneven, in which case the amount or the timing of the inflow varies each year.

For capital budgeting purposes, a reduction in costs is equivalent to an increase in revenues because either results in an increase in a health plans net income. In the case of a replacement proposal, such as a computer system, the salvage value of the old computer system is treated as a cash inflow. Salvage value is the residual value or selling price of a tangible (physical) asset at the end of its useful life. The time value of money concept is critical to capital budgeting decisions because such decisions require 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 years ago or five years in the future. Calculating the present value or future value associated with each capital project is therefore critical to the decision-making process. Although a complete discussion of the time value of money is beyond the scope of this course, Figure 14B-1 provides a summary of this concept.

Estimating Cash Flows Besides considering the time value of money, a health plans managers need to consider the opportunity costs associated with its capital budgeting decisions. In other words, by committing money today for a specified capital project, the health plan is giving up the opportunity to invest in other capital projects. Before we review a few of the evaluative methods that health plans use in making capital budgeting decisions, we first review the selection of the appropriate discount rate to use in calculating a capital projects estimated cash flows. Because of the importance of the time value of money, some capital budgeting methods involve the calculation of discounted or compounded cash flows. It is therefore vital that the health plan choose an appropriate rate to discount these cash flows to their present value and apply that rate consistently to each project being evaluated. The discount rate used in capital budgeting usually represents a health plans weighted-average cost of capital (WACC). A health plans cost of capital is the "price" that a health plan pays collectively for its various sources of financing. One way to determine a health plans cost of capital is to find the weighted

average cost of all sources of debt capital (primarily bank loans and bond issues) and equity capital (common stock, preferred stock, and retained earnings). Each components costs are measured in terms of interest payments, bond amortizations, stockholder dividend payments, and the opportunity cost of retained earnings (or surplus). Recall our discussion of the weighted average 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 help illustrate the concept. The WACC simply means that Mainline will factor into its calculation the amount of money financed at each discount rate. Suppose that 60% of Mainlines total capital comes from retained earnings and 40% comes from a new issue of common stock. Assume that the financial managers of Mainline have calculated the cost of retained earnings to be 13% and the cost of the common stock issue to be 18%. Mainlines cost of capital is the weighted average of these two sources of financing, calculated as shown in Figure 14B-2. Mainlines weighted average cost of capital is 15%. Therefore, an appropriate discount rate for Mainline 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 plan evaluates the capital projects that it is considering depends in part on the accuracy of its cash flow estimates. Once the health plan has calculated the relevant cash flows of each proposed capital investment, the health plan evaluates all proposals and decides which, if any, to accept and implement. A health plan may use a variety of evaluation methods to quantify the value of each proposed capital project. Quantifying the value of each capital project in financial terms makes it easier for a health plans management to compare proposals with each other or with some predefined decision-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 plan evaluates the capital projects that it is considering depends in part on the accuracy of its cash flow estimates. Once the health plan has calculated the relevant cash flows of each proposed capital investment, the health plan evaluates all proposals and decides which, if any, to accept and implement.

A health plan may use a variety of evaluation methods to quantify the value of each proposed capital project. Quantifying the value of each capital project in financial terms makes it easier for a health plans management to compare proposals with each other or with some predefined decision-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 to evaluate proposed capital projects to determine which ones meet a minimum standard of financial acceptability. 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) internal rate of return method. Admittedly, capital budgeting is imprecise because the process requires an estimation of expected cash inflows and outflows. Therefore, a health plan often uses more than one capital budgeting method to minimize the chance of making incorrect decisions about investment proposals. A health plans management applies the health plan-defined decision rules to the results of one or more of these analyses to decide whether to accept or reject a particular capital project. Instead of emphasizing the mathematical calculations inherent in these methods, the following sections highlight the decision rules that a health plan may use and the way these methods assist in decision making. The Payback Method The payback method is a capital budgeting technique that calculates how long it will take a health plan 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 come into the health plan as a result of its investment in a project. If the annual revenues or savings are expected 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 laser printers at a cost of $75,000 (a cash outflow). The new printers will enable Mainline to print all its forms in-house. Under the current system, Mainline spends $25,000 a year to have forms printed 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 amount would change from year to year as the cost of external printing increases or decreases and as the volume of printing increases or decreases. For simplicity, this example ignores these factors.) To compute the payback period, divide an health plans initial investment by the annual expected cash inflow (in our example, $75,000 $25,000 = 3 year payback period). If Mainlines decision rule is to accept all proposed capital projects that have payback periods of four years or less, then it would accept this proposal. If the decision rule requires a payback period of less than three years, then Mainline would reject the proposal. The main benefit of the payback method is its simplicity. Also, the payback method suggests a degree of risk inherent in a proposed capital project. Generally, a longer payback period indicates a greater risk because the health plans initial investment may not be recovered.

The payback method has several limitations. One drawback of the payback period is that it does not measure profitability, so the payback period provides no information about the rate of return on the health plans investment. Also, the payback method ignores the time value of money and ignores all cash inflows and cash outflows that occur after the payback period. In our example, the new printers may reduce Mainlines expenses by $25,000 for each of the first three years (the payback period), but what about cash flows in the fourth year and succeeding years? Because of these limitations, many health plans supplement the payback method with another analysis method. Many health plans use the payback method only as an initial screening device, because the payback period alone is not enough justification for undertaking or rejecting a proposed capital project. The Discounted Payback Method Similar to the payback method is the discounted payback method, which overcomes one drawback of the payback method by taking into account the time value of money. The discounted payback method calculates, in terms of discounted dollars, how long it will take a health plan to recover its initial investment. Again, lets assume that the Mainline health plan is considering the purchase of the 20 printers at an 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 weightedaverage cost of capital. The cash inflows for each year, discounted to their present value, are shown in Figure 14B-3.

According to the discounted payback method, Mainline recovers only $57,100 of its investment after Year 3 and $71,400 after Year 4. Not until Year 5 does Mainline recover its entire $75,000 initial investment. Therefore, consideration of only discounted cash flows has increased the payback 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 with payback periods of four years or less. Because it considers the time value of money, the discounted payback method is superior to the payback method. However, the discounted payback method 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 net present value (NPV) method evaluates a proposal based on its net present value (NPV), or the difference between the present value (PV) of a projects cash inflows revenues, cost savings, and interest incomeand the present value (PV) of its cash outflowsproject or investment costs and expenses. Unlike the payback method and the discounted payback method, which both evaluate proposed projects according to the length of time needed to recoup a projects initial investment, the NPV method states a proposed projects cash flows in terms of present value for the entire life of the project. The Net Present Value Method The NPV method has an advantage in that this method considers the time value of money. The NPV calculation involves determining the proposed capital investments useful life and selecting an appropriate discount rate. Again, an appropriate discount rate for a health plan may be the health plans weighted-average cost of capital. The decision rule for accepting a proposal under the NPV method is that the present value of a projects cash inflows must exceed the present value of the project itself. In other words, the net present 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 a project 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 Mainlines discount rate is 15%, then the NPV for Mainlines printer proposal is $8,825, as shown in Figure 14B-4. Assume that Mainlines decision rule is to accept all capital projects that have an NPV greater than zero. In this case, Mainline would accept the printer proposal. The NPV method considers a health plans profitability with respect to a proposed capital project, because a projects NPV can be thought of as additional wealth to the health plan. The NPV method also considers the time value of money, and all cash flows during a capital projects useful life, including those cash flows that occur after the projects payback period. However, to use the NPV method, a health plan must first determine its WACC. Also, a direct comparison of the NPVs of two or more capital project proposals may be misleading unless all proposed 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 of return (IRR) method , also called the time-adjusted rate of return method, determines the discount rate at which the net present value of a capital project equals zero. In other words, the IRR method determines the rate at which a projects cash inflows must be discounted to recoup the projects initial investment. A capital projects IRR is determined by analyzing the projects yearly cash inflows, then using the appropriate interest factor to calculate the present value of those cash inflows. Lets return to our example. To find an appropriate IRR for a project, divide the amount of the required investment by the annual net cash inflows to obtain a present value interest factor of an annuity (PVIFA). In our example, Mainline would divide the projects required investment of $75,000 by the projects 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 is closest to 3.0. Mainline would use a present value interest factor of an annuity (PVIFA) table to find the discount rate. Mainline finds that, on the PVIFA table, the factor that is closest to 3.0, for five periods, is between 19% and 20%. Therefore, the IRR of Mainlines proposed printer is between 19% and 20%. Calculating the precise IRR involves the use of PVIFA tables and interpolation, which are beyond the scope of this course. The interpolated IRR for Mainlines printer proposal, assuming a useful life of five years, is 19.87%. The decision rule for the IRR method requires that a health plan compare its WACC to the proposed projects IRR. If the projects IRR exceeds the health plans WACC, then the projects benefits should exceed its costs. Thus, the project would be accepted according to the IRR method. Otherwise, the health plan would reject the project. Mainlines printer project is acceptable because the proposed printers IRR of 19.87% exceeds the Mainlines WACC of 15%. If Mainline must choose among this project and other proposed projects, then Mainline would accept the project that has the highest IRR.

Figure 14B-5 summarizes the four capital budgeting methods we discussed and the evaluation each one provided for Mainlines proposed capital project.

Investing Decisions and Financing Decisions As shown in Figure 14B-5, different capital budgeting methods may yield conflicting evaluations of the same proposal. In our example, the decision rule for the discounted payback period indicates that Mainline should reject the proposal, although the other three capital budgeting methods indicate that Mainline should accept the proposal. Conflicting results often occur when a health 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 lead to 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 longterm 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 its calculation of the project. However, doing so could lead the health plan to accept a proposal that has a rate of return that is less than the health plans WACC, although the projects return may be greater 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 the proposals are independent or mutually exclusive. Independent proposals have cash flows that are unrelated; that is, the acceptance of one independent proposal does not automatically eliminate any others. Mutually exclusive proposals involve investment choices that perform essentially the same function, so the acceptance of one proposal automatically eliminates all others from consideration. A health plan may accept any number of independent proposals but only one in a group of mutually 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 exclusive alternatives automatically eliminates the other choice. Capital Rationing A health plan may find that it has more acceptable capital proposals than it has available resources 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 plans capital project proposals. Under capital rationing, a health plan ranks all capital project proposals according to expected rates of return and accepts only those with the highest rankings. There are several ways to rank all acceptable proposals. If a health plan relies on each projects IRR to screen capital proposals, the health plan ranks them by their expected IRR. For example, assume that an health plan has four acceptable capital proposals with IRRs as follows: If the health plan has resources to accept only two proposals, it should choose proposals C and D because they have the highest IRRs.

Profitability Index Recall that, unlike the IRR method, the NPV method does not allow for direct comparisons of proposed capital projects, unless they require an equal amount of investment. So, if a health plan uses the NPV method, the health plan calculates the profitability index to rank proposals for comparative purposes. The profitability index (PI) is the ratio of the present value of future cash flows expected from a project to the amount of a health plans 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 projects NPV is zero. The decision rule for using PI involves rejecting projects that have a PI of less than 1.0. If a health plan is considering several projects, 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 health plans management has perfect knowledge of the future. Keep in mind that any number of assumptions could be wrong. In the Mainline example, suppose the printers actually could provide only $15,000, rather than $25,000, of cash inflows per year. Suppose the printers could be usable for only four years instead of five. If either or both were to happen, would Mainline still accept the printer proposal?

To address these types of circumstances, an health plans managers apply sensitivity analysis. Recall from The Strategic Planning Process in Health Plans that sensitivity analysis determines a variety of scenarios by calculating how far reality can vary from estimates without invalidating an health plans 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-even point of the printer proposals cash flows, divide Mainlines cost of the investment by the present value interest factor of an annuity (PVIFA) at 15% and five years: $75,000 3.352 = $22,375. Mainlines managers also would perform a similar calculation to determine the amount of cushion in its estimate of the printers useful life of five years. In light of the new information, Mainlines managers would assess the likelihood that the printer proposal will actually meet its investment thresholds.