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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.
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.
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 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 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.
The Danner Bank loaned money to the CareWell Health Plan to fund an expansion of a healthcare facility. With respect to the type of financial information user Danner represents to CareWell, it is correct to say that Danner is an: internal user with a direct financial interest internal user with an indirect financial interest external user with a direct financial interest case-mix adjustment
Answer: C
concerns, including how a health plans financial information can be analyzed and interpreted, later in this course.
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-forprofit status
determines to a great extent the way a health plan approaches critical financial decisions, such as funding, allocation of profits, and tax payments.
Legal Forms of Organization That Affect Health Plan Finance 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)
All health plans have potential access to the first two funding sources. However, notfor-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.
Health plans have access to a variety of funding sources depending on whether they are operated as for-profit or not-for-profit organizations. The Verde Health Plan is a for-profit health plan and the Noir Health Plan is a not-for-profit health plan. From
the answer choices below, select the response that correctly identifies whether funds from debt markets and equity markets are available to Verde and Noir: Funds from Debt Markets: available to Verde and Noir Funds from Equity Markets: available to Verde and Noir Funds from Debt Markets: available to Verde and Noir Funds from Equity Markets: available to Verde only Funds from Debt Markets: available to Verde only Funds from Equity Markets: available to Noir only Funds from Debt Markets: available to Noir only Funds from Equity Markets: available to Verde only
Answer: B
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.
Legal Forms of Organization That Affect Health Plan Finance Types of Health Plans
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.
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 lowerthan 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.
Page no: 1-47 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
Types of 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.
Types of Risk
The Concept of Risk
1
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 investmentthe 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.
Types of Risk
The Concept of Risk 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 party for 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. The following examples describe situations that expose an individual or a health plan to either pure risk or speculative risk: Example 1 A health plan invested in 1,000 shares of stock issued by a technology company. Example 2 An individual could contract a terminal illness. Example 3 A health plan purchased a new information system. Example 4 A health plan could be held liable for the negligent acts of an employee.
The examples that describe pure risk are examples 1 and 2 examples 1 and 4 examples 2 and 3 examples 2 and 4
Types of Risk
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 gain in 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.
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 trade-off. 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.
Types of Risk
Types of Risk
Risk Categories Faced by Health Plans 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:
Types of Risk
Risk Categories Faced by Health Plans C-Risks and Solvency
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 longterm 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, an 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.
Types of Risk
Risk Categories Faced by Health Plans 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 an 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.
Types of Risk
Risk Categories Faced by Health Plans Regulatory and Antiselection Risks
In a health plan environment, antiselection is the tendency of people who have a greater-than-average likelihood of loss to seek healthcare coverage to a greater extent than individuals 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. Contingency risks, or C-risks, are general categories of risk that have a direct bearing on both the cash flow and solvency of a health plan. One of these C-risks, pricing risk (C-2 risk), is typically the most important risk a health plan faces. Pricing risk is crucial to a health plans solvency because: a sizable portion of any health plans assets are held in long-term investments and any shift in interest rates can significantly impact a health plans ability to pay medical benefits a health plan relies heavily on the sound judgment of its management, and poor management decisions can result in financial losses for the health plan a situation in which actual expenses exceed the amounts budgeted for those expenses may result in the health plan failing to retain assets sufficient to cover current obligations a sizable portion of the total expenses and liabilities faced by a health plan come from contractual obligations to pay future medical costs, and the exact amounts of those costs are not known at the time a products premium is established
Types of Risk
Risk Categories Faced by Health Plans Regulatory and Antiselection Risks
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.
Types of Risk
Risk Categories Faced by Health Plans 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 selffunded 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).
Types of Risk
Regulatory Solvency and Risk-Based Capital Requirements 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.
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. The HMO Model Act sets certain requirements that an entity that wishes to operate as an HMO must meet. These requirements include: having an initial net worth of at least $5 million maintaining a net worth equal to at least 5% of premium revenues for the first $150 million in premium revenue using a prospective method to estimate future risk obtaining a certificate of authority (COA) before beginning operations
Types of Risk
Regulatory Solvency and Risk-Based Capital Requirements 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.
Types of Risk
Regulatory Solvency and Risk-Based Capital Requirements 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 riskbased 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-than-expected 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 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 riskthe 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.
Types of Risk
Regulatory Solvency and Risk-Based Capital Requirements The Development of Risk-Based Capital Requirements
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.
The risk-based capital formula for health plans defines a number of risks that can impact a health plans solvency. These 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. The following statements are about the effect of a health plan transferring utilization risk to providers. Select the answer choice containing the correct statement: The net effect of using provider reimbursement contracts to transfer risk is that the health plans net worth requirement increases. Once the health plan has transferred utilization risk to its providers, it is relieved of the legal obligation to provide medical services to plan members in the event of the providers insolvency. 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. By decreasing its utilization risk, the health plan increases its underwriting risk.
Types of Risk
Regulatory Solvency and Risk-Based Capital Requirements The Development of Risk-Based Capital Requirements
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 an 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 a future lessons.
Types of Risk
Regulatory Solvency and Risk-Based Capital Requirements 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.
Types of Risk
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 an 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.
Types of Risk
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.
Types of Risk
Strategies for Controlling Risk 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 an 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 elements that financially motivate providers to avoid supplying medically unnecessary treatments. We discuss these reimbursement contracts in the next few lessons.
Types of Risk
Strategies for Controlling Risk 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 an 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 forprofit 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.
AHM Health Plan Finance and Risk Management: Risk Management in Health Plans Page No: 1-39 AHM Health Plan Finance and Risk Management: Risk Management in Health Plans
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 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 self-insured 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, highquality, 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.
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.
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 well-publicized protection provided by the Employee Retirement Income Security Act of 1974 (ERISA).3 That protection includes barring jury trials and punitive damage awards, limiting compensation to medical expenses, and preempting actions against a health plan for the "administration" of an ERISAqualified 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 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 utilization management activities. Negotiating arrangements with selective providers with proven skills and competence to 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.
The amount of risk for health plan products is dependent on the degree of influence and the relationships that the health plan maintains with its providers. Consider the following types of managed care structures: Preferred provider organization (PPO) Group model HMO Staff model health maintenance organization (HMO) Traditional health insurance
Of these health plan products, the one that would most likely expose a health plan to the highest risk is the: preferred provider organization (PPO) group model HMO staff model health maintenance organization (HMO) traditional health insurance
Answer: C
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).
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 therapists, to support the physician provider Developing promotional or marketing materials that allow a relationship to be inferred
The risk manager may wish to review documents provided to patients to ensure that the 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. The theory of vicarious liability or ostensible agency can expose a health plan to the risk that it could be held liable for the acts of independent contractors. Factors that may give rise to the assumption that an agency relationship exists between a health plan and its independent contractors include: requiring the providers to supply their own office space employing nurses and other healthcare professionals to support the physician providers requiring providers to maintain their own medical records all of the above
Answer: B
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 Application Forms Review Protocols Observe Methods Evaluate Organizational Structure Review Due Process Provisions Require Practitioners To Report Ensure HCQIA Compliance Establish Rapport Review Policies, Procedures, Bylaws, and Contracts 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.
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.
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.
Many clinicians are concerned about the development of practice guidelines that seek to define appropriate healthcare services that should be provided to a patient who has been diagnosed with a specific condition. To avoid the risk associated with using such guidelines, health plans should advise clinicians that the existence of such a guideline: 1. Establishes standards of care to be routinely utilized with all patients presenting a specific condition 2. Preempts a physicians judgment when assessing the specific factors related to a patients condition Both 1 and 2 1 only 2 only Neither 1 nor 2 Answer: D
officer or helath plan administrator, can evaluate the best ways either to fund for or to transfer this risk.
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.
The Convergence of Financial and Risk Management 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
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.
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.
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.
AHM Health Plan Finance and Risk Management: Provider Reimbursement and Plan Risk Page No: 1-33 AHM Health Plan Finance and Risk Management: Provider Reimbursement and Plan Risk
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 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.
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.
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.
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.
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 low-income state residents through Medicaid contracts.
The National Association of Insurance Commissioners (NAIC) is a nongovernmental 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.
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, 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.
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.
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.
The Jamal Health Plan operates in a state that mandates that a health plan either 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. This type of law is known as: a fair procedure law a direct access law an any willing provider law a due process law
Answer: C
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 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 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 datatracking 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. Mandated benefit laws are state or federal laws that require health plans to arrange for the financing and delivery of particular benefits. Ways that mandated benefits have the potential to influence health plans include: 1. Causing a lower degree of uniformity among health plans of competing health plans in a given market 2. Increasing the cost of the benefit 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 Both 1 and 2 1 only 2 only Neither 1 nor 2 Answer: C
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.
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.
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.
AHM Health Plan Finance and Risk Management: Provider Reimbursement Methods Page No: 1-50 AHM Health Plan Finance and Risk Management: Provider Reimbursement Methods
After completing this lesson you should be able to Discuss the advantages and disadvantages of traditional, salary, fee-forservice, 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
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.
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.
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.
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 provideremployees 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.
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 plan members that is, a larger customer base. Even providers who are not seeking to expand their plan member bases may join panels to avoid losing plan members that they already have. Finally, unlike salary reimbursement systems, providers who supply more services under FFS automatically receive higher reimbursement, 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-than-expected 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.
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 resourcebased 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.
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 nonemergency 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 costeffective 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.
Dr. Martin Cassini is an obstetrician who is under contract with the Bellerby Health Plan. Bellerby compensates Dr. Cassini for each obstetrical patient he sees in the form of a single amount that covers the costs of prenatal visits, the delivery itself, and post-delivery care . This information indicates that Dr. Cassini is compensated under the provider reimbursement method known as a: global fee relative value scale unbundling discounted fee-for-service
Answer: A
risk pool, and any deficit in the fund at the end of the period would be paid by both Dr. Winburne and Honor according to percentages agreed upon at the beginning of the contract period withhold, and any deficit in the fund at the end of the period would be the sole responsibility of Honor withhold, and any deficit in the fund at the end of the period would be paid by both Dr. Winburne and Honor according to percentages agreed upon at the beginning of the contract period Answer: B
Provider Incentive Methods: Withholds, Risk Pools, and Bonuses 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.
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.
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.
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 perdiem 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 per-diem arrangement that pays $800 per day for medical admissions, and the total allowable charges (billed charges less charges for noncovered items provided during the admission) for a 5-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. Cascade Hospital has negotiated with the McBee Health Plan a straight per-diem rate of $1,000 per day for medical admissions. One of McBees plan members was admitted to Cascade for 10 days. Total billed charges equaled $10,000, of which $2,000 were for noncovered items. This information indicates that, for this admission, the amount that McBee was obligated to reimburse Cascade was: $0 $8,000 $10,000 $12,000 Answer: C
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.
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 demonostration 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.
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 allinclusive, 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.
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.
AHM Health Plan Finance and Risk Management: Capitation in Provider Reimbursement Page No: 1-74 AHM Health Plan Finance and Risk Management: Capitation in Provider Reimbursement
payments, the provider retains the savings. In other words, in exchange for accepting financial risk of higher-than-expected utilization costs, the provider receives the right to share in any savings that occur 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
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
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. The Chamber Health Plan reimburses primary care physicians on a monthly basis by using a simple capitation method. Chamber assumes an annual utilization rate of three visits per year. The FFS rate per office visit is $75, and all plan members are required to make a $10 copayment for each office visit. This information indicates that the capitation rate that Chamber calculates per member per month (PMPM) is equal to: $6.25 $16.25 $18.75 $21.25 Answer: B
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.
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.
Global capitation
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.
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.
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.
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 services services 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.
health plan will be insufficient to meet the entitys fixed PMPM obligations to its subcapitated physicians.
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.
and financial investment and can present a significant barrier for provider organizations seeking global capitation arrangements.
Absorbed by the health plan (e.g., expensive services excluded from a riskpool calculation)
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.
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.
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
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
them single signature authority, which enables the IPA or PHO to sign a binding contract with a health plan.
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.
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.
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.
contracts will want to know the fee-for-service equivalent fees they received for each unit of service.
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.
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
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.
AHM Health Plan Finance and Risk Management: Risk Transfer in Health Plans Page No: 1-27 AHM Health Plan Finance and Risk Management: Risk Transfer in Health Plans
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 selffunded 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. The Longview Hospital contracted with the Carlyle Health Plan to provide inpatient services to Carlyles enrolled members. Carlyle provides Longview with a type of stop-loss coverage that protects, on a claims incurred and paid basis, against losses arising from significantly higher than anticipated utilization rates among Carlyles covered population. The stop-loss coverage specifies an attachment point of 130% of Longviews projected $2,000,000 costs of treating Carlyle plan members and requires Longview to pay 15% of any costs above the attachment point. In a given plan year, Longview incurred covered costs totaling $3,000,000. With regard to the type of stop-loss coverage provided to Longview by Carlyle and to whether this coverage is classified as insurance or reinsurance, the risk transfer approach used in this situation can be described as: aggregate stop-loss reinsurance aggregate stop-loss insurance specific stop-loss reinsurance specific stop-loss insurance Answer: B
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.
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. The Longview Hospital contracted with the Carlyle Health Plan to provide inpatient services to Carlyles enrolled members. Carlyle provides Longview with a type of stop-loss coverage that protects, on a claims incurred and paid basis, against losses arising from significantly higher than anticipated utilization rates among Carlyles covered population. The stop-loss coverage specifies an attachment point of 130% of Longviews projected $2,000,000 costs of treating Carlyle plan members and requires Longview to pay 15% of any costs above the attachment point. In a given plan year, Longview incurred covered costs totaling $3,000,000. For the year in which Longviews incurred covered costs were $3,000,000, the amount for which Longview will be responsible is: $2,000,000 $2,600,000 $2,660,000 $3,900,000 Answer: C
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 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. The Longview Hospital contracted with the Carlyle Health Plan to provide inpatient services to Carlyles enrolled members. Carlyle provides Longview with a type of stop-loss coverage that protects, on a claims incurred and paid basis, against losses arising from significantly higher than anticipated utilization rates among Carlyles covered population. The stop-loss coverage specifies an attachment point of 130% of Longviews projected $2,000,000 costs of treating Carlyle plan members and requires Longview to pay 15% of any costs above the attachment point. In a given plan year, Longview incurred covered costs totaling $3,000,000. Carlyle most likely is responsible for paying Longview for the claims incurred before Longview has actually paid the medical expenses. True False Answer: B
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 high-cost 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.
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.
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.
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.
securing stop-loss coverage. The greater the financial strength of the stop-loss carrier, the lower the health plans affiliate risk.
AHM Health Plan Finance and Risk Management: Health Plan Funding Page No: 1-12 AHM Health Plan Finance and Risk Management: Health Plan Funding
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.
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.
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.
Cover administrative and selling expenses, including administrator fees and broker or agent commissions Provide some profit for the health plan or insurer
Under a self funded plan with separate stop loss insurance coverage or a partially self 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.
In a self-funded plan, an employer is relieved of all risk associated with paying for the healthcare costs of its employees. Self-funded plans are subject to the same state laws and regulations that apply to health insurance policies. Employers electing to self-fund a health plan are required to pay claims from a separate trust established for that purpose. An employer electing to self-fund a health plan has the option of purchasing stop-loss insurance to transfer part of the financial risk to an insurer. Answer: D
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.
AHM Health Plan Finance and Risk Management: Alternative Funding Methods Page: 1-20 AHM Health Plan Finance and Risk Management: Alternative Funding Methods
example, the discussion of cost savings and improved cash flow is from an employers perspective, rather than that of a health plan. However, the underlying definitions and concepts remain valid for health plans. Generally, whenever this lesson discusses an insurance company or insurer, the statement also applies to health plans, which are sometimes referred to as medical expense plans. Also, keep in mind that the term claims in the context of health plans refers to medical expenses or expenses for healthcare services provided to or for plan members. Figure 5B-1 is a list of the definitions of several key terms that are not defined in the lesson itself.
In contrast to the first category of alternative funding methods, some of these alternatives can be used by small employers. With regard to alternative funding arrangements, the part of a health plan premium that is intended to contribute to the claims reserve that a health plan maintains to pay for unusually high utilization is known as the: interest charge retention charge risk charge surplus Answer: C
Premium-Delay Arrangements
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.
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.
Answer : C
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. A noncontributory plan. A nonunion situation. The ability to effectively and efficiently handle claims. The ability to provide other administrative services. The ability to obtain discounts from medical care providers if medical expense benefits are self-funded.
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 self-funding, 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 self-administered 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, self-administration 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.
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. Advantages to a company that elects to self-fund and to administer all aspects of its healthcare benefit plan include: eliminating state premium taxes avoiding state-mandated benefit requirements improving its cash flow position all of the above Answer: D
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.
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 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.
the trust is properly funded, ASO contracts and stop-loss coverage can be purchased.
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-than-half-time employees, and (4) employees covered by a collectivebargaining 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.
AHM Health Plan Finance and Risk Management: Financial Aspects of Medicare and Medicaid for Health Plans Pages No: 1-63 AHM Health Plan Finance and Risk Management: Financial Aspects of Medicare and Medicaid for Health Plans
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
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.
who are not enrolled under a Medicare contract but are enrolled under the health plans commercial lines of business.
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
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-than-average 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. Health plans with risk-based Medicare contracts are required to calculate and submit to CMS a Medicare adjusted community rate (Medicare ACR). Medicare ACR can be defined as the: estimated cost of providing services to a beneficiary under Medicare FFS, adjusted for factors such as age and gender health plans estimate of the premium it would charge Medicare enrollees in the absence of Medicare payments to the health plan average amount the health plan expects to receive from CMS per beneficiary covered health plans actual costs of providing benefits to Medicare enrollees in a given year Answer: B
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.
The types of financial risks and costs to which a health plan is subject depends on whether the health plan provides services to the Medicare and/or Medicaid populations or to the commercial population. One distinction between providing services to the Medicare and Medicaid populations and to the commercial population is that Medicare and Medicaid enrollees typically: are locked into a plan for a 12-month period, whereas enrollees from the commercial population may disenroll from a plan on a monthly basis require less enrollee education than do enrollees from the commercial population have higher incidences of chronic illness than do enrollees from the commercial population are enrolled in a health plan through a group situation, whereas the commercial population typically enrolls in a health plan on an individual basis Answer: C
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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits 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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits Medicaid Eligibility Groups Eligible to Enroll in Health Plans
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 Medicaidcontracting health plan, but would not be able to require the same beneficiary to obtain Medicare-covered services from a health plan. Geena Falk is eligible for both Medicare and Medicaid coverage. If Ms. Falk incurs a covered expense, then: Medicaid will be Ms. Falks primary insurer Medicare will be Ms. Falks primary insurer either Medicare or Medicaid will be Ms. Falks primary insurer depending on her election Medicare and Medicaid will each be responsible for one-half of Ms. Falks covered expense Answer: B
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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits 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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits Guaranteed Eligibility Provision
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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits 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 Medicaid-contracting health plans. Because it was unlikely that all Medicaidcontracting 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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits Cost of Compliance with Medicare and Medicaid Regulatory Requirements
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 Medicarecontracting 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 Medicare-contracting 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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits Cost of Compliance with Medicare and Medicaid Regulatory Requirements
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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits Cost of Compliance with Medicare and Medicaid Regulatory Requirements
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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits Cost of Compliance with Medicare and Medicaid Regulatory Requirements
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.
Financial Risk of Providing Services to Medicare and/or Medicaid Benefits Cost of Compliance with Medicare and Medicaid Regulatory Requirements
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 Medicaid-contracting health plans.
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.
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.
Paying Providers to Provide Medicare and/or Medicaid Services 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. Juan Ramirez, a licensed social worker, and Dr. Laura Lui, a licensed psychiatrist, are under contract to the Peninsula Health Plan. Peninsula has contracted with CMS to provide services to Medicare and Medicaid beneficiaries. Both Mr. Ramirez and Dr. Lui provide the same type of counseling services to Peninsula's enrollees. With respect to amendments made to the Balanced Budget Act (BBA) of 1997 that impact provider reimbursement, the amount by which Peninsula will reimburse Mr. Ramirez will be equal to:
50% of Dr. Lui's reimbursement 75% of Dr. Lui's reimbursement 90% of Dr. Lui's reimbursement 100% of Dr. Lui's reimbursement Answer: D
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 anti-kickback 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.
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.
Medicaid-contracting health plans were more recently added by regulation to this list of exceptions to the self-referral ban.
Typically, health plans enter into one contract with a provider that covers all the health plans lines of business.
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.
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.
Structuring Provider Payment Arrangements 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.
Structuring Provider Payment Arrangements Providers and Financial Risk in Medicare and Medicaid
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.
Structuring Provider Payment Arrangements Providers and Financial Risk in Medicare and Medicaid
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 risksharing arrangements to serve its business purposes, and then performs an analysis of the arrangements compliance with the physician incentive law.
Structuring Provider Payment Arrangements Providers and Financial Risk in Medicare and Medicaid
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. Correct statements about the financial risks associated with benefits that health plans provide to the Medicare and Medicaid markets include: that, because the government sets the payments received by health plans, the health plans cannot easily obtain an increase in those payments even in the face of rising costs that regulators determine which services must be provided under Medicare and Medicaid and which persons are eligible to enroll in a plan that 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 all of the above
Answer: D
Under Medicaid, some providers that have traditionally provided services to lowincome 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 Medicare-contracting 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.
Structuring Provider Payment Arrangements 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.
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.
Structure its payment arrangements to attract providers who will work well in a health plan environment Provide incentives to appropriately control utilization and manage care, and to be consistent with the health plans financial goals given the payment rate that the health plan receives from the state or federal government.
AHM Health Plan Finance and Risk Management: The Relationship Between Rating and Underwriting Pages No: 1-45 AHM Health Plan Finance and Risk Management: The Relationship Between Rating and Underwriting
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
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)
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. The following paragraph contains two pair of terms enclosed in parentheses. Determine which term in each pair correctly completes the statements. Then select the answer choice containing the two terms you have chosen.
In a typical health plan, an (actuary / underwriter) is ultimately responsible for the determination of the appropriate rate to charge for a given level of healthcare benefits and administrative services in a particular market. The (actuary / underwriter) assesses and classifies the degree of risk represented by a proposed group or individual. actuary / actuary actuary / underwriter underwriter / actuary underwriter / underwriter Answer: B
the HMO because they are less likely to be concerned about the limits imposed by the HMO.
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.
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).
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.
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.
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.
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 multiplechoice environment in more detail in Pricing a New Health Plan.
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.
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.
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.
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 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.
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. In evaluating the claims experience during a given rating period of the Lucky Company, the Calaway Health Plan determined that the claims incurred by Lucky were lower than Calaway anticipated when it established Luckys premium rate for the rating period. Calaway, therefore, refunded a portion of Luckys premium to reflect the better-than-anticipated claims experience. This rating method is known as: durational rating retrospective experience rating blended rating prospective experience rating Answer: B
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.
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:
The Norton Health Plan used blended rating to develop a premium rate for the Roswell Company, a large employer group. Norton assigned Roswell a credibility factor of 0.7 (or 70%). Norton calculated Roswells manual rate to be $200 and its experience claims cost as $180. Nortons retention charge is $3. This information indicates that Roswells blended rate is:
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.
AHM Health Plan Finance and Risk Management: Group Underwriting Pages No: 1-40 AHM Health Plan Finance and Risk Management: Group Underwriting
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
Group Underwriting
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.
Group Underwriting
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.
Group Underwriting
Federal Laws and Regulations 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.
Group Underwriting
Federal Laws and Regulations 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 broadreaching 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.
Group Underwriting
Federal Laws and Regulations
Group Underwriting
Federal Laws and Regulations 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.
Group Underwriting
Federal Laws and Regulations 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 ratesetting process.
Group Underwriting
Federal Laws and Regulations Health Insurance Portability and Accountability Act
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.
Group Underwriting
Federal Laws and Regulations Health Insurance Portability and Accountability Act
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.
Group Underwriting
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.
Group Underwriting
State Laws and Regulations
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.
Group Underwriting
State Laws and Regulations
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.
Group Underwriting
State Laws and Regulations
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.
Group Underwriting
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.
Group Underwriting
Major Risk Factors in Group Underwriting
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 25year-old females. A health plan may also have to adjust published or proprietary morbidity rates to account for non-sex-related differences. For example, an HMO with half its plan members from a steel 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.
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
Key Aspects of Group Underwriting
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 an 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.
Group Underwriting
Key Aspects of Group Underwriting
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.
Group Underwriting
Group Underwriting
Key Aspects of Group Underwriting 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 Multiple-Employer Groups Professional Associations
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 MultipleEmployer 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 rofessional 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 Underwriting
Key Aspects of Group Underwriting 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.
The Arista Health Plan is evaluating the following four groups that have applied for group healthcare coverage: The Blaise Company, a large private employer The Colton County Department of Human Services (DHS) A multiple-employer group comprised of four companies The Professional Society of Daycare Providers
With respect to the relative degree of risk to Arista represented by these four companies, the company that would most likely expose Arista to the lowest risk is the: Blaise Company Colton County DHS multiple-employer group Professional Society of Daycare Providers Answer: A
Group Underwriting
Key Aspects of Group Underwriting 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 newparticularly youngenrollees, because such flow helps maintain the desired age spread in a group.
Group Underwriting
Key Aspects of Group Underwriting 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.
Group Underwriting
Group Underwriting
Key Aspects of Group Underwriting Stability
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.
Group Underwriting
Key Aspects of Group Underwriting 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.
Group Underwriting
Key Aspects of Group Underwriting 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 experiencebased 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
Group Underwriting
Group Underwriting
Group Underwriting
Key Aspects of Group Underwriting 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.
Group Underwriting
Key Aspects of Group Underwriting 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.
Group Underwriting
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? How many employees want to cover their spouses? 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? 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)?
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)?
Johann Benini, his 80-year-old father who relies on Julio for support and maintenance The health plan most likely would consider that the definition of a dependent, for purposes of healthcare coverage, applies to:
Elena, Maria, and Johann Elena and Maria only Elena only Maria only
Answer: B
Group Underwriting
Key Aspects of Group Underwriting 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.
Group Underwriting
Group Underwriting
Key Aspects of Group Underwriting Prior Coverage and Claims Experience
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 claim Billing statements Employee plan description material Information about disabled employees and dependents
Note, however, that it may be difficult for health plans to obtain even one years documentation, depending on the employer and its previous coverage.
Group Underwriting
Key Aspects of Group Underwriting 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-than-average 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.
Group Underwriting
Key Aspects of Group Underwriting 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.
Group Underwriting
Key Aspects of Group Underwriting 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.
Group Underwriting
Group Underwriting
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.
AHM Health Plan Finance and Risk Management: Small Group and Individual Underwriting Pages No: 1-43 AHM Health Plan Finance and Risk Management: Small Group and Individual Underwriting
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
The Raven Health Plan is domiciled in a state that requires the health plan to offer small employers and their employees a comprehensive healthcare benefit plan that approximates the healthcare benefits available to large employer-employee groups. This type of uniform benefit plan is known as: a basic plan a low-option plan a standard plan an essential plan Answer: C
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.
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.
The following statements are about the Health Insurance Portability and Accountability Act (HIPAA) as it relates to the small group market. Three of these statements are true and one statement is false. Select the answer choice containing the FALSE statement.: A health plan that participates in the small group market is required to issue a contract to any employer that requests healthcare benefits, as long as the employer meets the statutory definition of a small group. A small group must consist of more than 10 employees in order to be underwritten on a group, rather than an individual, basis. A health plan is prohibited from canceling a small groups healthcare coverage because of poor claims experience. A health plan that participates in the small group market is limited in placing restrictions such as waiting periods and pre-existing conditions exclusions to individuals in high risk categories. Answer: B
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.
Small Group Reform Laws and Underwriting 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.
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.
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.
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. In a comparison of small employer-employee groups to large employer-employee groups, it is correct to say that small employer-employee groups tend to: more closely follow actuarial predictions with respect to morbidity rates generate more administrative expenses as a percentage of the total premium amount the group pays have less frequent and smaller claims fluctuations expose an health plan to a lower risk of antiselection Answer: B
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 groupsize 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.
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.
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.
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.
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 rates? Is the group seeking to add employees who were not covered under the prior health plans health plan and would have been considered late entrants under that plan? Are certain dependents being added who were not covered by the prior plan?
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.
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.
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.
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.
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.
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. The following statements are about state health coverage reinsurance programs. The reinsurance offered through these programs is administered on a for-profit basis by the federal government. The purpose of these programs is to reinsure MCOs and other carriers who offer guaranteed healthcare plans to small employers. These programs must reinsure only an entire small group, not specific individuals within a group. Any shortfalls in the pool established by these programs are funded by the state government. Answer: B
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
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.
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-thanaverage 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 less-than-average risk of loss Modifications and exclusions Any combination of a higher premium rate, modifications, and exclusions
To evaluate the risk represented by an applicant, underwriters use a numerical rating 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.
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.
conditions as arthritis, back injuries, spinal curvature, recurring bronchitis, gallstones or kidney stones, and mild neuroses are examples.
Background: Medicare and Medicaid Payment to Health Plans 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.
AHM Health Plan Finance and Risk Management: Pricing a Health Plan Pages No: 1-28 AHM Health Plan Finance and Risk Management: Pricing a Health Plan
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.
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.
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.
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.
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 twoyear 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. Generally, both the level of underwriting risk that an MCO assumes in providing benefits and the market competition it encounters directly affect the size of the assumed underwriting margin in a health plan. The following statement(s) can correctly be made about an MCOs assumed underwriting margin: 1. The more competition a health plan faces in the marketplace, the larger the plans assumed underwriting margin. 2. The greater the underwriting risk of a health plan, the larger the plans assumed underwriting margin. Both 1 and 2 1 only 2 only Neither 1 nor 2
Answer: C
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 longterm 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.
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.
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.
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.
health planssuch as an HMO, a PPO, and an HMO with a POS optionin a multiplechoice environment include the Actuarial value of each plan options benefits, provider reimbursement arrangements, utilization management differences, retention charges, and expense margins HMO/non-HMO enrollment mix In-network and out-of-network provider utilization under the non-HMO option Relative cost of benefits for those plan members who enroll in a non-HMO option, compared to the costs for those plan members who enroll in the HMO
Note that this discussion focused on a specific scenario: one health plan that offers several 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.
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.
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.
AHM Health Plan Finance and Risk Management: Rate-Setting in Health Plans Pages No: 1-17 AHM Health Plan Finance and Risk Management: Rate-Setting in Health Plans
Four Tier Rates(1) Single, (2) Couple, (3) Family, and (4) Subscriber plus child(ren). Five Tier Rates(1) Single, (2) Couple, (3) Family, (4) Subscriber plus children, and (5) Subscriber plus child.
The effect of a typical family rate ratio is that a family rate is somewhat higher than it otherwise should be, and the single rate is somewhat lower that it otherwise should be. Answer: A
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.
providers, and (3) out-of-area 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.
Cost sharing features in a traditional indemnity plan often include deductibles, coinsurance, out-of-pocket maximums, and plan maximums. One example is a $100 deductible, 80/20 coinsurance, a $1,100 out-of-pocket maximum (including the deductible), and a $1,000,000 lifetime 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.
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
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-of-network costs to arrive at a composite claims cost for the PPO plan.
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: Accounting Principles and Concepts Pages No: 1-25 AHM Health Plan Finance and Risk Management: Accounting Principles and Concepts
a companys financial condition, including what the company owns, what it owes, what it earns, what it spends, and what it retains. To successfully manage a complex, dynamic company, the companys managers must have ready access to all sorts of financial transaction records and reports. Accounting provides a structured way of summarizing and reporting the information contained in a companys financial records so that a companys managers can stay abreast of the companys financial condition and profitability. In so doing, accounting enables a companys managers to make informed decisions about managing the companys resources.
solvency).3 Note that a company that must comply with statutory requirements can follow both sets of accounting principles for financial reporting, depending on the purpose for reporting financial information. In other words, the use of GAAP and SAP in companies that must comply with both sets of requirements is not mutually exclusive. Note that, whenever we discuss GAAP, we mean U.S. GAAP and that, whenever we discuss SAP, we mean codified statutory requirements.
Under the entity concept, a company can define its own accounting entities. For example, a corporation is an entity for accounting purposes. Within the entity of the corporation, however, there can be many additional entities. If a health plan owns subsidiary companies, and each subsidiary prepares its own financial statements, then each subsidiary is an accounting entity. Further, accounting entities within the health plan can be smaller portions of the company itself, such as divisions, departments, lines of business, profit centers, and so on. Typically, entities at lower levels of a health plan maintain detailed records of accounting transactions; these records in turn are summarized and consolidated into the health plans overall financial reports. To understand and interpret a company's financial information, and to compare this information with information about one or more other companies, an interested user must first be able to identify which entity the company's financial statements represent: Is it the parent company alone? An individual subsidiary? Or a consolidation of the parent company and one or more subsidiaries? The use of GAAP and SAP in financial statements benefits users of financial information because each set of accounting principles and practices specifies the requirements concerning how a health plan accounts for all its financial activities.
Accounting principles provide two methods for identifying the correct entity. First, a company must clearly label each entity's financial statements with the entity's name. If the statements are for the Keycard Company only, then the headings should read "Keycard Company." If the statements are consolidated financial statements for Keycard and its subsidiaries, then the headings should read "Consolidated Financial Statements of Keycard Company." Suppose Keycard is the parent company of two
subsidiaries: an HMO and an insurance company. In this case, the HMO and the insurance company are accounted for as separate entities; in turn, their financial results would be included in Keycards consolidated financial statements. Second, the Financial Accounting Standards Board (FASB), a private organization whose purpose is to establish and promote GAAP in the United States, requires that the activities of a parent company's various business operations be disclosed in the companys annual report to stockholders. Typically, these disclosures are made in notes and supplementary information that accompany a company's consolidated financial statements. These notes describe in detail the source of the amounts represented on the consolidated statements. The National Association of Insurance Commissioners (NAIC) prescribes statutory accounting practices.
The going-concern concept means that accounting processes are typically based on the assumption that a company will continue to operate for an indefinite period of time. Thus, unless there is evidence to the contrary, accounting does not assume that a company is about to be liquidated. From another perspective, liquidation typically reflects the process of converting a company's assets (things owned by a company) to cash, usually to pay off all of a company's liabilities. (Endnote 6) For example, suppose the state insurance commissioner, acting for the state court, takes control of and administers an insolvent HMOs business. In this case, all of the HMOs business and assets are transferred to other carriers or are sold to satisfy the HMOs outstanding obligations, and the HMOs business is terminated.
All publicly traded health plans in the United States are required to prepare financial statements for use by their external users in accordance with generally accepted accounting principles (GAAP). In addition, health insurers and health plans that fall under the jurisdiction of state insurance departments are required by law to prepare certain financial statements in accordance with statutory accounting practices (SAP). In a comparison of GAAP to SAP, it is correct to say that: GAAP is established and promoted by the National Association of Insurance Commissioners (NAIC), whereas SAP is established and promoted by the Financial Accounting Standards Board (FASB) the going-concern concept is an underlying premise of GAAP, whereas SAP tends to focus on the liquidation value of the MCO or the insurer
GAAP provides for a single method of valuing all of a health plans assets, whereas SAP offers the health plan more than one method for valuing its assets the principle of conservatism is fundamental to GAAP, whereas SAP generally is not conservative in nature Answer: B
For example, when the total dollar amount of fee-for-service (FFS) payments to providers equals the amount recorded for such payments in a health plan's accounting records and source documents, then the information is considered to be reliable. If information is to be reliable, a health plan must record a given transaction in a consistent manner each time a similar transaction occurs. An independent third party must be able to evaluate and interpret specific amounts on a financial statement easily and through standard techniques. Note, however, that there are many areas in which judgment must be used to determine the particular dollar amount of a business transaction. It is important that the methods and estimates be fair. For example, the amounts of incurred but not reported (IBNR) claims, deferred acquisition costs, and premiums due and unpaid
must be accounted for objectively and reasonably. The majority of an insurers financial obligations consist of IBNR claims.
Figure 10A-3 is an excerpt from a hypothetical health plan's notes to the financial statements regarding changes in accounting policies. The effect of an accounting change can be documented on a Retroactive basis Cuttent basis Prospective basis
Mathematical errors or incorrect account classifications do not qualify as accounting changes. Therefore, a company treats an adjustment made on a retroactive basis to disclose the effects of an accounting change separately from an adjustment made to correct an accounting error. Because accounting changes affect a company's financial statements, an independent auditor must note in its opinion whether the company has consistently applied the same accounting policies and procedures over time. The auditor must also comment on the validity of the accounting change.
Retroactive basis
for example, an adjustment to correct a material error in a previous accounting period Cuttent basis for example, an adjustment to the previous years net income to determine the current years net income Prospective basis for example, spreading the effects on income over the current and future accounting periods
company to disclose the nature and impact of any changes to its accounting policies or procedures. While the concept of comparability enables users to compare and note trends in a companys financial performance from one accounting period to the next, the value of such comparisons is virtually useless if the concept of consistency is not applied to the financial statements.
The effectiveness of comparability also depends on the use of uniform accounting principles and concepts among different companies. Although publicly traded health plans, publicly traded health insurance companies, and mutual health insurers may all follow GAAP, within GAAP itself there are a number of acceptable methods of valuing assets and liabilities, recognizing revenues and expenses, and calculating net income. Unfortunately, diversity in the use of GAAP and SAP can reduce the effectiveness of comparing financial statements between two different companies. In the United States, state laws and regulations govern the implementation of SAP, with which all insurers and specified health plans must comply. Although many states have adopted the NAIC model laws, each states definition may vary with respect to the calculation of a particular account value, for example, and these variations can affect comparability.
The accounting concept of materiality requires that companies disclose all significant information in their financial statements. Significant or material information is information that, if a company omitted it or presented it in a misleading manner, could substantially affect an interested user's opinion of the company. Materiality has two related aspects. First, materiality requires a company to include in its financial statements all significant accounting information. This aspect relates to the concept of full disclosure, which we discuss later in this lesson. Second, materiality relieves a company from having to report all items as if each item carried the same financial significance. For example, under materiality, a company does not have to treat a pencil with the same significance as its automated accounting system. Both are assets, but the automated accounting system has greater materiality than a pencil.
In practice, whether accounting information is material or not relies heavily on the judgment of a company's accountants and management. Materiality also may vary from company to company. The purpose of an entitys financial reports, the size of the entity, and common sense, among other factors, significantly impact materiality. Further, what is material to one user of financial information may not material to another user. For example, a $100,000 financial obligation means something different to a health plan that is starting up than it does to a multibillion dollar established health plan. In another example, a large health plan may consider office supply purchases of less than $5,000 to be immaterial. However, a much smaller health plan may establish a lower minimum requirement, perhaps $100, for materiality purposes. The subject of the information also helps to determine its materiality. For example, a health plan may decide that a $2,000 difference in the way it calculates a particular expense is immaterial, but a $2,000 difference in cash is material. Most companies establish a percentage of net income below which a monetary amount is immaterial. A health plan may decide, for example, that only dollar amounts that are greater than 4% of the health plans net income are material to its income statement. The health plan would include items that are below this threshold, but it would not separately list them on its financial statements.
However, the combined effect of many individually immaterial items may produce an aggregate result that is material to the company's financial information. For this reason, the magnitude of a transaction or the dollar amount or percentage relationship to an account classification is only one clue as to the transaction's materiality. The effects that an item may have on a company's solvency and profitability can also determine its materiality. Ultimately, though, the rule for applying the concept of materiality is as follows: If the disclosure, the lack of disclosure, or the misrepresentation of an item of information could lead interested users to change their opinions about the company's financial strength or profitability, then the item is material in nature.
By its nature, accounting is conservative. This quality helps to offset the tendency of many businesses (and many people) to overstate their successes and understate their failures. In accounting terminology, conservatism is the choice of a financial reporting method that results in the projection of lower values for a company's assets, higher values for its liabilities and expenses, and a lower level of net income than would be the case if a company used a more optimistic reporting method. The intent of accounting conservatism is to protect customers, investors, the general public, and the companies themselves from unforeseen occurrences and from
problems that can arise from an imprudently optimistic point of view. According to the principle of conservatism, a company (1) records revenues only when they are certain; (2) records expenses when they are expected, not necessarily certain; (3) reports losses immediately; and (4) reports gains only after they actually occur.
AHM Health Plan Finance and Risk Management: Principles for Maintaining Accounts Pages No: 1-26 AHM Health Plan Finance and Risk Management: Principles for Maintaining Accounts
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. The Wallaby Health Plan purchased an asset two years ago for $50,000. At the time of purchase, the asset had an appraised value of $52,000. The asset carries a value on Wallabys general ledger of $47,000, and its current market value is $80,000. According to the cost concept, Wallaby would report on its financial statements a value for this asset equal to: $47,000 $50,000 $52,000 $80,000 Answer: B
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.
Because many individuals need financial information periodically during the life of the company, the time-period concept has evolved.
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.
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.
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.
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. The Proform Health Plan uses agents to market its small group business. Proform capitalizes the commission expense relating to this line of business by spreading the commissions over the premium-paying period of the healthcare coverage. This approach to expense recognition is known as:
systematic and rational allocation matching principle immediate recognition associating cause and effect Answer: D
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.
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.
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
AHM Health Plan Finance and Risk Management: Financial Statements Pages No: 1-28 AHM Health Plan Finance and Risk Management: Financial Statements
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
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.
Financial Statements
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-for-profit health plans may send an annual report to their policyholders and to other interested parties as part of communicating their service strength, for example.
Financial Statements
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
Financial Statements
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.
Financial Statements
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.
Financial Statements
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.
Financial Statements
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:
Financial Statements
Balance Sheet
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 entity, owns. The right side of the equation (Liabilities and Owners' Equity) represents what the health 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.
Financial Statements
Balance Sheet
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.
Financial Statements
Balance Sheet
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
Financial Statements
Balance Sheet
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.
Financial Statements
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
Financial Statements
Income Statement
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.
Financial Statements
Income Statement
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.
Financial Statements
Income Statement
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.
Financial Statements
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.
Financial Statements
Income Statement 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)?
Financial Statements
Income Statement 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.
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
Financial Statements
Income Statement 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)
Financial Statements
Income Statement Cash Flow Statement
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 account) Paying expenses (a decrease in an expense account)
You can calculate a company's net cash flow for an accounting period by using the following formula:
Financial Statements
Income Statement Cash Flow Statement
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 Investing activities Financing 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. Changes in a companys cash flow occur as the result of three activities: operating activities, investing activities, and financing activities. Activities that would be considered financing activities include: issuing common stock purchasing bonds receiving investment income paying expenses associated with healthcare services
Answer: A
Financial Statements
Income Statement 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.
Financial Statements
Income Statement Cash Flow Statement
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.
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
Financial Statements
Statement of Owners' Equity
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.
$ $
50,000 100,000
Total Liabilities and Stockholders Equity $ 1,050,000 This type of financial statement is called: a balance sheet an income statement a statement of owners equity a cash flow statement Answer: A
Financial Statements
Statement of Owners' Equity 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.
Financial Statements
Financial Statements
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 long-term liabilities (balance sheet accounts), depending on the nature of the expense. Note also that
The $56,851 of net income on Sheridan Health 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
Financial Statements
Financial Statement Integration
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.
AHM Health Plan Finance and Risk Management: The Strategic Plan Pages No: 1-16 AHM Health Plan Finance and Risk Management: The Strategic Plan
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.
As the first part of its strategic planning process, the Lakeland Health Plan developed the following statements: Statement 1 We will be recognized as the leader in the healthcare industry in all of our markets by the end of the next decade. Statement 2 We will deliver and finance quality healthcare at a reasonable cost to our customers.
From the answer choices below, select the response that correctly identifies these statements as vision statements or mission statements. Statement Statement Statement Statement Statement Statement Statement Statement Answer: B 1: 2: 1: 2: 1: 2: 1: 2: vision vision vision mission mission mission mission vision
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.
Figure 11A-2. SWOT Analysis: Analyzing Strengths and Weaknesses Within an MCO.
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.
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.
The Strategic Planning Process 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.
The Strategic Planning Process Implement and Monitor the Strategic 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) Health Plan Employer Data and Information Set (HEDIS) Servicefor example, average telephone wait time Financefor example, cash flow or net income
Leadership could be defined in terms of market share (service), public policy influence (quality), financial success (finance), or a combination of all three. Other metrics of interest to health 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.
AHM Health Plan Finance and Risk Management: The Strategic Financial Plan Pages No: 1-29 AHM Health Plan Finance and Risk Management: The Strategic Financial Plan
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 11B-1 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.
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.
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 for-profit 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.
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.
The following information relates to the capital structure of the Laredo Health Plan: After-Tax Type of Capital Percent of Capital Cost Rate Debt 0.40 0.07 Equity 0.60 0.13 This information indicates that Laredos weighted average cost of capital (WACC) is equal to: 4.7% 5.3% 9.4% 10.6% Answer: D
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.
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.
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.
have the needed cash available to implement its strategic plan. We explore these types of assumptions in the next lesson. Pro forma financial statements project what a companys financial condition will be at the end of an accounting period, assuming that the company achieves its objectives. Key drivers of assumptions used to project a companys assets include: cash flows accounts receivable as a percent of premium space required for continuing operations all of the above
Answer: D
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 sticks that 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.)
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.
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.
Implementing and Monitoring the Strategic Financial Plan Management Incentives and the Strategic Plan
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.
AHM Health Plan Finance and Risk Management: Financial Statement Analysis Pages No: 1-30 AHM Health Plan Finance and Risk Management: Financial Statement Analysis
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.
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:
This information indicates that Sheridans which is required if the MCO is regulated Sheridan Health Networks, Inc. Comparative Balance Sheets
($000s) As of December 31, 1997 1998 Assets Current Assets: Cash and cash equivalents $ 290,963 $ 312,047 Investment securities, at market value 775,652 810,512 Receivables, net 234,363 274,936 Other current assets 13,001 14,763 Total Current Assets $1,313,979 $1,412,258 Property and equipment, net 28,798 31,443 Intangible assets 174,627 182,091 Long-term investments 25,705 27,346 Other non-current assets 12,148 11,417 Total Assets $1,555,257 $1,664,555
Liabilities and Stockholders Equity Current Liabilities: Medical claims payable $ 330,665 $ 359,712 Reserves for future policy benefits 120,000 130,542 Unearned premiums 52,584 60,721 Accounts payable and accrued expenses 93,110 97,480 Experience rated and other refunds 63,906 71,538 Other current liabilities 77,428 78,314 Total Current Liabilities $ 737,693 $ 798,307 Reserves for future policy benefits, noncurrent 83,008 89,829 Long-term debt 217,000 221,405 Other noncurrent liabilities 11,771 13,662 Total Liabilities $1,049,472 $1,123,203 Stockholders Equity Common stock 175 175 Treasury stock, at cost (26) (26) Additional paid-in capital 220,578 220,578 Unrealized valuation adjustment (1,271) (1,271) Retained earnings 286,329 321,896 Total Stockholders Equity $ 505,785 $ 541,352 Total Liabilities and Stockholders Equity $1,555,257 $1,664,555
($000s) For the years ended December 31, 1997 1998 Revenues: Premium Revenue $1,306,976 $1,431,518 Management Services Revenue 95,809 99,037 Investment Income 53,826 57,546 Total Revenues $1,456,611 $1,588,101 Operating Expenses: Healthcare Services and Other Benefits 1,061,320 1,157,442 Selling Expense 65,131 68,259 General and Administrative Expense 213,275 238,148 Nonrecurring Costs 3,634 2,784 Total Operating Expenses $1,343,360 $1,466,633 Operating Income $ 113,251 $ 121,468 Interest Expense 9,165 11,782 Other Expense, Net 8,537 9,054 Income before Provision for Income Taxes $ 95,549 $ 100,632 Provision for Income Taxes 38,698 40,253 Net Income $ 56,851 $ 60,379
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 Stable Rapid
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
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.
|| 110 index number $180 million 150 million 30 million 150 million 0.20 100 20% increase || 120 index number $120 million 100 million 20 million 100 million 0.20 100 20% increase || 120 index number $140 million 100 million 40 million 100 million 0.40 100 40% increase || 140 index number 1996 $150 million = base period amount = 100 index number 1996 $100 million = base period amount = 100 index number 1997 1998 1997 1998 $38 million 40 million -2 million 40 million -0.05 100 5% decrease || 95 index number $5 million 10 million -5 million 10 million -0.50 100 50% decrease || 50 index number
$2 million 10 million -8 million 10 million -0.80 100 80% decrease || 20 index number 1996 $40 million = base period amount = 100 index number 1996 $10 million = base period amount = 100 index number 1997 1998 1997 1998 $40 million = $40 million base period with 0% increase = 100 index number
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 1998 given 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.
150 million 30 million 150 million 0.20 100 20% increase || 120 index number $120 million 100 million 20 million 100 million 0.20 100 20% increase || 120 index number $140 million 100 million 40 million 100 million 0.40 100 40% increase || 140 index number 1996 $150 million = base period amount = 100 index number 1996 $100 million = base period amount = 100 index number 1997 1998 1997 1998
10 million -0.80 100 80% decrease || 20 index number 1996 $40 million = base period amount = 100 index number 1996 $10 million = base period amount = 100 index number 1997 1998 1997 1998 $40 million = $40 million base period with 0% increase = 100 index number
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.
Insight 12A-1. Four-Year Trends Show Drop in HMO Net Income Despite Steady Rise in Enrollments, Revenues.
Health maintenance organizations in 1997 experienced an industrywide loss of $900 million, which yielded a return on equity of minus 8%. This compares with 1994, when earnings peaked at more than $2.7 billion to produce an impressive 36% ROE. These trends, based on data from Bests Aggregates & Averages HMO, are of particular interest when viewed against enrollment and revenue data. HMO enrollment increased 72% from December 1993 to December 1997, and total revenues rose 77% during that period. This disparity between net income and total revenue is due, in part, to competitive pricing, escalating claim costs and growing administrative expenses relating to various business initiatives. HMOs now insure a broader cross section of the population (not just the healthy). This development highlights the need for HMOs to provide care that is both efficient and clinically appropriate. A closer look reveals other interesting trends. HMOs in the Pacific Region which is dominated by the California markethave performed best. The region has achieved consistent profitability and was the only one to record a net income in 1997. Still, net income was only $511 million for 1997, down from $679 million in 1993. The Pacific Region also accounted for $11.8 billion and $3.7 billion of assets and net worth, respectively. It is the most mature of
the nine regions, and many of the nations largest managed-care organizations operate there. Accordingly, regional assets and net worth accounted for 32% and 35% of the respective aggregated industry sums. However, these figures have declined 9% and 2%, respectively, since 1993 due to HMO growth in less-penetrated markets particularly those in the Eastern Region. The Pacific Regions outperformance is due primarily to benefits derived from operating scale. Administrative expenses have generally been flat, with an average of about $13 on a per member per month (PMPM) basis over the past five years. By contrast, the average per member administrative expense in the other eight regions for 1997 was $20, which represents an increase of 21% since 1993. The Eastern Regionthe nextlargest and worst-performing of the nine regionsposted a net loss of $524 million. Heavy losses incurred in the New York market drove much of the regional decline in profitability. The region has experienced considerable growth in administrative costs due to steadily escalating claim costs. Surge in Enrollment Transition from indemnity healthcare products has resulted in considerable growth in the past four years. In 1993, total HMO enrollment was at about 43 million. Enrollment has since grown at a 14% compounded rate, to more than 75 million in 1997. Although commercial groups account for most of the growth, the fastest growth has occurred in the Medicare-risk segment, which serves as an alternative to the traditional Medicare program. However, many high-profile HMO companies have recently decided to withdraw from this market due to difficulty managing utilization, which translates into rising health-care costs and diminished earnings. The issue
is further complicated by governmentmandated limits on rate increases that constrain top-line growth. Such circumstances make it difficult for HMO companies to provide valued care to a segment of the market that accounts for substantial health-care cost outlays. Enrollment growth has been the strongest in the New England and East South Central Regions. Much of the growth in New England has been on the commercial group side, whereas the public-sector Medicaid market has contributed to much of the growth for the latter. New England and East South Central regional enrollment amounts to 4.5 million and 3.4 million, respectively. The Pacific Region continues to grow and now accounts for over 21 million enrollees, which is 28% of total HMO enrollment. Both the for-profit and nonprofit sectors have substantial enrollment, but the for-profit sector has seen stronger growth and accounted for over 80% of earnings in the past two years. Much of the recent earnings disparity is due to health-cost trends, which have differed by as much as 10 basis points in 1996 and 1997. Earnings In the four-year period ended in 1997, assets have grown at a compounded rate of 12.8%, to $38 billion, and total revenues have grown from $69 billion to $122 billion. At December 1997, the for-profit segment accounted for 57% of the continued on next page
On the liabilities and stockholders equity total assets must equal the dollar amount of
assets and 64% of the revenues. However, the nonprofit segment still contributed significantly to the industry profile. At December 1997, the nonprofit segment accounted for 45% of the net worth and performed slightly better from an earnings perspective, but still incurred a loss of $375 million. Over the past several years, the for-profit segment has grown much
more rapidly and has been generally more profitable than its nonprofit counterpart. In 1993, the two sectors were evenly matched, relative to financial development. However, the for-profit structure has provided easier and more efficient access to the capital markets, which has better enabled the for-profits to fund market expansion and systems development initiatives. Although these initiatives have resulted in consistently higher per member administrative expenses to the forprofit companies, health-care cost trends have been just the opposite. Such a trend should spur the industry to question whether HMOs are providing more effective care or merely experiencing a cost shift. Utilization Varies by Model and Region Utilization trends have varied according to HMO model type. The data reveal an upward trend in both physician visits and hospital patient days. However, one must consider the skewing effects of growth in the Medicare-risk market and the impact of serving a broader cross section of the commercial market. The group model provider arrangement has been the only model type to achieve a reduction in physician visits and patient days per 1,000 members. However, this model type has also posted a healthcare expense ratio consistently in the mid-90s range throughout the five-year period. The staff model the most tightly managed model also demonstrated an ability to improve hospital utilization, but was unable to contain the escalation in premium dollar health-cost outlays. Conversely, the network model exhibited the greatest increase in utilizationparticularly regarding physician visitsbut was the only profitable model type in 1997. The network model, whereby an HMO contracts with multiple physician groups, posted a net income of $111 million and an 87.1% healthcare expense ratio in 1997.
On a regional basis in 1997, physician utilization per 1,000 members spiked upward the most in the New England Region. Over a fiveyear period beginning with 1993, visits increased on a 10.6% compounded basis, from 3,855 visits in 1993 to 5,760 visits in 1997. The Midwest Region, which exhibited a very modest physician visit decline over the same period, achieved a more noticeable decline in hospital patient days per 1,000 members. The Southeast and East South Central regions also achieved noticeable utilization declines. Administration Dollars devoted to administrative expenses also have varied by the structure of the company and model type. For-profit companies devoted 14.3% of the premium dollar toward back-end costs, while the nonprofit companies devoted 10.1%. By model type, administrative PMPM expenses varied from a low of $9.10 for the group model type to $23.20 for the staff model type. The staff models lack of scale is the main reason for its high number. Overall, the industry has exhibited 5.7% growth in this expense category for the four-year period ended in 1997. Improved scale has resulted in only a 2% increase in the administrative ratio during the same period, from 10.8% to 12.8%. Over the next few years, A.M. Best expects improved performance from the HMO sector via more rational underwriting considerations, a greater focus on the fundamental issues of care management and continued back-end improvements designed to cut costs and deliver value. Furthermore, continued regulatory and legislative pressure combined with challenging provider-alignment initiatives will present significant challenges to the industry as it strives to improve the quality and affordability of health care.
Four-Year Trends Show Drop in HMO Net Income Despite Steady Rise in Enrollments, Revenues. (continued)
Source: Excerpted from Joseph Marinucci, Four-Year Trends Show Drop in HMO Net Income Despite Steady Rise in Enrollments, Revenues, BestWeek Life/Health Supplement, Special Report (9 November 1998): 13. A. M. Best Company, Inc. used with permission of the publisher.
Investment securities, at market value 775,652 810,512 49.9 48.7 Receivables, net 234,363 274,936 15.1 16.5 Other current assets 13,001 14,763 0.8 0.9 Total Current Assets $1,313,979 $1,412,258 84.5 84.8 Property and equipment, net 28,798 31,443 1.9 1.9 Intangible assets 174,627 182,091 11.2 10.9 Long-term investments 25,705 27,346 1.7 1.6 Other noncurrent assets 12,148 11,417 0.8 0.7 Total Assets $1,555,257 $1,664,555 100 100 Liabilities and Stockholders Equity Current Liabilities: Medical claims payable $ 330,665 $ 359,712 21.3 21.6 Reserves for future policy benefits 120,000 130,542 7.7 7.8 Unearned premiums 52,584 60,721 3.4 3.6 Accounts payable and accrued expenses 93,110 97,480 6.0 5.9 Experience rated and other refunds 63,906 71,538 4.1 4.3 Other current liabilities 77,428 78,314 5.0 4.7 Total Current Liabilities $ 737,693 $ 798,307 47.4 48.0 Reserves for future policy benefits, noncurrent 83,008 89,829 5.3 5.4 Long-term debt 217,000 221,405 14.0 13.3 Other noncurrent liabilities 11,771 13,662 0.8 0.8 Total Liabilities $1,049,472 $1,123,203 67.5 67.5 Stockholders Equity: Common stock 175 175 Treasury stock, at cost (26) (26) Additional paid-in capital 220,578 220,578 14.2 13.2 Unrealized valuation adjustment (1,271) (1,271) Retained earnings 286,329 321,896 18.4 19.3 Total Stockholders Equity $ 505,785 $ 541,352 32.5 32.5 Total Liabilities and Stockholders Equity $1,555,257 $1,664,555 100 100
Figure 12A-5. Vertical Analysis of Sheridans 1997 and 1998 Consolidated Balance Sheets.
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. The following information was presented on one of the financial statements prepared by the Rouge Health Plan as of December 31, 1998: Assets Current assets $ 950,000 Other assets 100,000 Total Assets $ 1,050,000 Liabilities Current liabilities Other liabilities Total Liabilities Stockholders Equity Common stock Additional paid-in capital
$ $
50,000 100,000
An analyst at Rouge determined that current assets represented approximately 81% of Rouges total assets. This type of analysis, which indicates the relationship of one financial statement item to another financial statement item, is called: vertical analysis horizontal analysis trend analysis benchmark analysis Answer: A
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.
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 commonsize income statement reveals additional information.
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.
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.
AHM Health Plan Finance and Risk Management: Fundamentals of Ratio Analysis Pages No: 1-42 AHM Health Plan Finance and Risk Management: Fundamentals of Ratio Analysis
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.
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.
Assets Current Cash $ 40,923 Investments 520,852 Other 26,253 Total Current Assets $588,028 Net Property, Plant & Equipment 85,332 Other 19,232 Total Assets $692,592 Liabilities Current Claims, including IBNR $203,333 Other 57,292 Total Current Liabilities $260,625 Long-Term Debt 100,000 Other 85,614 Total Liabilities $446,239 Equity 246,353 Total Liabilities & Equity $692,592 Key Statistics Cash and Investments as Percent of Premium 76.1% Equity as Percent of Premium 33.4%
Net Income as Percent of Revenue (0.9%) SG&A as Percent of Premium 12.4% Selling Expenses as Percent of Premium 2.0% Administrative Expenses as Percent of Premium 10.4%
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 following information was presented on one of the financial statements prepared by the Rouge Health Plan as of December 31, 1998: Assets Current assets $ 950,000 Other assets 100,000 Total Assets $ 1,050,000 Liabilities Current liabilities Other liabilities Total Liabilities Stockholders Equity Common stock Additional paid-in capital
$ $
50,000 100,000
Total Liabilities and Stockholders Equity $ 1,050,000 Rouges current ratio at the end of 1998 was approximately equal to: 0.84 1.06
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.
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.
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.
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).
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:
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 debtservice 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.
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.
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.
The following information was presented on one of the financial statements prepared by the Rouge Health Plan as of December 31, 1998: Assets Current assets $ 950,000 Other assets 100,000 Total Assets $ 1,050,000 Liabilities Current liabilities Other liabilities Total Liabilities Stockholders Equity Common stock Additional paid-in capital
$ $
50,000 100,000
Total Liabilities and Stockholders Equity $ 1,050,000 Rouges debt ratio, expressed as a percentage, is approximately equal to: 86% 100% 117% 131%
Answer: C
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.
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.
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.
Generally, the higher and health plan's ROE, the better for the health plan's stockholder.
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.
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. Notfor-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.
A 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 income-producing ability.
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
AHM Health Plan Finance and Risk Management: Health PlanSpecific Ratio Analysis Pages No: 1-29 AHM Health Plan Finance and Risk Management: Health PlanSpecific Ratio Analysis
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.
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 SelfFunded 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.
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).
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.
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:
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%.
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.
GAAP Statutory
Liquidity Ratios Liquidity Ratios Activity Ratios Capital Ratios Financial Leverage Ratios Financial Leverage Ratios Profitability Ratios Profitability Ratios
dividends Market price per share Price/earnings = of common stock (P/E) ratio Earnings per share Dividend payout Dividend = ratio Net income Gross gain from operations Gross profit = Beginning capital and surplus Net gain from operations Return on capital = Beginning capital and surplus Net gain from Statutory return operations = on assets (ROA) Average invested assets Investment income Investment yield = Average invested assets Net gain from Net gain-to-total operations = income Total income Realized capital gains and losses +
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%.
The following information relates to the Hardcastle Health Plan for the month of June: Incurred claims (paid and IBNR) equal $100,000 Earned premiums equal $120,000 Paid claims, excluding IBNR, equal $80,000 Total health plan expenses equal $300,000
This information indicates that Hardcastles medical loss ratio (MLR) for the month of June was approximately equal to: 40% 67% 83% 120% Answer: C
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.
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.
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-of-period 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.
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.
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
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%. The following information was presented on one of the financial statements prepared by the Rouge health plan as of December 31, 1998: Assets Current assets $ 950,000 Other assets 100,000 Total Assets $ 1,050,000 Liabilities Current liabilities Other liabilities Total Liabilities Stockholders Equity Common stock Additional paid-in capital
$ $
50,000 100,000
Total Liabilities and Stockholders Equity $ 1,050,000 When calculating its cash-to-claims payable ratio, Rouge would correctly divide its: cash by its reported claims only cash by its reported claims and its incurred but not reported claims (IBNR) reported claims by its cash reported claims and its incurred but not reported claims (IBNR) by its cash Answer: B
AHM Health Plan Finance and Risk Management: Management Accounting Pages No: 1-51 AHM Health Plan Finance and Risk Management: Management Accounting
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 revenuerelated variances in a health plan setting
Management Accounting
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.
Management Accounting
The Role of Management Accounting
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.
Management Accounting
Management Accounting
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 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.
Department/Function
Marketing Underwriting Member Services Financial Planning Investments Information Services Medical Services Provider Contracting and Provider Relations
Management Accounting
Management Accounting
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.
Management Accounting
Management Accounting
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.
Management Accounting
The Role of Management Accounting 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.
Management Accounting
Management Accounting
The Role of Management Accounting 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 Accounting
The Role of Management Accounting 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.
Management Accounting
The Role of Management Accounting Management by Objectives
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.
Management Accounting
Answer: B
Management Accounting
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.
Management Accounting
Management Accounting
Standard costs are predetermined costs that a company expects to incur during normal business operations.
Management Accounting
Performance Measurement and Evaluation Variance Analysis
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. Variance analysis is the study of the difference between expected results and actual results. Variances can be positive or negative. A positive variance is typically considered: favorable for both expenses and revenues favorable for expenses, but unfavorable for revenues favorable for revenues, but unfavorable for expenses unfavorable for both expenses and revenues Answer: C
Management Accounting
Performance Measurement and Evaluation Variance Analysis
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.
Management Accounting
Performance Measurement and Evaluation Variance Analysis
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.
Management Accounting
Performance Measurement and Evaluation 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.
Management Accounting
Performance Measurement and Evaluation Segment Reporting in Cost Centers and Profit Centers
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.
Management Accounting
Performance Measurement and Evaluation Segment Reporting in Cost Centers and Profit Centers
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.
Management Accounting
Performance Measurement and Evaluation Segment Reporting in Cost Centers and Profit Centers
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:
Management Accounting
Performance Measurement and Evaluation Segment Reporting in Cost Centers and Profit Centers
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:
Management Accounting
Management Accounting
Performance Measurement and Evaluation 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:
Management Accounting
Performance Measurement and Evaluation Return on Investment
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.
Management Accounting
Management Accounting
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:
Management Accounting
Performance Measurement and Evaluation Return on Investment
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:
Management Accounting
Management Accounting
Performance Measurement and Evaluation Return on Investment
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%.
Management Accounting
Management Accounting
1. Reducing expenses to increase operating income 2. Increasing controllable investment Both 1 and 2 1 only 2 only Neither 1 nor 2 Answer: B
Management Accounting
Management Accounting
Performance Measurement and Evaluation Return on Investment
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.
Management Accounting
Performance Measurement and Evaluation 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.
Management Accounting
Performance Measurement and Evaluation Return on Investment and Residual Income Compared
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.
Management Accounting
Performance Measurement and Evaluation Return on Investment and Residual Income Compared
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.
Management Accounting
Performance Measurement and Evaluation Return on Investment and Residual Income Compared
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.
Management Accounting
Management Accounting
Performance Measurement and Evaluation Issues Associated with Performance Evaluation
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.
Management Accounting
Management Accounting
Performance Measurement and Evaluation Overemphasis on Variance Analysis
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).
Management Accounting
Management Accounting
Performance Measurement and Evaluation 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 understaff 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.
Management Accounting
Performance Measurement and Evaluation 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.
Management Accounting
Management Accounting
Management Accounting
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 Pages No: 1-45 AHM Health Plan Finance and Risk Management: Cost Accounting
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
Cost Accounting
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
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.
Cost Accounting
Cost Accounting
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 Accounting
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.
Cost Accounting
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. In order to achieve its goal of improved customer service, the Evergreen Health Plan will add three new customer service representatives to its existing staff, install a new switching station, and install additional phone lines. In this situation, the cost that would be classified as a sunk cost, rather than a differential cost, is the expense associated with: adding new customer service representatives maintaining the existing staff installing a new switching station installing additional phone lines Answer: B
Cost Accounting
Cost Classification Costs Classified by Description
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.
Cost Accounting
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. Fixed Cost A cost that remains constant for all levels of operating activity or production. Examples of an MCOs fixed costs are rent on a regional office, fire insurance on the home office facility, and depreciation on computer equipment. Whether an MCO enrolls one member or one million members during a given period, these fixed costs remain the same. We can further categorize fixed costs as either committed costs or discretionary costs, which we described earlier.
costs remain the same for all levels of sales volume, while variable costs increase as the volume of sales increases. Semi-Variable Cost A cost, also called a mixed cost, that contains elements of both fixed and variable costs. A semivariable cost contains a fixed cost component plus the amount of a variable component over time and at each volume level.
_ _ _
Costs that can be defined by behavior are most commonly classified as fixed costs, variable costs and semi-variable costs. Examples of fixed costs include: rent, insurance expense, and depreciation on computer equipment rent, claims processing costs, and selling expenses claims processing costs, telephone expense, and depreciation on computer equipment premium processing, rent, and selling expenses Answer: A
Cost Accounting
Cost Classification 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.
Cost Accounting
Cost Accounting
Cost Accounting
Cost Classification Unit Costs
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.
Cost Accounting
Cost Accounting
Cost Classification 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.
Cost Accounting
Cost Classification Marginal Costs
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.
Cost Accounting
Cost Classification Opportunity Costs
In making decisions about expenditures, a health plan must consider both its out-ofpocket 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.
Cost Accounting
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. A cost for which a benefit is forfeited in choosing one decision alternative over another is known as: a marginal cost a unit cost an incremental cost an opportunity cost Answer: D
Cost Accounting
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 Accounting
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.
Cost Accounting
Cost Accounting
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.
Cost Accounting
Cost Accumulation 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.
Cost Accounting
Cost Accumulation 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 segment for 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.
Cost Accounting
Cost Accumulation 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.
Cost Accounting
Cost Accumulation Accumulating Costs by Function
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 Accounting
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 Accounting
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.
Cost Accounting
Cost Accumulation
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 Accounting
Cost Accumulation 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 Accounting
Cost Accounting
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.
Cost Accounting
Cost Analysis 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.
Cost Accounting
Cost Analysis 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.
Cost Accounting
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
Cost Accounting
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.
Cost Accounting
Cost Accounting
Cost Accounting
Cost Analysis Analysis-Based Costing
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-valueadded 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 Accounting
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 Accounting
Cost-Volume-Profit Analysis
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.
Cost Accounting
Cost-Volume-Profit Analysis 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. Two Variations
Cost Accounting
Cost-Volume-Profit Analysis 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 break-even 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.
For a given healthcare product, the Magnolia Health Plan has a premium of $80 PMPM and a unit variable cost of $30 PMPM. Fixed costs for this product are $30,000 per month. Magnolia can correctly calculate the break-even point for this product to be: 274 members 375 members 600 members 1,000 members Answer: C
Cost Accounting
Cost Accounting
Cost Accounting
Cost-Volume-Profit Analysis Uses of Cost-Volume-Profit Information
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.
Cost Accounting
Cost-Volume-Profit Analysis Uses of Cost-Volume-Profit Information
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 Pages No: 1-32 AHM Health Plan Finance and Risk Management: The Budgeting Process
organizing, and controlling, budgeting is one of the central planning activities, and budgets are an important instrument in the controlling process.
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.
Level of resources the health plan should spend on technology, training, and compliance with regulatory requirements during the coming year
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 "reprojections" semiannually.
Figure 13C-2. Relationships Among the Financial Components of the Master Budget.
General Operating Budget Medical Benefits + Operating Expenses Revenue Budget Premium Income Investment Income Sales Forecast Individual Department or Product Line Benefits Operating Budgets Budgets Sales Expense Budget Capital Expenditures Budget Forecast of Other
Revenue Sources Cash Budget Cash Inflows Cash Outflows Pro Forma Balance Sheet Assets = Liabilities + Owners Equity Pro Forma Cash Flow Statement Net Increase or Decrease in Cash Pro Forma Income Statement Revenues Expenses Investment Forecast
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.
The Amethyst Health Plan uses a budgeting approach that requires each line of business within Amethysts operation to justify its continued operation. Amethyst begins with the premise that no resources will be allocated for the following period unless each dollar to be spent is justified and is shown to be within departmental plans and corporate goals and objectives. The budgeting approach used by Amethyst is known as: bottom-up budgeting top-down budgeting zero-based budgeting master budgeting Answer: C
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.
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.
In the following sections, we discuss two basic types of operational budgets: revenue budgets and expense 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.
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.
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, (2)the selling expense budget, and (3)the administrative expense budget. Some health plans have two expense budgets: a medical expense budget and a selling and administrative 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. 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. 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.
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 Pages No: 1-15 AHM Health Plan Finance and Risk Management: Cash 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
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.
Cash Management
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.
A health plan may experience negative working capital whenever healthcare expenses generated by plan members exceed the premium income the health plan receives. Ways in which a health plan can manage the volatility in claims payments, and therefore reduce the risk of negative working capital, include: 1. Accurately estimating incurred but not reported (IBNR) claims 2. Using capitation contracts for provider reimbursement Both 1 and 2 1 only 2 only Neither 1 nor 2
Answer: A
Cash Management
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.
Cash Management
Developing the Cash Budget
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.
Cash Management
Developing the Cash Budget
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.
Cash Management
Developing the Cash Budget
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.
Cash Management
Cash Management
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.
Cash Management
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
Cash Management
Developing the Cash Budget The Cash Disbursements Budget
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 investessentially 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.
Cash Management
Cash Management
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)
Cash Management
Developing the Cash Budget The Cash Budget
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.
Cash Management
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.
Cash Management
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.
AHM Health Plan Finance and Risk Management: Capital Budgeting Pages No: 1-29 AHM Health Plan Finance and Risk Management: Capital Budgeting
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
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 long-term 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.
Capital Budgeting
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.
Capital Budgeting
The Capital Budgeting Process 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.
Capital Budgeting
The Capital Budgeting Process 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 Replacements Cost reduction programs Safety and regulatory expenditure programs
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.
Capital Budgeting
Capital Budgeting
The Capital Budgeting Process Estimating Cash Flows
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.
Capital Budgeting
The Capital Budgeting Process Estimating Cash Flows
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.
An investor deposited $1,000 in an interest-bearing account today. That sum will accumulate to $1,200 two years from now. One true statement about this transaction is that: the process by which the original $1,000 deposit grows to $1,200 is known as compounding
$1,200 is the present value of the $1,000 deposit the $200 increase in the deposits value is its incremental cash flow the $200 difference between the original deposit and the accumulated value of the deposit is known as the deposits discount Answer: A
Capital Budgeting
Capital Budgeting
The Capital Budgeting Process Estimating Cash Flows
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 Planing 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.
Capital Budgeting
Capital Budgeting
Capital Budgeting
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.
Capital Budgeting
Capital Budgeting
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.
Capital Budgeting
Capital Budgeting Methods The Payback Method
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.
Capital Budgeting
Capital Budgeting Methods 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 weighted-average cost of capital. The cash inflows for each year, discounted to their present value, are shown in Figure 14B-3.
Capital Budgeting
Capital Budgeting Methods The Discounted Payback Method
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.
Capital Budgeting
Capital Budgeting Methods 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 following statements are about the capital budgeting technique known as the payback method. Select the answer choice containing the correct statement: The main benefit of the payback method is that it is simple to use. The payback method measures the profitability of a given capital project. The payback method considers the time value of money. The payback method states a proposed projects cash flow in terms of present value for the life of the entire project. Answer: A
Capital Budgeting
Capital Budgeting Methods 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.
Capital Budgeting
Capital Budgeting Methods The Net Present Value Method
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 14B4. 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.
Capital Budgeting
Capital Budgeting Methods 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.
Capital Budgeting
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.
Capital Budgeting
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 long-term bank loan at an interest rate of 10%. It might seem logical for the health plan to use the 10% interest rate as the discount rate for 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.
Capital Budgeting
Investing Decisions and Financing Decisions 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 Budgeting
Investing Decisions and Financing Decisions 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.
Capital Budgeting
Investing Decisions and Financing Decisions 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 an health plans initial investment in the project.
Capital Budgeting
Investing Decisions and Financing Decisions Profitability Index
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. The Jade Health Plan used a profitability index (PI) to rank the following capital proposals: Proposal PI A 0.45 B 1.05 This information indicates that, of these two projects, Jade would most likely select: Proposal A, and the PI indicates that the net present value (NPV) for this project is less than zero
Proposal A, and the PI indicates that the net present value (NPV) for this project is greater than zero Proposal B, and the PI indicates that the net present value (NPV) for this project is less than zero Proposal B, and the PI indicates that the net present value (NPV) for this project is greater than zero Answer: D
Capital Budgeting
Capital Budgeting
Investing Decisions and Financing Decisions Sensitivity Analysis
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.
AHM Health Plan Finance and Risk Management: Case Study: Lifelong Health, Inc. Pages No: 1-17
AHM Health Plan Finance and Risk Management: Case Study: Lifelong Health, Inc.
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.
Lifelongs Strategic Plan: Renegotiate HMO provider contracts to lower costs by 5%, to reflect the results of Lifelongs analysis of per member per month (PMPM) reimbursement levels. Partner with Lifelongs PPO providers to provide incentivessuch as provider bonus poolsto reduce unnecessary procedures by 10%, while being careful not to withhold needed care. Install applications software to improve medical outcomes by 15% in Lifelongs disease management programs. Increase HMO plan membership by 8%, in part by migration from Lifelongs PPO product, where the previous two action items will have greater impact.
Figure 11C-2.
1997 and 1998 Summary Income Statements and Membership and Price Data.
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 a much faster rate than forecasted Competitors Graymount, Global, and Sage Healthcare reduced their prices in 1998, leading to lower-than-planned membership growth for Lifelong. Dr. Chandler noted 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.
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.
Figure 11C-3.
Development and Review of Lifelongs Pro Forma Financial Statements Review of Assumptions
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.
Review of Assumptions
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.
Development and Review of Lifelongs Pro Forma Financial Statements Review of the Pro Forma Income Statement
In the pro forma income statement shown in Figure 11C-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. (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 mid-year price change.
Figure 11C-3.
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.
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.
Development and Review of Lifelongs Pro Forma Financial Statements Review of the Pro Forma Cash Flow Statement
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.
Development and Review of Lifelongs Pro Forma Financial Statements Review of the Pro Forma Cash Flow Statement
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.
A
ABC See activity-based costing. Accountant A person who collects, records, summarizes, reports, and analyzes an health plans financial information. Accounting A system or set of rules and methods for collecting, recording, summarizing, reporting, and analyzing a companys financial operations. Accounting-Entity Concept See entity concept. Accounting Period A specified length of time during which a companys business transactions are recorded, summarized, and reported. Accrual-Basis Accounting An accounting basis in which a company records revenues when they are earned and expenses when they are incurred, even if cash has not actually changed hands. Accumulated Value See future value (FV). Acquisition-Cost Concept See cost concept.
ACR See adjusted community rating. Activity . Any procedure that generates work. Activity-Based Costing (ABC) . A type of functional cost accounting that links costs to products according to the activities consumed in producing the products or services. Activity Driver . The output of an activity being performed. Activity Ratios Calculations that measure how quickly a health plan converts specified financial statement items into premium income or cash; these ratios gauge a health plans productivity and efficiency. Also known as operating efficiency ratios or operating ratios. Actual Margin The difference between the assumed values and the actual values for a health plans benefit costs, expenses, or investment income, which emerges after the plan has been in force. Actual Value The value of a health plan that actually occurs after a plan has been in force. Actuarial Function The work group and/or processes that a health plan establishes to be responsible for ensuring that the health plans operations are conducted on a mathematically sound basis. Actuary A person who develops premium rates and evaluates claims experience with respect to the risks associated with healthcare benefits for product pricing, provider contracting, and other purposes. ADA See Americans with Disabilities Act. Additional Paid-In Capital The difference per share between the issue price of common stock and the par value of the stock. Also known as paid-in capital in excess of par or premium on common stock. Adequate-Disclosure Concept See fulldisclosure concept Adjusted Community Rating (ACR) A rating method under which a health plan calculates the ratio of a groups experience to the groups historical manual ratewhich is based on age, sex, industry, and so onthen multiplies this ratio by the groups future manual rate. Also known as modified community rating. Administrative Expense Budget An expense budget that is the sum of all departmental expense budgets. Administrative Expense Ratio The ratio of a health plans administrative expenses to its earned premiums. Administrative-Services-Only (ASO) Contract
An arrangement in which the employer purchases specific administrative services from an insurance company or from an independent third party administrator. Admitted Asset An asset that state HMO or insurance laws permit on the Assets page of a companys Annual Statement. Affiliate Risk The risk that the financial condition of an affiliated entity causes an adverse change in a health plans capital. Aggregate Stop-Loss Coverage Insurance or reinsurance that protects against losses that occur when utilization rates among a covered population as a whole are significantly higher than anticipated when either the reimbursement rates or the premium rates were established. Americans With Disabilities Act (ADA) A 1990 federal law that protects disabled individuals from various types of discrimination. Ancillary Services An umbrella term for a variety of healthcare services outside of surgery, primary care, and most hospital treatment, such as diagnostic services, physical and behavior therapy, dialysis, home health care, and pharmacy services. Typically these services are provided by non-physicians. Annual Report . The yearly report that a companys management sends to its stockholders, policyholders, and other interested parties to describe the companys performance during the previous year. Anti-Kickback Law A federal law that 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. Antiselection In a managed care environment, 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, the possibility that a higher-than-anticipated percentage of people who need greater-than average healthcare benefits will sign up with a healthcare plan. Any Willing Provider (AWP) Laws Laws that require health plans to 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 in the health plans network. APS See Attending Physicians Statement.
Asset Risk The risk of adverse fluctuations in the value of a health plans assets. Assets Items of readily determinable value owned by a company. Associating Cause And Effect An approach to expense recognition whereby 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. ASO Contract See administrativeservices-only contract. Assumed Interest Rate The interest rate that a company assumes when pricing a product. Assumed Margin The difference between a health plans assumed value and its expected value for the premium that the health plan charges for a health plan. Assumed Value The value a health plans actuaries use in calculating the premium on a health plan. Attending Physicians Statement (APS) A written statement from the physician who has treated, or is currently treating, a proposed plan member for one or more conditions. Average Collection Period See days in accounts receivable. AWP Laws See any willing provider laws. BACK TO TOP
B
Balance Sheet A financial statement that shows a companys financial position as of a specified date and summarizes its assets, liabilities, and owners equity. Bank Line See line of credit. Bare-Bone Plans See low-option plans. Base Indemnity Claims Cost The result of adjusting an indemnity plan as though the entire eligible group of employees had been enrolled in the indemnity plan. Basic Plans See low-option plans.
Benchmarking A process by which a company compares its own performance, products, and services with those of other organizations that are recognized as the best in a particular category. Blended Rating 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. Bonus Arrangements Agreements which pay providers over and above their usual reimbursement at the end of a financial period based on the performance of the plan as a whole, a group of providers within the plan, or an individual provider. Book Value The value at which an asset is recorded or carried in a companys accounting records, specifically its general ledger. Bottom-Up Budgeting A method of budgeting that generates a budget at the department level by lower management and presents the budget in the form of recommendations to upper management. Break-Even Analysis See cost-volumeprofit (CVP) analysis. Break-Even Point The point at which total revenues equal total costs, and fixed costs equal the contribution margin. Budget A financial plan of action, expressed in monetary terms, that covers a specified time period. See also master budget. Budget Method See salary reimbursement method. Bundled Case Rates See package pricing. Business-Entity Concept See entity concept. Business Risk The general risk of conducting business, including the risk that actual expenses will exceed amounts budgeted. BACK TO TOP
C
Capital And Surplus Ratio A measurement of a health plans financial strength, calculated by dividing a health plans capital and surplus by its total liabilities. Capital Asset Pricing Model (CAPM)
A method of calculating the cost of equity that uses beta and the market return to help investors evaluate risk-return trade-offs in making investment decisions. Capital Budget A budget in which a company estimates its need for capital. Capital Budgeting The analysis of decisions about investing in long-term assets. Capital Gain The amount by which the selling price of an asset exceeds its purchase price. Capitalization The process of deferring the recognition of expenses until future accounting periods. Capital Rationing The process of allocating limited resources to a health plans capital project proposals. Capitation 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 on the basis of the cost or number of services that are actually provided. Capitation Rate An amount paid to a provider or provider organization, typically monthly, on a per plan member (per capita) basis. Also known as the per member per month (PMPM) rate. CAPM See capital asset pricing model. Carrier An entity that provides stop-loss coverage. Carve-Outs Services that are excluded (or carved out) from a capitation payment, a risk pool, or a health benefit plan; the term also refers to discrete programs covering entire categories of caresuch as mental health, pharmacy benefits, and even specific diseasesthat are usually administered by independent organizations. Case Rates Rates that are established on a case by case basis. Case Stripping A process in which a few employees and/or dependents with expected high medical costs remain under an health plans plan, but over time, the healthier plan members drop coverage or purchase less expensive group coverage elsewhere. Cash And Investments-To-Premium Income Ratio The ratio of a health plans cash and investments to its premium income. Cash-Basis Accounting An accounting basis in which a company recognizes revenues or expenses only when it receives or disburses cash. Cash Budget
A budget that shows all expected cash inflows, cash outflows, and ending cash balance during a period. Cash Budgeting Budgeting that anticipates the flows of cash into and out a health plan during a given period. Cash Disbursement The payment of cash by a company to a recipient. Cash Disbursements Budget A budget that attempts to estimate the timing and amount of all of a companys cash disbursements. Cash Flow Statement A financial statement that provides information about a companys cash receipts (inflows) and cash disbursements (outflows) during a given accounting period. Also known as a statement of cash flows. Cash Inflow A source of funds. Cash Management The management of a companys short-term cash needs. Also known as treasury management or working capital management. Cash Outflow A use of funds. Cash Receipt A check, money order, electronic funds transfer (EFT), or other cash transaction that is remitted to a company as some form of payment. Cash Receipts Budget A schedule of cash receipts that the company expects to receive during a period. Cash-To-Claims Payable Ratio A liquidity ratio that indicates the relationship between a health plans cash and its claims payable. Certificate Of Authority (COA) A certificate issued by the state authority that regulates HMOs and that certifies that all requirements have been met for the establishment of an HMO in accordance with the states HMO laws. Also known as a license. Change Analysis The comparison of costs in one period to the same costs in a different period. Churning The practice of a physician or other providers either seeing a plan member more often than is necessary, or providing more treatments and tests than are necessary; the excessive services ultimately add to the costs of the health plan and therefore increase the cost of healthcare coverage to the plan member and the employer (or other payor). COA See certificate of authority. COBRA
See Consolidated Omnibus Budget Reconciliation Act. Code Creep The condition that occurs when a provider frequently bills for more lucrative services than those actually performed. Combined Ratio The sum of the medical loss ratio and the expense ratio, used to determine whether a health plan is collecting enough premiums to pay both its claims obligations and its operating expenses. Committed Cost A cost that results from prior management decisions that cannot be changed quickly. Common Cost See indirect cost. Common-Size Financial Statement A financial statement that displays only percentage relationships to a specified item; there are no dollar figures for each item. Common Stock A unit of ownership that typically entitles the owner to vote on the selection of directors and on other important company matters and also entitles the owner to receive stockholder dividends. Community Rating A rating method that sets premiums for financing healthcare benefits according to the expected costs for healthcare in a whole market or segment rather than to a subgroup within that market. Both low-risk and high-risk classes are factored into community rating, which spreads the expected costs across the entire community. Community Rating By Class (CRC) A modified form of community rating that allows a health plan to classify members in tiers on the basis of experience or duration. Rating classes, such as age, sex, industry, and so on, are overlayed on these tiers, and the premium rate developed results from calculating the weighted average of these factors. Also known as factored rating. Comparability A quality of accounting information in which financial statements enable an interested party to identify similarities and differences in financial information across accounting periods and among different companies. Comparative Financial Statements Financial statements that present a companys financial information for two or more accounting periods. Compounding The process of converting the present value of a specified amount of money to its future value. Comprehensive Budget See master budget. Comptroller
See controller. Concept Of Periodicity See time-period concept. Conservatism The choice of a financial reporting method that results in the projection of lower values for a companys assets, higher values for its liabilities and expenses, and a lower level of net income than would be the case if a company used a more optimistic reporting method. Consistency A quality of accounting information in which a companys financial statements use the same accounting policies and procedures from one accounting period to the next, unless there is a sound reason for changing a policy or procedure. Consolidated Financial Statements Financial statements that include the assets, liabilities, owners equity, revenues, and expenses of the subsidiary company with those of the parent company. Consolidated Omnibus Budget Reconciliation Act (COBRA) A 1986 federal law that 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. Contact Capitation 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. Contingencies Unexpected events that cause expenses, investment earnings, morbidity rates, or other factors to vary significantly from a companys forecasts. Contingency Risks See C-risks. Continuity Of Coverage A contract provision that allows a successor health plan to provide coverage outside the plan contract for an employee or dependent who would otherwise lose coverage as a result of the employers changing to the new health plan. Also known as no-loss, no gain. Continuous Budget See rolling budget. Contribution Margin The difference between a products selling price and its variable costs. Contribution Margin Ratio The contribution margin divided by the segments total revenues. Contributory Plan Any health plan or other employee benefit plan in which plan participants must make contributions to fund the plan. Controllable Cost
A cost over which a particular manager or level of management has power and influence. Controllable Investment All balance sheet items controlled by the manager of an investment center. Controller (Comptroller) A person who controls a health plans operations and protects its resources and wealth. Copayment A specified charge that a health plan member must pay out-of-pocket for a service at the time the service is rendered. Corporate Budget See master budget. Cost The amount of a companys resources (assets) consumed or used for any purpose. Cost Accounting A system that defines, describes, accumulates, records, and assigns all the costs incurred by a company. Cost Accumulation The process of capturing all of a companys costs and categorizing them in meaningful ways. Cost Allocation The accounting process of assigning or distributing an indirect cost or expense according to a method or formula. Cost Center A department or other business segment to which costs can be charged. Cost Concept An accounting concept which states that companies should list items on their financial statements according to the actual cost of those items at the time of purchase. Also known as the historicalcost concept, initial-recording concept, or acquisition-cost concept. Cost Object In cost accounting, any purpose for which a company measures its costs. Cost Of Capital The overall rate of interest or dollar amount that an organization pays for the long-term funds it employs. See also weighted average cost of capital (WACC). Cost Of Incurred Claims The portion of the premium that a health plan determines will be needed to pay claims. Also known as incurred claims expense. Cost-Related Variance See price variance. Cost-Volume-Profit (CVP) Analysis The study of the effects of changes in product prices, sales volume, fixed costs, variable costs, and the mix of products. Also known as break-even analysis or profit-volume analysis.
Cost-Volume-Profit (CVP) Graph A diagram that highlights cost-volume-profit relationships over a wide range of sales levels. CRC See community rating by class. Credentialing A review process conducted to determine the current clinical competence of providers and to ensure that providers meet the organizations criteria. Credibility A measure of the statistical predictability of a groups experience. Credibility Factor The expression in percentage or decimal form of a measure of the statistical predictability of a groups experience. 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. Crediting Interest Rate The interest rate that a company uses to credit investment return to a product. Credit Risk The risk that providers and plan intermediaries paid through reimbursement methods that require them to accept utilization risk will not be able to provide the services contracted for, and the risk associated with recoverability of the amounts due from reinsurers. C-RISKS Four general categories of risk (asset risk, pricing risk, interest-rate risk, and general management risk) that have direct bearing on both cash flow and solvency. Also known as contingency risks. Current Assets Those assets that a company expects to use up or convert to cash during the current accounting period, typically one year. Also known as short-term assets. Current Liabilities Those debts that a company must pay within one year. Also known as short-term liabilities or short-term obligations. Current Liquidity Ratio A ratio that compares all of a health plans total assets not invested in its affiliates to all the health plans total liabilities, not just its claims liabilities and IBNR claims liabilities. Current Market Value The price at which an asset can be sold under current economic conditions. Also known as fair market value or market value. Current Ratio The ratio of a health plans current assets to its current liabilities. Customers
See plan members. CVP Analysis See cost-volume-profit analysis. CVP Graph See cost-volume-profit graph. BACK TO TOP
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Days In Accounts Receivable The number of days that a health plan takes to collect premium income from plan sponsors and others, calculated by dividing a health plans accounts receivable by its average daily revenues. Also known as the average collection period. Debt A key source of capital in the form of creditor interest in an organization. Debt Ratio The ratio of a health plans total liabilities to its total assets. In other words, the measurement of the proportion of total assets against which plan contractors and others have legal claims, such as healthcare benefits, including IBNR claims. Debt-Service Coverage Ratio The ratio of a health plans earnings before interest and taxes (EBIT), not only to all its interest payment obligations, but also to all its principal and lease payment obligations. Debt-To-Equity Ratio The ratio of a health plans total liabilities to its stockholders equity. Defensive Medicine An attempt by providers 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. Depreciation The process of allocating the cost of an asset over the assets estimated useful life.
Diagnosis-Related Groups (DRGs) A system that classifies hospital patients into groups according to a variety of factors such as primary and secondary diagnoses, surgery and other procedures, complications, age, and gender. Differential By Day In Hospital A type of hospital reimbursement method under which the first days charges are higher because hospitalization is more expensive on the first day; subsequent charges are usually paid on a per-diem basis. Differential Cost
A future cost that changes as a result of a future decision. Also known as an incremental cost or marginal cost. Direct Access Laws Laws that allow health plan members to see certain specialists without first being referred to those specialists by a primary care provider. Direct Cost A cost incurred for or traceable to one specific product line, line of business, or department or function. Also known as a traceable cost. Direct Method A method of determining net cash flow from operating activities by taking a companys major types of operating cash receipts and then subtracting each major type of cash disbursement. The difference between the cash receipts and cash disbursements is the net cash for the period. Discontinued Operations One-time transactions that result from ending operations through the sale or other disposition of a business segment. Discounted Fee-For-Service (FFS) A reimbursement method under which the health plan pays the provider on a pertreatment basis at a level below the providers usual charge for that service. Discounted FFS See discounted fee-forservice. Discounted Payback Method A capital budgeting technique that calculates, in terms of discounted dollars, how long it will take a health plan to recover its initial investment. Discounting The process of determining the present value of a future sum. Discretionary Cost A cost that results from periodic management decisions that may change as conditions require. Dividend Payout Ratio A ratio that represents the proportion of earnings (net income) paid out to stockholders in the form of cash dividends, calculated by dividing the amount of a health plans dividends by its net income. Doctrine Of Corporate Negligence A principle by which 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. DRGs See diagnosis-related groups. Due Process Laws See fair procedure laws. Durational Rating
A type of prospective experience rating under which premium rates increase automatically with group tenure in a health plan for a specified period, such as six months or a year. Dynamic Budget See flexible budget. BACK TO TOP
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Earnings Multiple See price/earnings (P/E) ratio. Earnings Per Share (EPS) The amount of net income per share of a companys common stock, calculated by dividing a health plans net income minus preferred stock dividends by the number of common stock shares outstanding. Also known as earnings per share of common stock. Earnings Per Share Of Common Stock See earnings per share (EPS). Effectiveness The extent to which a responsibility center is able to establish and achieve appropriate objectives. Efficiency The extent to which a responsibility center is able to achieve objectives with a minimum of waste. Employee Class A group of employees categorized by position, earnings, or rank. Employee Retirement Income Security Act (ERISA) A broad-reaching 1974 federal law that regulates employer-sponsored benefit plans and established strict reporting requirements and requirements for the disclosure of plan provisions and funding. Employment Waiting Period See service requirement. Enrollees See plan members. Entity The basic economic unit for which a company maintains distinct accounting records and reports. Entity Concept An accounting concept which states that a company must account separately for the business activities of each economic unit. Also known as the accounting-entity concept or businessentity concept. EPO
See exclusive provider organization. EPS EPS See earnings per share. Equity A form of ownership in an organization that typically can be generated through surplus or retained earnings or a stock issue. Equity-To-Premium Income Ratio a health plans equity divided by its premium income. ERISA See Employee Retirement Income Security Act. Essential Plans See low-option plans. Exclusion Rider See impairment rider. Exclusive Provider Organization (EPO) A health plan that is similar to a PPO in structure, administration, and operation, but that usually does not cover out-of-network care or does so on a very limited basis. Expected Margin The profit margin that a health plan intends to produce and believes is most likely to occur. Expected Value At the pricing stage of a health plan, the value that a health plans actuaries believe is most likely to occur. Expense A reduction in a companys assets that applies to the current accounting period. Also known as an expired cost. Expense Budget . A schedule of expenses expected during a given period. Expense Margin 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. Expense Ratio The ratio that measures the percentage of health plan expenses, other than medical expenses, paid for each dollar of a health plans premium income. Expenses The amount of one or more assets a company uses to receive a certain benefit or service. Experience Period The period of time during which a health plan collects claims experience data. Experience Rating
A rating method under which a health plan considers a groups actual experience, including its healthcare costs and utilization rates, to determine premium rates. Experience Rating Dividend The part of a groups premium that a health plan refunds after the rating period is over if the groups experience has been better than expected during the rating period. Also known as an experience refund or experience rating refund. Experience Rating Refund See experience rating dividend. experience refund See experience rating dividend. Expired Cost See expense. Exposure Period In renewal rating and underwriting, 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. External (Independent) Auditors Independent public accountants who issue an opinion as to whether a health plans financial statements present fairly, in all material aspects, the health plans operations and adherence to applicable accounting principles; external auditors also review and recommend changes to a health plans internal control system and prepare audit reports for the health plans audit committee. Extraordinary Item A non-core business transaction that is typically rare in occurrence and not based primarily on management decisions. BACK TO TOP
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Factored Rating See community rating by class (CRC). Fair Market Value See current market value. Fair Procedure Laws 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. Also known as due process laws. Fee-For-Service (FFS) A reimbursement method under which providers are paid per treatment or per service that they provide.
FFS See fee-for-service. Finance In managed care, the effective and efficient management of money to achieve a health plans strategic goals and objectives. Financial Accounting The type of accounting that focuses on communicating a health plans financial information to meet the needs of the health plans external users. Financial Analysis A process that assesses a companys financial performance and position and compares the company with other companies within and outside its industry. Also known as financial statement analysis. Financial Information Any numerical data compiled for and from a companys records. Financial Leverage A type of leverage that involves financing company assets with debt or other borrowed funds. Financial Risk The possibility of economic or monetary lossor gainin undertaking or neglecting to undertake a certain action. Financial Statement Analysis See financial analysis. Financial Statements Statements, including the balance sheet, the income statement, the cash flow statement, and the statement of owners equity, that report major financial events and transactions of a company. Financing Activities Transactions involving borrowed funds and cash payments to or from owners of a stock company. Fixed-Amount Budget See static budget. Fixed Budget See static budget. Fixed-Charge Coverage Ratio 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. Fixed Costs Costs that remain constant for all levels of operating activity or products. Flexible-Amount Budget See flexible budget. Flexible Budget
A type of budget that provides alternative sets of figures to use under the different circumstances that may arise during a budgeting period. Also known as a flexibleamount budget, dynamic budget, or variable budget. Formulary A listing of drugs, classified by therapeutic category or disease class, that are considered preferred therapy for a given managed care population and that are to be used by a health plans providers in prescribing medicines. For-Profit Health Plan a health plan that seeks to produce profits for its owners to provide them with a satisfactory return on their equity investment in the health plan. Foundation For Medical Care (FMC) See medical foundation. Full-Disclosure Concept An accounting concept which 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. Also known as the adequate-disclosure concept. Full Professional Capitation A type of capitation payment that covers all physician services, including primary care and specialty services. Also known as full professional services capitation. Full Professional Services Capitation See full professional capitation. Full-Risk Capitation See global capitation. Fully Funded Plan 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. Also known as a fully insured plan. Fully Insured Plan See fully funded plan. Functional Cost Analysis The study of costs as they apply to workflow rather than to organizational structures. Functional Costs The accumulated costs of the activities involved with a certain function, without regard to departmental lines. Functional Unit Cost The total functional cost divided by an appropriate base unit, such as number of plan members, number of claims, or amount of premiums collected. Funding Vehicle In an employer selffunded health plan, the account into which the employer deposits the money that the employer and employees normally would have paid in
premiums to a health plan or insurer until the money is paid for healthcare expenses. Future Value (FV) An amount that represents the principal plus earned interest over a specified period of time. Also known as accumulated value. FV See future value. BACK TO TOP
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GAAP See generally accepted accounting principles. Gain Income obtained by a transaction other than a core business function. General Asset Plan 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. Also known as a nontrusteed plan. General Expense Ratio The ratio of a health plans general expenses to its earned premiums. Generally Accepted Accounting Principles (GAAP) A set of financial accounting standards that all publicly traded U.S. stock companies (including wholly owned subsidiaries) must follow when preparing and filing financial statements Global Capitation A type of capitation payment that covers all physician and facility services, including hospital inpatient and outpatient services, primary and specialty care, and some ancillary services. Also known as full-risk capitation. Global Fee A single fee that a provider is given for all services associated with an entire course of treatment given to a patient. Goal Congruence An operational condition in which the goals of a company and the goals of its managers are mutually supportive. Goal Incongruence An operational condition in which management goals and the companys goals are in conflict. Going-Concern Concept The accounting concept which states that accounting processes are typically based on the assumption that a company will continue to operate for an indefinite period of time. Gross Leverage Ratio See insurance leverage ratio.
Gross Profit Ratio A ratio that compares a health plans gross gain from operations before interest expenses and taxes with its beginning capital and surplus for a specified accounting period. Guaranteed Issue Provision A clause in most small group laws that 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. Guaranteed Renewal Provision A clause in most state and federal small group laws that prohibits health plans from canceling a 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. BACK TO TOP
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Health Insurance Portability And Accountability Act (HIPAA) A 1996 federal law that contains provisions to ensure that prospective or current enrollees in a group health plan are not discriminated against based on health status and to guarantee access to health insurance for small employers and certain other eligible individuals. Health Maintenance Organization (HMO) A health plan that assumes both the financial risks and the delivery risks associated with providing comprehensive medical services to an enrolled population in a particular geographic area, usually in return for a fixed, prepaid monthly premium. An HMO brings together the delivery, financing, and administration of healthcare into a single integrated system. Health Maintenance Organization Act (HMO Act) A 1973 federal law designed to help contain rising healthcare costs by encouraging development of HMOs. The HMO Act established requirements that health plans must meet to obtain federal qualification and, for a period of time, provided federal funds for the establishment of HMOs. Health Plan In managed care, the delivery and financing system of healthcare benefits, rather than the benefits themselves. Health Plan Funding The process of determining the source of payment for services rendered by a health plan to its plan members. HIPAA See Health Insurance Portability and Accountability Act.
Historical-Cost Concept See cost concept. HMO See health maintenance organization. HMO Act See Health Maintenance Organization Act. Horizontal Analysis A type of financial analysis that measures the numerical amount by which corresponding items change from one financial statement to another over consecutive accounting periods. BACK TO TOP
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IBNR Claims Ratio The estimate of IBNR (incurred by not reported) claims divided by total claims liabilities. IDS See integrated delivery system. Immediate Recognition An approach to expense recognition that recognizes all applicable costs as expenses during the current accounting period. Impairment For health coverage underwriting purposes, any aspect of an applicants present health, medical history, health habits, family history, occupation, or activities that could increase that persons expected morbidity risk. Impairment Rider A policy attachment that excludes from coverage any loss that arises from a specified disease or physical impairment or that concerns a specific part of the body. Also known as an impairment waiver or an exclusion rider. Impairment Waiver See impairment rider. Income Statement A financial statement that shows how much money a company has realized from its operations during an accounting period, and, ultimately, to what extent the companys general operations during that period resulted in an increase or decrease in its assets. Incremental Cash Flows The additional costs or revenues that result from a capital project. Incremental Cost See differential cost. Incurred Claims Expense See cost of incurred claims. Incurred Claims Method
A claims settlement process that requires the stop-loss carrier to make payments on the applicable claims as of the date the medical expense was incurred. Independent Auditors See external auditors. Independent Proposals Proposals that have unrelated cash flows, so that the acceptance of one proposal does not automatically eliminate any others. Index-Number Trend Analysis See trend analysis. Indirect Cost A cost that is not incurred for or cannot be traced to one specific product, line of business, or department or function. Also known as a common cost or shared cost. Indirect Method A method of financial reporting that begins with the net income figure as reported on the income statement, and then reconciles this amount to operating cash flows through a series of adjustments. Initial-Recording Concept See cost concept. Insurable Interest The condition in which a person would suffer a genuine loss if the covered event were to occur. Insurance Leverage Ratio A ratio that relates a health plans contractual reserves to its capital and surplus. Also known as the gross leverage ratio. Integrated Delivery System (IDS) A combination of two or more legally affiliated health plans, group practices, clinics, or hospitals that combine their assets, efforts, risks, and rewards to deliver comprehensive healthcare, and, in certain circumstances, to arrange for the financing and administration of that care. Interest Charge In a premium-delay arrangement, the part of a premium that offsets the amount of interest lost to a health plan or insurer when an employer is allowed to pay delayed premiums. Interest Margin The difference between a products assumed interest rate or crediting interest rate and the actual interest rate earned by a company on the assets supporting that product. Internal Auditor A person who examines and evaluates the financial records and procedures of his or her employer to ensure that its financial statements are presented fairly and its operational procedures and policies are effective. Internal Rate Of Return (IRR) Method
A capital budgeting technique that determines the discount rate at which the net present value of a capital project equals zero. Also known as the time-adjusted rate of return method. Investing Activities Transactions that involve the purchase or sale of assets and the lending of funds to another entity. Investment Budget The part of the revenue budget that projects the types of investments that a health plan will make and the expected amount of investment-related income for each type. Investment Center A department or other business segment that has control over costs, revenues, and the assets or investment funds used to meet operating needs. Investment Forecast a health plans estimate of earnings based on the performance of bonds, stocks, mortgages, and other invested assets the health plan owns. Investment Margin The difference between the amount of investment income that a health plan earns on money that it has invested and the amount of investment expenses that a health plan incurs associated with those investments. Investment Turnover A measure of the revenue that can be generated for each dollar invested by the responsibility manager, calculated by dividing total revenues by controllable investment. Investment Yield Ratio A ratio that measures how effectively a health plan earns adequate or high returns on the health plans investment portfolio. Also known as the net yield ratio. IRR Method See internal rate of return method. BACK TO TOP
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Leverage A financial effect in which the use of fixed-cost funds magnifies both risks and returns to a health plans owners. Also known as trading on the equity. Leverage Effect The effect that fixed costs have on magnifying a health plans risk and return. Liabilities The current and future obligations of a company. License See certificate of authority (COA). Line Of Business (LOB)
A segment that differs from other segments with respect to sales approach or with respect to client or member service; in cost accounting, a line of business is a segment of products that has a cost pattern distinct from that of other product segments. Line Of Credit A prearranged agreement that allows a company to borrow money on demand up to a specified amount. Also known as a bank line. Liquid Assets Those assets that are either held in cash or can be easily and quickly converted into cash. Liquidation The process of converting a companys assets to cash, usually to pay off all a companys liabilities. Liquidity Ratios Ratios that measure a companys ability to meet its current liabilities. Loading See retention charge. LOB See line of business. Long-Term Budget A type of budget that addresses periods of more than one year. Loss The event that occurs when a company loses money on an activity that does not arise from normal business operations. Loss Ratio See medical loss ratio (MLR). Low-Enrollment Guarantees Contractual provisions that allow capitated providers to be paid on a discounted FFS basis until the providers enrollment meets or exceeds a threshold number. Low-Option Plans Uniform benefit designs developed by states for health plans to offer to small groups. These plan designs typically feature high annual deductibles, high copayments, limits on lifetime and annual benefits, and a limited list of covered services and supplies. Also known as basic plans, essential plans, or bare-bone plans. BACK TO TOP
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Managed Care Organization (Health Plan) An entity that utilizes certain concepts or techniques to manage the accessibility, cost, and quality of healthcare delivery and financing.
Management Accounting The process of identifying, measuring, analyzing, and communicating financial information to assist managers in making decisions. Also known as managerial accounting. Management By Exception A concept which states that managers should focus on operational results or activities that differ from expected norms by a certain amount or percentage. Management By Objectives (MBO) A process by which responsibility managers manage with the intention of achieving stated goals. Management Services Organization (MSO) A legal entity, owned by a hospital or a group of investors, that provides a variety of administrative and other services for participating physicians practices. These services may include any combination of contract negotiations, centralized purchasing, administrative support, marketing, and practice management. Managerial Accounting See management accounting. Mandated Benefit Laws 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. Manual Rating A rating method under which a health plan uses its average experience and sometimes the experience of other health plansrather than the purchasers actual experience, to estimate a groups expected experience. Margin The amount by which a products price exceeds its costs. Also known as the spread or profit margin. Marginal Cost See differential cost. Marginal Unit Cost The increase or decrease in the unit cost as a result of an additional unit of a good or service. Market Value See current market value. Master Budget A network of separate budgets and schedules, each reflecting operating and financial plans for specific segments of a health plan grouped together to show the overall operating and financial plans for the health plan during a specified period. Also known as the operating budget, comprehensive budget, corporate budget, performance plan, profit plan, or budget. Matching Principle
An accounting principle which 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. Materiality An accounting concept requiring companies to disclose all significant information in their financial statements. MBO See management by objectives. Measuring-Unit Concept An accounting concept which states that a company should record the amounts associated with its business transactions in monetary terms, such as U.S. dollars. Also known as the stablemonetary- unit concept, unit-of-measurement concept, or stable-dollar concept. Medicaid A joint federal-state matching entitlement program established in 1965 under Title XIX of the Social Security Act to provide healthcare coverage to lowincome families and certain categories of aged and disabled individuals. Medical Care Foundation See medical foundation. Medical Expense Budget A type of expense budget that indicates the amount of money a health plan expects to pay for medical benefits during the next period. Medical Foundation A not-for-profit entity that owns and manages most or all purchased assets of physicians practices. Also known as a foundation for medical care (FMC) or medical care foundation. Medical Information Bureau (MIB) An organization that serves as a clearinghouse for medical information for the insurance industry. Medical Loss Ratio (MLR) The percentage of a health plans incurred claims to its earned premiums. Also known as the loss ratio. Medical Underwriting Claims Ratio The use of health questionnaires, medical histories, paramedical examinations, or physical examinations to assess, classify, and select or decline the risk for a group. Medicare The federal governments hospital expense and medical expense insurance plan for persons age 65 and older and for certain other persons as specified by law. Medicare ACR See Medicare adjusted community rate. Medicare Adjusted Community Rate (Medicare ACR) a health plans estimate of the premium it would charge Medicare enrollees in the absence of Medicare payments to the health plan.
Medicare APR See Medicare average payment rate. Medicare Average Payment Rate (Medicare APR) The average amount a health plan receives or expects to receive from CMS per Medicare beneficiary covered. Medicare Part C See Medicare+Choice. Medicare+Choice A portion of the Medicare program authorized by the Balanced Budget Act and designed to expand the healthcare coverage choices available to Medicare beneficiaries by allowing more types of health plans to apply for Medicare contracts and to change the system for determining the rates that will be paid to health plans with Medicare contracts. Also known as Medicare Part C. Mental Health Parity Act (MHPA) A 1996 federal law which prohibits, under certain circumstances, a health plan that provides mental health benefits from imposing lower annual or lifetime dollar benefit limits for mental illness than for physical illness. MHPA See Mental Health Parity Act. MIB See Medical Information Bureau. Minimum-Premium Plan An alternative funding method in which the employer assumes the financial responsibility for paying claims up to a specified level, usually from 80% to 95% of estimated claims. Mission Statement A statement that summarizes an organizations reason for existence and overall purpose. Mixed Cost See semi-variable cost. MLR See medical loss ratio. Modified Community Rating See adjusted community rating (ACR). Monte Carlo Simulation 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. Months Of Claims Reserve The sum of a health plans adjusted, unpaid claims liabilities divided by its average claims expense. Months Of Surplus A measurement that tells the length of time a health plan could meet its incurred obligations if it relied solely on funds in its surplus account, calculated by
dividing the health plans end-of-period surplus by the average underwriting deduction. Moral Hazard 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. Morbidity Sickness, injury, or failure of health. Morbidity Rate The rate at which sickness and injury occur within a defined group of people. MSO See management services organization. Multiple-Choice Environment Any situation where purchasers or individuals have a choice among several of a health plans products or services. Multiple-Employer Group An association formed when two or more employers in the same industry provide coverage for their employees through one group plan. Mutually Exclusive Proposals Proposals that involve investment choices that perform essentially the same function, so that the acceptance of one proposal automatically eliminates all others from consideration. BACK TO TOP
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NAIC See National Association of Insurance Commissioners. National Association of Insurance Commissioners (NAIC) A non-governmental organization that consists of the commissioners or superintendents of the various state insurance departments. Net Gain From Operations See net income. Net Gain From Operations Before Taxes See operating income. Net Gain-To-Total Income Ratio The ratio of a health plans net gain from operations to the sum of its total income, plus realized capital gains, minus realized capital losses. Net Income The excess of an entitys total revenues over its total expenses. Also known as net gain from operations. Net Loss The excess of total expenses over total revenues.
Net Present Value (NPV) Method A capital budgeting technique that evaluates a proposed capital project based on its net present value, or the difference between the present value of a projects cash inflowsrevenues, cost savings, and interest incomeand the present value of its cash outflowsproject or investment costs and expenses. Net Profit Margin A margin that shows how much after-tax profit is generated by each dollar of total revenue. Also called rate of return on net sales or return on sales. Net Working Capital A method of measuring a health plans liquidity, obtained by subtracting current liabilities from current assets. Net Worth An organizations total admitted assets minus its total liabilities. Net Worth Statement See statement of owners equity. Net Yield Ratio See investment yield ratio. Newborns And Mothers Health Protection Act (NMHPA) A 1996 federal law that requires a health plan to 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. NMHPA See Newborns and Mothers Health Protection Act. No Balance Billing A clause in FFS payment agreements that states that the physician agrees to accept the payment made by the health plan as full payment for a service and will not bill the plan member for that service. No-Loss, No Gain See continuity of coverage. Nonconfinement Requirement A contractual provision that allows a health plan to delay the effective date of group coverage for an eligible dependent if the dependent is confined to a hospital or under the care of a healthcare provider on the date that coverage begins for an employee. Noncontributory Plan Any health plan or other employee benefit plan in which contributions to fund the plan are made entirely by the plan sponsor. Noncontrollable Cost A cost over which a particular manager or level of management has no power or influence. Nontrusteed Plan See general asset plan. Non-Value-Added Activity
An activity that does not make a product or service more valuable to the customer. Notes To The Financial Statements Factual disclosures of the details behind some of the amounts presented in the financial statements, usually accompanying or immediately following the financial statements in a companys annual report, that enable users to understand some of the more complex items in the published financial statements. Not-For-Profit Health Plan a health plan, organized and operated in the public interest, that cannot distribute its profits to individuals for personal gain; instead, a not-for-profit health plan must use its profits for the benefit of the company and its purposes. NPV Method See net present value method. BACK TO TOP
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Operating Activities Transactions associated with a companys major lines of business that directly determine a companys net income. Operating Budget See master budget. Operating Efficiency Ratios See activity ratios. Operating Income The amount of income before subtracting income taxes. Also known as net gain from operations before taxes. Operating Leverage The effect whereby incurring fixed operating costs automatically magnifies a companys risks and potential returns. Operating Ratios See activity ratios. Operational Budget A short-term budget that covers all or part of an organizations operations. Operational Planning See tactical planning. Opportunity Cost The benefit that is given up when limited resources are used to achieve one goal rather than another. Optimistic, Most Likely, Pessimistic Scenario Modeling A process that involves preparing two 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. Ostensible Agency See vicarious liability. Out-Of-Pocket Costs Costs that require outlays of cash or other resources. Outstanding Stock Stock that has been issued. Overutilization The use of medical services or procedures that are not medically necessary. Owners Equity The owners investment and retained earnings in a company. BACK TO TOP
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Package Pricing An all-inclusive rate that represents reimbursement for both professional services and the hospital or other institution where the services take place. Also known as bundled case rates. Paid Claims Method A claims settlement process that requires the stop-loss carrier to make stop-loss payments based on when the stop-loss policyholder pays 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. Paid-In Capital In Excess Of Par See additional paid-in capital. Partial Capitation See PCP capitation. Par Value The designated legal value assigned to each share of stock. Payback Method A capital budgeting technique that calculates how long it will take a health plan to recover its investment in a capital project. PBM Plan See pharmacy benefit management plan. PCP Capitation A type of capitation payment that reimburses the provider for primary care services only. Also known as partial capitation. P/E Ratio See price/earnings ratio. Percent-Of-Premium Arrangements
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. Performance Plan See master budget. Period Budget A type of budget that covers a specific time frame, such as one month or one year. Per Member Per Month (PMPM) Rate See capitation rate. Phantom Stock An incentive, issued to a privately held companys employees, that is similar to publicly traded stock, but its price is set by a formula. Pharmacy Benefit Management (PBM) Plan A type of managed care specialty service organization that seeks to contain the costs of prescription drugs or pharmaceuticals while promoting more efficient and safer drug use. Also known as a prescription benefit management plan. PHO See physician hospital organization. Physician Hospital Organization (PHO) A joint venture between a hospital and many or all of its admitting physicians to serve their common interests, such as marketing and contractual bargaining power with other health plans or payors or purchasers of healthcare services. Physician Management Corporation See physician practice management (PPM) company. Physician-Owned Organization See provider-sponsored organization (PSO). Physician Practice Management (PPM) Company A specific type of management services organization that typically purchases the assets of physician practices, provides practice management and administrative support services to participating providers, and usually offers physicians a longterm contract and sometimes an equity (ownership) position in the PPM company. Also known as a physician management corporation. Physician Self-Referral Law A law that 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. PI See profitability index. PIP-DCG See principal inpatient diagnostic cost group. Plan Members The enrolled population of individuals for which a health plan provides a range of healthcare services. Also known as enrollees or customers. PMPM Rate
See capitation rate. Point-Of-Service (POS) Option A type of health plan design that allows members to decide, at the point of service, whether to go to a provider within that plans network or outside the plans network. Also known as a POS plan. Pooling A method of determining a groups premium in which underwriters treat several small groups as one large group for assessment purposes. The more enrollees (or proposed enrollees) that are grouped together in a pool, the better the underwriters chances of accurately estimating the whole groups claims costs. POS Option See point-of-service option. POS Plan See point-of-service (POS) option. PPM Company See physician practice management company. PPO See preferred provider organization. Predictive Quality A feature of financial information that enables a health plans external and internal users who analyze the health plans financial statements to develop a reasonably accurate estimate of the companys financial strength or earnings potential. Preferred Provider Arrangement (PPA) See preferred provider organization (PPO). Preferred Provider Organization (PPO) An organization that offers healthcare benefit arrangements designed to supply medical services generally at a discounted cost, by providing incentives for members to use network providers, while also providing more limited coverage for services rendered by providers who are not part of the PPO network. Sometimes called a preferred provider arrangement (PPA). Preferred Stock A unit of ownership that does not ordinarily carry the voting rights of common stock, but does carry a stated preferred stock dividend rate or amount that has a priority over common stock. Premium A payment or series of payments made to a health plan or insurance company by purchasers, and often plan members, for healthcare benefits. Premium-Delay Arrangements An alternative funding method that allows the employer to defer payment of monthly premiums for some time beyond the usual 30-day grace period. Premium On Common Stock See additional paid-in capital. Prescription Benefit Management Plan
See pharmacy benefit management (PBM) plan. Price/Earnings (P/E) Ratio A ratio that represents the amount of money that investors are willing to pay for each dollar of a health plans earnings, calculated by dividing the market price of a health plans common stock by EPS. Also known as the earnings multiple. Price Variance The difference between a products actual rate (or unit cost or price) and its budgeted rate, multiplied by the number of units sold or processed. Also known as the rate variance or cost-related variance. Pricing See rating. Pricing Factor A number that illustrates the risk represented by group members working in a particular industry. Principal Inpatient Diagnostic Cost Group (PIP-DCG) A risk adjustment methodology, to be implemented by CMS in the year 2000, that will account for variations in per capita Medicare costs based on health status. Privately Held Corporation A company whose shares of stock are not offered to the general public. Profit 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). Profit Center A department or other business segment that is evaluated on its profitability and is responsible for both costs and revenues. Profit Margin See margin. Profit Plan See master budget. Profitability Accounting See responsibility accounting. Profitability Index (PI) 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. Profitability Ratios The relationship of a health plans returns to its sales, total revenues, assets, stockholders equity, capital, surplus (if applicable), or stock share price. Profit-Volume Analysis See cost-volumeprofit (CVP) analysis. Pro Forma Financial Statements 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. Prospective Experience Rating
An experience rating method that uses a groups experience to establish the premium for the next contract period. Prospective Reimbursement A payment system that compensates providers at a predetermined rate in advance of the providers supplying treatments or services. Provider-Owned Organization See providersponsored organization (PSO). Provider Reimbursement Trend The change in the reimbursement that a provider receives over time for the same service. Providers The physicians, hospitals, ancillary service providers, and other healthcare professionals that deliver healthcare services to plan members. Provider-Sponsored Organization (PSO) A risk-bearing entity that is established or operated by providers to arrange for the delivery, financing, and administration of healthcare services. Also known as a physician-owned organization or a provider-owned organization. PSO See provider-sponsored organization. Publicly Traded Corporation A company whose shares of stock are offered to the general public. Also known as a stock company. Purchasers And Payors The entities that pay the premiums or the employers, federal or state governments, health plans, or insurance companies that are financially liable for healthcare coverage for plan members. Pure Risk A risk that involves no possibility of gain; there is either a loss or no loss. Back to TOP
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Quick Liquidity Ratio A ratio that compares a health plans liquid assets to the health plans contractual reserves. BACK TO TOP
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Rated Policy
A policy issued to a person considered to have a greater-than-average risk of loss. Rate Of Return On Net Sales See net profit margin. Rate Ratio The markup factor from a single rate to any other rate category. Rate Spread Limit 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. Rate Variance See price variance. Rating 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. Also known as pricing. Rating Agencies Organizations that evaluate the financial condition of a health plan and provide information to potential customers and investors in the health plan. Rating Schedule A table, used to evaluate the risk represented by an applicant, that enables an underwriter to convert the total of the applicants debits to a rating percentage. Ratio A comparison of two or more numbers in fraction form. Ratio Analysis A method of financial statement analysis that consists of comparing various financial statement values for the purpose of assessing a health plans financial performance or condition. RBC Formula For health plans, a set of calculations, based on information in the health plans annual financial report, that yields a target capital requirement for the organization. RBRVS See resource-based relative value scale. Realization Principle An accounting principle which states that a company should recognize revenue during the accounting period in which it is earned. Also known as the revenue principle or revenue recognition principle. Reconciliation The periodic process by which the health plan assesses providers performance relative to contractual terms and reimbursement. Also known as a year-end reconciliation or settlement. Referral Circle A geographically distinct group of physicians to which a health plan ties an enrollees choice of PCP for all specialty referrals.
Regulatory Risk The risk that changes in regulations or laws may adversely affect the financial condition of a health plan. Relative Value Scale (RVS) A method of determining uniform fee reimbursement in which 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. To determine the amount the health plan will pay to the physician, the weighted value is multiplied by a money multiplier. Relevance A quality of accounting information in which the information contained in financial statements is useful, timely, and likely to affect an interested users decisions about a company. Reliability A quality of accounting information in which the information contained in financial statements is accurate, objective, and free from bias and misrepresentation. Renewal Rating 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. Renewal Underwriting The process by which a health plan reviews all the selection factors that were considered when a 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. Reserve-Reduction Arrangement An alternative funding method in which the employer is allowed to retain an amount of the annual premium that is equal to the claims reserve. Reserves Estimates of money that a health plan or insurer sets aside to pay future business obligations. Residual Component Of Trend See residual trend. Residual Income (RI) The amount of income an investment center earns above a certain minimum required rate of return on investment. Residual Trend The difference between total trend and the portion of the total trend caused by changes in provider reimbursement levels. Also known as the residual component of trend. Resource-Based Relative Value Scale (RBRVS)
A means of determining provider reimbursement that attempts to take into account all resources that providers use in providing care to patients, including procedural, educational, mental, and financial resources. Responsibility Accounting 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. Also known as profitability accounting. Responsibility Center A companys business unit over which a manager has control and responsibility. Responsibility Manager The manager of a responsibility center. Retained Earnings The cumulative amount of a companys earnings that has been kept (retained) in the company over time as part of its continuing operations. Retention See retention charge. Retention Charge The part of a premium that is intended to cover expenses (other than for medical services rendered) and contingencies and to allow a health plan or insurer to make a profit. Also known as a retention or loading. Retrospective Experience Rating 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. RetrospectiveRating Arrangements An alternative funding method in which the insurance company charges the employer an initial premium that is less than what would be justified by the expected claims for the year. Return On Assets (ROA) A ratio that measures a health plans success in using its assets to earn a profit, calculated by dividing a health plans net income by total assets. Return On Capital Ratio The ratio of net gain from operations to beginning capital and surplus. Return On Equity (ROE) A ratio that measures the rate of return on the book value of the stockholders investment in a firm, calculated by dividing a health plans net income by its stockholders equity. Also known as the return on stockholders equity. Return On Investment (ROI) The ratio of operating income to controllable investment. Return On Revenue A measurement of managements ability to control operating income in relation to total revenues, calculated by dividing operating income by total revenues. Return On Sales See net profit margin. Return On Stockholders Equity
See return on equity (ROE) Revenue Budget A type of budget that indicates the amount of income from operations that a company expects in the coming budget period. Revenue Principle See realization principle. Revenue Recognition Principle See realization principle. Revenues Amounts earned from a companys sales of products and services to its customers. RI See residual income. Risk Charge The part of a premium that is intended to contribute to the claims reserve that an insurer or health plan maintains to pay for unusually high utilization. Risk Management The process of identifying risk, assessing risk, and dealing with risk. Risk Pod 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. Risk Pool 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 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. Risk-Return Trade-Off The direct relationship between the amount of risk and the amount of the potential return required to make the risk financially acceptable; 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. ROA See return on assets. ROE See return on equity. ROI See return on investment. Rolling Budget A type of budget that allows a company to continually maintain projections for a certain time period into the future. Also known as a continuous budget. Run-In Period
A set number of months or days before the contract year of a stop-loss contract begins. Run-Out Period The time a health plan allows for the receipt of all (or nearly all) claims for a given evaluation period. RVS See relative value scale. BACK TO TOP
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Safe Harbor Regulations Regulations developed by the Secretary of HHS that make exceptions to the antikickback law for some types of arrangements that are unlikely to lead to fraud or abuse. Salary Reimbursement Method A payment system in which providers are paid an agreed-upon salary in exchange for providing healthcare services. Also known as a budget method. Sales Budget The part of the revenue budget that projects premium income from both new business and renewal business. Sales Forecast a health plans estimate of new business and renewal business premiums for a particular period. Salvage Value The residual value or selling price of a tangible (physical) asset at the end of its useful life. SAP See statutory accounting practices. Segment Margin The portion of the contribution margin that remains after a segment has covered its direct fixed costs. Segment Margin Ratio The segment margin divided by the segments total revenues. Self-Funded Plan A form of group health coverage in which a group plan sponsor typically a large employerrather than a health plan or insurer, is financially responsible for the costs of healthcare services rendered to or for plan members. A self-funded plan may be completely or partially self-funded. Also known as a self-insured plan. Self-Insured Plan See self-funded plan.
Selling Expense Budget A type of expense budget based primarily on the costs incurred in selling managed care coverage. Selling Expense Ratio The ratio of a health plans selling expenses to its earned premiums. Semi-Variable Cost A cost that contains elements of both fixed and variable costs. Also known as a mixed cost. Sensitivity Analysis A process of taking the key assumptions made in a strategic financial plan and estimating a range of uncertainty concerning these assumptions to measure the downside risk and upside potential of the plan and to allow for the development of contingency plans. Service-Related Case Rates A payment method in which various service types are defined and the hospital receives a flat per admission reimbursement for whatever type of service to which the patient is admitted. Service Requirement The length of time that a person must be employedusually three to six months before being eligible for coverage under his or her employers health plan. Also known as an employment waiting period. Service Risk Under a straight salary system, the risk that patients will demand more services from the physician than had been anticipated when the salary schedule was designed. Settlement See reconciliation. Shared Cost See indirect cost. Short-Term Assets See current assets. Short-Term Budget A type of budget that addresses a period of one year or less and relates mainly to a health plans operations during that period. Short-Term Liabilities See current liabilities. Short-Term Obligations See current liabilities. Sliding Scale Discount On Charges A payment method under which a health plan discounts a hospitals submitted claims based on a percentage of the hospitals total volume of admissions and outpatient procedures. Sliding Scale Per-Diem Charges
A payment method under which a health plan negotiates an interim per diem that it will pay for each day in the hospital. Small Group Employee groups that range from 1 to 50 or more employees, depending on state law. Solvency A business organizations ability to meet its financial obligations on time. Specialty Capitation A reimbursement method that uses capitation to pay individual specialists or single-specialty groups to provide a contractually defined set of services to a health plans members. Specialty Health Plan An entity that uses an HMO model or a PPO model to provide healthcare services to a subset or a single specialty of medical care. Specific Stop-Loss Coverage Insurance or reinsurance that provides protection against losses arising from individual cases in which medical expenses are disproportionately large or catastrophic. Speculative Risk A risk that involves three possible outcomes: loss, gain, or no change. Spread See margin. Stable-Dollar Concept See measuring-unit concept. Stable-Monetary-Unit Concept See measuring-unit concept Standard Costs Predetermined costs that a company expects to incur during normal business operations. Standard Plans 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. Statement Of Cash Flows See cash flow statement. Statement Of Owners Equity A financial statement that shows the changes that occurred in the Owners Equity portion of the balance sheet. Also known as a statement of shareholders (stockholders) equity, a statement of policyholders (policyowners) equity, or a net worth statement. Statement Of Policyholders (Policyowners) Equity See statement of owners equity. Statement Of Shareholders (Stockholders) Equity See statement of owners equity.
Static Budget A type of budget that generally does not change unless management has approved the changes. Also known as a fixed budget or a fixed-amount budget. Statutory Accounting Practices (SAP) A set of financial accounting standards that focus on the requirements of insurance regulators and policyholder interests (specifically solvency). Statutory Return On Assets (ROA) Ratio The ratio of a health plans net gain from operations to its average invested assets. Stock Company See publicly traded corporation. Stockholders Owners of a publicly held health plan. Stock Options Stock offered as an incentive by a company to its executives at an identified price on a specified date. Stop-Loss Coverage Insurance or reinsurance that transfers the risk of loss on medical expenses above a certain amount and which can be purchased by any of the parties who accept utilization risk in a managed care contract, including health plans, providers, provider groups, hospitals, and employers or other groups with self-funded plans. Stop-Loss Insurance A type of insurance for 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 that transfers the risk of loss on medical expenses above a certain amount. Stop-Loss Reinsurance 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 the insurer for the healthcare coverage. Straight Charges A payment method under which a hospital submits its claim in full to a health plan and the plan pays the bill. Straight Discount On Charges A payment method 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, which the hospital accepts as payment in full. Straight Per-Diem Charge A single negotiated rate that a health plan pays a hospital for each day a plan member spends in the hospital, regardless of any actual charges or costs incurred. Strategic Alliance Partners Independent health plans that are pursuing individual strategic goals but that have joined with a health plan in a prolonged relationship involving the sharing of certain risks and rewards.
Strategic Financial Plan A long-term plan, expressed in monetary terms, that describes how an organization will achieve the goals established in the overall strategic plan. Strategic Planning 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. Strengths, Weaknesses, Opportunities, And Threats Analysis See SWOT analysis. Subcapitation A provider reimbursement method in which an entity 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. Sunk Cost A past cost that does not change as the result of a future decision. Surplus The amount by which a health plans or insurers assets exceed its liabilities and capital. SWOT (Strengths, Weaknesses, Opportunities, And Threats) Analysis 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. Systematic And Rational Allocation An approach to expense recognition that expenses an assets cost over its estimated useful life, regardless of when the company realizes revenues from using the asset. BACK TO TOP
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Tactical Planning The process of determining how to accomplish specific tasks with available resources. Also known as operational planning. Thin Margin A narrow or small profit margin, expressed in monetary or percentage terms. Third Party Administrator (TPA) An entity that contracts with health plans or employers to provide services to help administer healthcare benefits. Time-Adjusted Rate Of Return Method See internal rate of return (IRR) method.
Time Analysis A method of allocating indirect salary costs that determines the percentage of time a manager spends with different departments or activities. Time-Period Concept An accounting concept which states that a companys financial statements should report the companys business operations during a specified time period. Also known as the concept of periodicity. Times Interest Earned Ratio The ratio of a health plans earnings before interest and taxes (EBIT) divided by its contractual payments only. Time Value Of Money The concept that the value of a sum of money will change over time as the result of the effect of interest. Top-Down Budgeting A method of budgeting that generates a budget on the corporate level by upper management and passes the budget down to lower management. Tort A violation of a legal duty to another person imposed by law, rather than contract, that causes harm to the other person and for which the law provides a remedy. Total Asset Turnover Ratio a health plans total revenues divided by its total assets. Total Bed Days The total number of days plan members receive inpatient care at a given hospital. TPA See third party administrator. Traceable Cost See direct cost. Trading On The Equity See leverage. Transfer Price The price of a good or service that one segment of a company charges another segment of the same company. Treasurer A person who manages a health plans cash inflows and cash outflows. Treasury Management See cash management. Treasury Stock A type of stock that represents an insurers purchase of its own outstanding stock. Trend The change in dollar amount or ratio of an index over time. Trend Analysis A type of financial analysis designed to identify changes in a companys financial statement values over the course of several financial reporting periods. Also known as trend percentages or index-number trend analysis.
Trend Percentages See trend analysis. Trusteed Plan A type of self-funded plan under which covered healthcare expenses are paid from a trust established by the employer or other group sponsor. BACK TO TOP
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Unbundling 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. Underwriter A person who assesses and classifies the degree of risk represented by a proposed group or individual. Underwriting 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. Underwriting Cycle 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. Underwriting Function 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. Underwriting Guidelines General rules that the underwriting function uses in assessing, classifying, and selecting risks that an insurer or health plan assumes. Underwriting Margin The difference between a health plans actual benefit costs and the benefit costs (medical expenses) that a health plan assumes in its pricing. Underwriting Risk The risk that premiums will not be sufficient to pay for services or claims. Unit Cost A cost that is the incurred expense attributable to a single measured amount of work; the basic measurement in cost accounting. Unit-Of-Measurement Concept See measuring-unit concept. Unrealized Gain (Loss)
The difference between an assets book value and its market value as of the financial statement date. Upcoding The practice of a providers billing for a procedure that pays more than the procedure actually performed by the provider. URO See utilization review organization. Usage Variance See volume variance. Utilization Review Organization (URO) An external reviewing entity that assesses the medical appropriateness, value, and quality of suggested courses of treatment for plan members. A URO may offer medical cost management services in areas such as inpatient review, outpatient review, and case management of high-risk conditions. Utilization Risk For health plans, the possibility that the rate of use of medical services by a given enrolled population will exceed the predicted rate. BACK TO TOP
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Value-Added Activity An activity that makes a product or service more valuable to the customer. Variable Budget See flexible budget. Variable Costs Costs that fluctuate in direct proportion to changes in the level of operating activity. Variance The difference between an actual result and an expected result. Variance Analysis The study of the difference between expected results and actual results. Vertical Analysis A type of financial analysis that indicates the relationship of each financial statement item to another financial statement item. Vicarious Liability A theory under which hospitals have been held accountable for the acts, errors, and omissions of their independent contractors. Also known as ostensible agency. Vision See vision statement. Vision Statement A statement of an ideal that an organization would like to achieve, intended to inspire enthusiasm and commitment in the organizations employees. Also known as a vision.
Volume-Related Variance See volume variance. Volume Variance The difference between the budgeted quantities to be sold or processed and the actual quantities sold or processed, multiplied by the budgeted amount. Also known as the usage variance or volume-related variance. BACK TO TOP
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WACC See weighted average cost of capital. Weighted Average Cost Of Capital (WACC) The overall cost that a company pays to obtain new funds from all sources. Wide Margin A relatively large profit margin, expressed in monetary or percentage terms. Withhold An arrangement in which 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. Working Capital Management See cash management. BACK TO TOP
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Year-End Reconciliation See reconciliation. BACK TO TOP
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ZBB See zero-based budgeting. Zero-Based Budgeting (ZBB)
A budgeting approach in which, for every accounting period, each line of business within a health plan must justify its continued operation.