Richard Frese
Patrick Kitchen

CFOs should use care in selecting the discount rate to apply to self-insured medical malpractice reserves.


At a Glance  

  • The hospital CFO often works with the hospital's actuary and external auditor to calculate the reserves recorded in financial statements.  
  • Hospital management, usually the CFO, needs to decide the discount rate that is most appropriate.  
  • A formal policy addressing the rationale for discounting and the rationale for selecting the discount rate can be helpful to the CFO, actuary, and external auditor.  

The financial markets took a severe downturn between October 2007 and March 2009, resulting in the lowest investment returns in decades. With this financial instability, questions regarding the appropriate discount rate used in financial reporting of medical malpractice reserves by self-insured hospitals became common. Should the discount rate be maintained at levels consistent with historical rates, or should it match the current market conditions? What source(s) should hospitals look to in selecting a discount rate? Does any official guidance exist on this issue? What dollar impact will a change in the discount rate have on the discounted reserves recorded? Should such reserves be discounted at all?

The ultimate decision of the discount rate for use in self-insured medical malpractice reserves is often made by the hospital CFO. When estimating and recording the self-insured reserves, the CFO should work with both the hospital's actuary and its external auditor.

The Case for Discounting

The Financial Accounting Standards Board (FASB) issued Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, to provide a framework for using future cash flows as the basis for accounting measurements, general principles that govern the use of present value, and a common understanding of the objective of present value in accounting measurements. Discounting of medical malpractice reserves in hospital financial statements is a long-standing practice based on present value theory, recognizing that medical malpractice claims typically take several years to develop and be paid.

Subtopic 450 (Contingencies) under Topic 954, Health Care Entities, of the FASB Accounting Standards Codification (ASC) does not explicitly permit discounting of medical malpractice reserves, but requires footnote disclosure of the carrying amount of accrued malpractice claims as well as the discount rate(s) used. A key assumption when discounting a liability is that the amount and timing of the payments are fixed and readily determinable.

Recently, questions have been raised as to whether payments related to medical malpractice claims are sufficiently fixed and determinable to support recording the related liability on a discounted basis. Although the FASB recently declined to add this issue to the Emerging Issues Task Force agenda, the task force charged with revising the American Institute of Certified Public Accountants' Health Care Entities Audit and Accounting Guide may include additional non-authoritative guidance in a future version of the Guide regarding the need to consider whether the amount and timing of malpractice claim payments are sufficiently fixed and determinable to support discounting.

In addition, the Actuarial Standard of Practice No. 20 of the Actuarial Standards Board (ASB), Discounting of Property and Casualty Loss and Loss Adjustment Expense Reserves, also permits the use of discounting. Actuaries should be able to justify the components of discounting, including the context of use, payment pattern, selected discount rate, and consideration of a risk margin in the calculation of the discounted reserves.

Diversity in Practice

Let's first explore the merits of a variety of sources that hospitals have historically considered when selecting a discount rate for self-insured medical malpractice reserves. Financial theory often suggests that one should look at the expected cash flows of a liability and match it with an asset of similar maturities. The expected return of an asset or portfolio of assets matched to the weighted average time of payment of the reserves may be considered as an option of the discount rate to apply to the reserves. This concept is similar to one used by pension plans to determine the discount rate inherent in the actuarial calculations. A clear advantage of this approach is that the calculated weighted average of time of payment of the reserves is based on the same selected payment pattern of the hospital that is used in the calculation of the reserves, which can vary from an industry pattern to a pattern based on the hospital's own history.

Selections in the investment asset (or portfolio) that hospitals use to develop a benchmark rate tend to differ. Many hospitals will use the return of a "less risky" investment such as a bond or fixed-income portfolio, or even a risk-free rate from a Treasury investment. However, if the hospital wants to use a bond or similar portfolio, should it develop a benchmark using a corporate, government, or municipal bond/portfolio? And should that bond/portfolio have a rating of AAA, BBB, or something else? When evaluating rates for discounting pension obligations, the Securities and Exchange Commission has indicated that companies should look at hypothetical portfolios of fixed-rate debt instruments with ratings no lower than the second-highest rating given by a recognized rating agency (e.g., AA). The selected rate from the benchmark may need to be adjusted to the hospital's own expectation of future rates that are likely to prevail over the period of future cash flows.

Often a hospital with assets segregated in a medical malpractice self-insurance trust will consider its historical return on those assets, but recently many hospitals have been moving away from trust funds. From the authors' experience, about half of hospitals use a trust fund-a significant decline from previous decades. This raises the question of how to estimate a return on assets that are not segregated in a trust to pay medical malpractice claims. Some hospitals may have assets board-designated to pay medical malpractice claims, or may fund such payments out of general unrestricted cash and investments. In these instances, a hospital will often look to the historical return on such assets in selecting a discount rate. Of course, historical returns on such assets, segregated or not, should not be relied on exclusively in selecting a discount rate.

Hospitals should consider the current composition of the assets and the returns expected to be generated over the period of time during which the medical malpractice claims will be paid. For example, for a conservative portfolio of high-quality fixed-income securities, in periods of declining interest rates, as securities mature and are replaced by new securities, the new securities are likely to have lower yields and may warrant an adjustment to the discount rate assumption.

For hospitals that do not have segregated or other assets earning a return, a risk-free rate is usually considered in selecting the discount rate. Some may argue that a hospital without segregated assets or assets earning a return should not discount. If a CFO believes there is an inherent economic amount of discount (even if small) built into any payment that will be made into the future, it is appropriate for the CFO to discount losses. Even if assets earning a return (or a suggested benchmark) that would support a higher discount rate exist, a hospital may still decide to use a risk-free rate as a means of incorporating a risk margin on the discount rate and subsequently the reserves. A risk-free rate can be obtained from Treasuries or other U.S. government securities with maturities corresponding to the expected cash flows of the claim payments. The rates should reflect the market interest rates at the valuation date and may need to be adjusted for expected future variations.

The Sensitivity

The dollar amount of discounts can be significant in relation to the undiscounted malpractice reserves. As a result, relatively small changes in the discount rate can result in significant changes in the discounted reserve. In fact, for a typical hospital, the discount subtracted to arrive at the net recorded reserve may represent 10 to 25 percent of the undiscounted reserves, depending on the discount rate used alone. The dollar amount of the discount is greatly affected by the discount rate selected and the payment pattern used by the actuary.

An individual hospital's medical malpractice loss history is often not given full credibility because a single hospital's medical malpractice losses may be considered statistically small-which, when combined with the low-frequency, high-severity nature of medical malpractice losses, frequently distorts average patterns. Therefore, an actuary might blend the hospital's payment pattern with an industry pattern, or might simply use only the industry pattern.

Let's look at a simple example based on the latest 10 occurrence years for a hospital. (Please note that the same principle applies to claim-made discounting as well.) The tables referenced here are shown purely for example and should not be used in practice by hospitals. A sample (rounded) industry pattern of 1.0 percent paid in the first year, 5.0 percent in the second year, 15.0 percent in the third year, and so on, applied to a hospital for an average accident year (AY) is shown in the top exhibit below.

The weighted average time of payment based on the above payment pattern is 4.66 years, assuming midyear payments. Now let's assume that a sample hospital has 25.0 percent of its total reserves in the most recent AY (2010 in this example), 20.0 percent in 2009, 17.5 percent in 2008, and so on, so that the outstanding reserves as a percentage of the total reserves look like the bottom table below.

Exhibits 1 and 2

f_frese_exh1-2

The final variable in our estimation of the amount of discount is the discount rate itself. Let's assume an array of discount rates so that the sensitivity of this assumption becomes apparent: from 0 percent (no discounting) to 6 percent by increments of 100 basis points. The result is the table of discount factors shown below. 

Exhibit 3

f_frese_exh3

When the discount factor is multiplied by the corresponding percentage of the reserves for an AY, the result is the percentage of reserves that is discounted for that particular AY. The table on page 89 shows the sensitivity of the discount rate used.

The ratio of the discounted reserves to undiscounted reserves in this example varies from 100 percent to 87 percent by using a discount rate from 0 to 6 percent, respectively. This would result in a hospital with $10 million of undiscounted reserves having a discount of $1.3 million using a 6 percent discount rate. Keep in mind that this example is grossly simplified by limiting the payments to only 10 years. In reality, a hospital has the potential to make payments on medical malpractice claims for 10 to 20 years from the incident date (depending on the jurisdiction), which would result in additional discount. It should be noted that a faster payment pattern would also result in less discount while a longer payment pattern would result in more discount.  

The Concerns

 As discussed in the previous section, the discounted reserves are sensitive to the discount rate used, and large changes in reserves can result if discount rates fluctuate significantly from year to year. A large change in the discount rate from one year to the next can significantly change the discounted reserves, even if a hospital's loss experience remains the same. In the authors' experience, hospitals commonly employ discounting. This practice varies from that used by corporations, most of which do not discount self-insured reserves.

This difference raises the question as to whether accounting rules around discounting differ by industry. Is the difference due to the long-tail nature of medical malpractice claims? Or is the difference due to recording a reserve at a higher percentile compared to the mean? Many hospitals tend to book a discounted reserve at a percentile (higher than the mean) where the amount of discount may closely offset the additional amount of reserves from the higher percentile, while corporations tend to book an undiscounted reserve at the mean.

Working Together

Hospital management (typically the CFO) has the ultimate responsibility for estimating the self-insured medical malpractice reserves in the financial statements. The reserves recorded in the financial statements are often calculated with the assistance of an actuary and examined by an external auditor. Therefore, the CFO, the actuary, and the auditor need to communicate with each other.

Assuming a hospital discounts its self-insured medical malpractice liability, hospital management needs to choose the most appropriate discount rate. Both the CFO and the auditor may rely on the actuary to understand the dollar impact of a change in the discount rate. However, the selection of the discount rate is ultimately made by the CFO, with the concurrence of the auditor and the actuary. As with any significant accounting estimate in the financial statements, management is responsible for implementing internal controls to ensure that the data supporting the estimation of the self-insured medical malpractice reserve, including the discount rate, is relevant, sufficient, and reliable, and that the estimates are prepared by qualified individuals and are adequately reviewed and approved.

Exhibit 4

f_frese_exh4

The CFO, the auditor, and the actuary should agree on the basis for how the discount rate is selected and how the discount rate will be adjusted in the future based on changes in market or other conditions. A formal policy addressing the rationale for discounting (including why management believes the medical malpractice payments are fixed and readily determinable), as well as the rationale for selecting the discount rate (and how that rate will be monitored and adjusted over time), can help ensure a common understanding among the CFO, actuary, and external auditor. This policy should address all considerations that lead to management's conclusion regarding the approach to be taken.

A consistent approach based on a formally documented policy will help in planning for the effects of discount rate changes and in avoiding misunderstandings and surprises. A change in approach, including whether to discount the reserve as well as a change in the method used to determine the discount rate used, represents an accounting change that should be justified as preferable by management.


Richard Frese is a consulting actuary, Milliman, Chicago (richard.frese@milliman.com).

Patrick Kitchen is a partner, McGladrey & Pullen, LLP, Chicago, and a member of HFMA's First Illinois Chapter (patrick.kitchen@mcgladrey.com).


 

Publication Date: Monday, January 03, 2011

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