Richard C. Frese
Patrick J. Kitchen
At a Glance
- FASB ASU No. 2010-24, Healthcare Entities (Topic 954): Presentation of Insurance Claims and Related Insurance Recoveries changes how healthcare entities present medical malpractice liabilities on financial statements.
- Healthcare CFOs may need the assistance of their auditors and actuaries to ensure that ASU 2010-24 is appropriately implemented.
- Actuaries need to estimate the recoverable asset, using methods such as historical loss experience, increased limits factor, and commercial premium.
In August 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-24, Healthcare Entities (Topic 954): Presentation of Insurance Claims and Related Insurance Recoveries. Effective for financial statements with fiscal years, and interim periods within those years, beginning after Dec. 15, 2010, ASU 2010-24 requires healthcare entities to report medical malpractice and similar liabilities on a gross basis, separately reporting any receivable relating to anticipated insurance recoveries. Previously, many U.S. healthcare entities presented such liabilities net of expected insurance recoveries.
Although the FASB's desire to achieve more consistency in financial reporting is clear, a number of questions will likely result from the implementation of ASU 2010-24:
- What is the expected impact, if any, on the healthcare entity's financial statements?
- What are the potential challenges in implementing ASU 2010-24?
- How can the gross liability and anticipated recoveries receivable be estimated?
Healthcare CFOs may need the assistance of their auditors and actuaries to ensure that ASU 2010-24 is appropriately implemented.
Background, Effective Date, and Transition
Generally accepted accounting principles in the United States-specifically FASB Accounting Standards Codification (ASC) Subtopic 210-20, Balance Sheet/Offsetting, and International Financial Reporting Standards-do not permit offsetting, or netting, liabilities with anticipated insurance recoveries from third parties. Prior to the effective date of ASU 2010-24, healthcare entities were permitted an exception to this rule for expected insurance recoveries receivable relating to medical malpractice claims, and many healthcare entities presented medical malpractice liabilities net of such receivables.
The FASB believes that the accounting required by ASU 2010-24 is preferable because:
- It reduces the diversity in practice related to healthcare entities' accounting for medical malpractice claims and related anticipated insurance recoveries.
- It results in more consistency with accounting by entities in other industries.
- It better reflects that healthcare entities generally remain liable for payment of, and retain risk of loss associated with, such claims.
- It better reflects that the healthcare entity is exposed to credit risk from the insurer.
The accounting required also is consistent with International Financial Reporting Standards, which do not permit offsetting of the types of assets and liabilities described in ASU 2010-24.
The provisions of ASU 2010-24 should be applied as of the beginning of the period of adoption, with the initial adoption expected to result in a grossing-up of the claim liability and insurance recovery receivable on the balance sheet. To the extent that the gross-up of the claim liability does not equal the additional insurance recovery receivable recognized, a cumulative-effect adjustment to beginning retained earnings or unrestricted net assets would result.
Understanding Coverage and Loss Layers
The majority of healthcare entities in the United States that self-insure medical malpractice risk tend to purchase claims-made excess insurance coverage for losses above the self-insured retention. A claims-made excess policy will cover the claims of the healthcare entity that are reported within the policy period when the claim amount is within the layer of the policy. These claims are above the self-insured retention and are capped at the uppermost limit of the policy (known as the excess layer). Claims that are reported after the policy's expiration date are not covered by the policy, and therefore, healthcare entities usually purchase claims-made policies continually for the reportings in subsequent years or purchase a tail policy for prior acts that have yet to be asserted. The majority of these same entities record a liability in the financial statements of the self-insured retention on an occurrence basis. An occurrence basis is determined by when the incident happens or occurs, regardless of when it is reported.
A few questions may arise about layers of losses. First, implementation of ASU 2010-24 requires an estimate of the ceded losses, or the difference between gross losses and retained losses. (Gross losses should not be confused with unlimited losses; gross losses imply a limit based on the coverage purchased.) Ceded losses reported after the period covered by the policy are referred to as an excess tail liability, and diversity in practice exists in healthcare entities' recognition of this liability in their financial statements. FASB ASC 450-20-25-2 generally requires insured entities that maintain claims-made coverage to recognize a liability for probable losses from incurred-but-not-reported (IBNR) claims and incidents if the loss is probable and reasonably estimable, and this could include an excess tail liability.
There is also diversity in practice regarding establishing a limit when estimating the excess tail liability. Some believe a limit may be assumed, while others believe the excess tail liability should be unlimited. Some healthcare entities have established this limit based on the coverage provided by the policy in place as of the effective date of the tail. Other healthcare entities hold the view that such tail liability limits cannot be based on levels of insurance coverage, as the entity cannot assume that claims-made coverage will continue to be purchased in the future. These healthcare entities have usually established tail limits based on the entities' historical loss experience (also known as the working layer). Regardless of past practice, ASU 2010-24 will require estimated liabilities to be recorded gross of estimated insurance recoveries, making it inappropriate to establish tail limits based on insurance in place as of the effective date of the tail exposure.
Actuarial Estimation and Impact
Under ASU 2010-24, actuaries will need to estimate the recoverable asset. Although the method(s) the actuary uses is the ultimate choice of the actuary, the following are examples that can be employed.
Historical loss experience method. An actuary may decide to use the healthcare entity's own loss experience. This method can present difficulties if there is not enough credibility in the data or stability. For example, a small community hospital may have minimal losses for the majority of the years and then have a few adverse years with several large claims. Even with several large claims, there may not be enough credibility in the higher limits. Furthermore, a small hospital may have not even have a loss above the retained limits. A large health system, with higher-frequency claims of various magnitudes, may be more predictable in the higher layers. For both a large health system and a small community hospital, the actuary may need to rely on industry loss development patterns or use a blended pattern of the entity's experience with the industry.
Increased limits factor method. Under this method, an actuary would estimate the gross layers by relying on the estimate of losses in the retained layer and using an increased limits factor (ILF) to apply a theoretical increase for losses above the retained limits. The ILF can be an industry standard or can be calculated on the healthcare entity's data if the data are credible. The actuary may also need to extrapolate the ILFs for the entity's specific limits, which may introduce increased uncertainty in the estimate.
Commercial premium method. This method uses the commercial premium charged by the excess carrier or reinsurer and removes the profit, expenses, contingencies, and risk loads to arrive at the pure losses (pure premium) in the layer. The actuary applies a loss ratio to the commercial premiums, which may need to rely on industry information, especially when company-specific information is not available. The actuary should keep in mind outside influences that may influence the premium charged such as the market cycle and competitive pricing.
Each of the sample methods described here has different assumptions, strengths, and weaknesses. The actuary may use one method exclusively or blend the estimates to get a final estimate of the gross and/or ceded losses. Of course, with higher layers of coverage, there is more variability because of the low-frequency, high-severity nature of medical malpractice exposures. Actuaries will also need to consider jurisdictions, tort reform, future claim trends, risk management practices, and any other factor that can affect losses.
The magnitude of the asset recoverable of a healthcare entity will vary significantly among entities. The recoverable depends on several factors, including the coverage in place, the loss experience of the entity, and the exposures of the entity. For example, a healthcare entity that has many births may have more exposure and experience in higher commercial policy limits and therefore expect a larger recoverable. Industry standards may be used as a supplement but the calculation should be customized for each entity.
An important consideration in implementing ASU 2010-24 is the amount of actuarial analysis that will be required to estimate the gross liability to be recognized in the financial statements. Although the impact of adopting ASU 2010-24 will be recognized through a one-time cumulative-effect adjustment rather than retrospective application to prior financial statement periods, analysis is still required relating to claims associated with unpaid claim liability from all prior incident or claims-made years. Depending on the method(s) used by the actuary, the additional analysis required may be significant for healthcare entities with many years of claims. There may be additional limitations depending on the information provided by the healthcare entity regarding historical insurance contracts, limits, and premiums paid.
Additional Accounting Considerations
ASU 2010-24 provides that an insured entity "shall recognize an insurance receivable at the same time that it recognizes the liability, measured on the same basis as the liability, subject to the need for a valuation allowance for uncollectible amounts." Healthcare entities that have historically reported anticipated insurance recoveries net of the related claims liability have been required to consider the inherent collectability of those recoveries when recording a net liability in the financial statements. Uncertainty resulting from determining which insurance companies will contribute to recoveries on the ultimate loss, as well the financial viability of the insurance companies, may make it appropriate to establish an allowance for uncollectible insurance recoveries receivable. Given that insurance recoveries receivable will be reported gross under ASU 2010-24, the importance of carefully considering the need for such an allowance will be highlighted.
A question that will need to be addressed in implementing ASU 2010-24 relates to insurance recoveries receivable for pure IBNR claims (also known as tail claims) under claims-made coverage. Arguably, an insurance company providing claims-made coverage would not be liable for a claim unless it is properly reported to the insurance company during the period that it is providing coverage under the claims-made policy. Because pure IBNR claims, by their nature, have not yet been reported, a question remains as to whether an insurance recovery receivable can be recorded for such claims under a claims-made policy.
Unless the claim is expected to be made during the period that the insurance is in force, the answer is no; it is not possible to record an insurance recovery receivable relating to the IBNR portion of the gross liability to be recognized under ASU 2010-24. As a result, a cumulative-effect adjustment reducing beginning retained earnings or unrestricted net assets may be required upon the initial adoption of ASU 2010-24. Although the exposure to uninsured pure IBNR claims can be reduced by an effective risk management system that supports a healthcare entity's timely identification and reporting of incidents to the insurance carrier, it is unlikely that this exposure could be eliminated entirely.
Implementing ASU 2010-24
Although ASU 2010-24 permits early adoption, few healthcare entities have actually adopted its provisions early. The FASB expected that the adoption of ASU 2010-24 would have minimal impact on the financial statements of most healthcare entities. Because loss experience, insurance coverage and limits, and exposures differ among healthcare entities, the amount of insurance recovery receivable to be recorded, and the impact on the financial statements, could vary significantly. As more healthcare entities implement ASU 2010-24, additional questions may arise that could require additional guidance and clarification. A healthcare entity's CFOs should work with the entity's actuary and auditor to help ensure that ASU 2010-24 is properly implemented.
Richard C. Frese is a consulting actuary, Milliman, Chicago (email@example.com).
Patrick J. Kitchen is a partner, McGladrey & Pullen, LLP, Chicago, and a member of HFMA's First Illinois Chapter (firstname.lastname@example.org).
Publication Date: Monday, October 03, 2011