Richard C. Frese
At a Glance
Healthcare organizations can improve their year-end malpractice insurance accruals by taking the following steps:
- Maintain productive communication.
- Match accrual and accounting policies.
- Adjust amount of credit to own historical loss experience.
- Request more frequent analysis.
- Obtain a second opinion.
Determining an appropriate accrual at year-beginning for adequate reserves in year-end financial statements has its challenges. Complicated by the low-frequency and high-severity nature of medical malpractice losses and insurance program changes during the year, a program often may be significantly overaccrued or underaccrued when losses don't develop as expected, resulting in problems such as eliminating redundant reserves or quickly finding capital to reduce a deficit.
Furthermore, due to evolving guidelines and standards, an increasing number of healthcare entities are booking the unpaid claim liability reserve at a single point estimate (the actuarial central estimate, formerly known as the "best estimate") instead of booking within a range. This change in practice limits healthcare finance leaders' flexibility in determining an appropriate accrual amount for total year-end reserves. Issues such as these can be resolved by better understanding the accrual process and adhering to a few simple guidelines.
Interpretation of an Accrual
The meaning of accrual varies in practice. A common interpretation is the contribution amount for the next fiscal or policy year of exposures. A self-insured retention is often budgeted on an occurrence basis because financial reporting requires both claims-made and tail liability for late reportings, which total to occurrence liability. If the program is in a steady-state basis (similar characteristics and loss experience as in the past), the new occurrence-year contribution minus total payments for the program during the year is a quick approximation for estimating the change in liability during the fiscal year when ignoring investment income, changes in reserves, and trend.
Another common interpretation of accrual is the change in unpaid claim liability estimates during the fiscal year, or projected year-end liability minus the year-beginning liability. Liability comprises known claims, commonly called case reserves, as well as a provision for unknown losses, commonly called incurred-but-not-reported (IBNR) losses. IBNR losses are usually estimated by an actuary and consist of several components, including case reserve development on known cases, pure late reportings, reopened cases, and pipeline claims (reported but not yet in the system). A different view of liability is ultimate (retained) losses less payments. Ultimate losses are the sum of payments, known case reserves, and IBNR losses. Any change in the ultimate losses affects liability on a dollar-for-dollar undiscounted basis.
When considering an insurance expense for the fiscal year, some finance managers will also add the payments made during the year to the change in unpaid claim liability. Regardless of the interpretation, the core elements and principles are similar. All of these interpretations are theoretically alike when trends and other program changes are omitted. A formulaic illustration is shown in the exhibit below.
It is important to note that many auditors are primarily concerned with sufficient year-end reserves and do not express an opinion on the accrual process. It is up to the organization's finance leaders to decide whether and how much to accrue for self-insured losses during the year. Many prefer an equal monthly accrual, but some may opt for a different scheme to meet their needs, including using an actuary to project an accrual amount. As long as there are sufficient year-end reserves, most auditors do not have a preference for how the organization determines the amount.
Problems with an Unadjusted Accrual
Loss projection models and estimates rely on the assumption that the past indicates the future. In other words, if a program is in a steady-state basis, future losses will develop in a similar manner-similar reporting lag, closing lag, philosophy of reserving, and even an equal number of large losses. Loss projection models and estimates also assume that losses will trend at a comparable rate, that exposures are homogeneous, and that the retention remains unchanged. Even other program characteristics such as the percentile level (confidence level), rate of discount, and other expense provisions that may be added to the program are assumed to be stable over time.
Under the theory of consistency and a steady-state basis, the ultimate losses of a program, which determine the liability, would remain the same as initially projected. In reality, however, an insurance program and assumptions in a projection model are constantly evolving. Any midyear change in a program should be accounted for in a revised estimate of an accrual because the basis of the initial accrual has been altered. Generally, the most significant change finance leaders make during the year is to managing and reserving reported claims. For example, the leader may decide to initially step case reserves but later decide to reserve claims at the expected settlement amount (reserving to ultimate).
Since estimations commonly rely on long-term averages and/or industry information, a program may be overaccrued if there are not any large losses during a year, but then significantly underaccrued if a large loss does occur. Development patterns, frequency and severity trends, and other data are estimated over a long period because of the long tail nature of professional losses. In fact, the final ultimate losses in medical malpractice may not be known until 10 or more years after occurrence.
In such a long observation period, there may be years with large losses and years with very small losses, all of which are averaged into a long-term estimate. When a year is first projected, it is initially assumed to be average, but it often will later develop into a "good" year or a "bad" year. Averages work well over a long period of time, but in any given year, they may be too high or low. The situation is further complicated when a change in an insurance program results in the initial use of industry information (from a lack of credibility in the program's own data) that may cause a divergence if the program's actual experience does not match the industry average.
Tactics for Better Budgeting an Adequate Accrual
As policy or accident years mature, and when programs evolve, various methods may be employed to project losses. The estimate of ultimate losses always is in response to current information, making it difficult to precisely project year-end results. Typically, it is best for loss experience to drive the estimates and not the assumptions of the model. Following are some considerations for management when budgeting an accrual amount.
Maintain productive communication. When relying on an actuary's estimates, healthcare finance leaders will find that frequent conversations are beneficial. At minimum, these conversations should occur annually when commencing the actuarial evaluation, with a follow-up during the year if changes occur in the program or loss experience. It is important for the actuary to understand all program changes enacted by the healthcare organization. In addition, the actuary should be able to demonstrate the impact, per change, to the program's liability. The finance executive should understand the actuarial estimate and may want to inquire as to the number of expected large losses in the actuarial estimate, or even the estimated amount of payment during the next fiscal year, to see if these items align with his or her expectations.
Match accrual and accounting policies. Some programs budget the contribution at a percentile, such as the 75th percentile. Although the contribution amount is selected by the finance leader, the liability is regularly at the actuarial central estimate. There is inherent conservatism by using a contribution at a percentile. This option may be preferred because it decreases the chance of having a year-end deficit, but it also means most years will be overaccrued. By using the actuarial central estimate, the expected amount of surplus is reduced, but conservatism is also reduced.
Adjust amount of credit to the program's own historical loss experience. Projection methods rely on selected loss development patterns and trends. Credit should be given to the program's own experience as appropriate but may need to be complemented with industry information. The amount of credit given depends on many factors, including the program's size and the stability of the loss experience. When the assumptions of a model need to be updated, it may be best to blend the assumption change for the purpose of stability; however, sometimes the change is more sudden, resulting in an unstable accrual amount. It is particularly important to use a revised accrual amount when the change is abrupt.
Request more frequent analysis. When a program undergoes multiple changes during a fiscal year or is on an unstable basis, or even if the organization's finance executive wants additional assurance that the monthly accrual is reasonable, the executive can always request an interim study. Depending on the size of the program, quarterly or semiannual analyses are reasonable. To decide whether an interim study is appropriate, the finance leader should determine his or her comfort level with current loss activity during the year and program changes. For example, when new exposures are added, the accrual should increase. An additional look during the year allows the actuary and management to respond to current information, which will lead to fewer year-end "surprises" for the organization and help smooth the accrual.
Obtain a second opinion. To gain even further comfort about the accrual estimate, the finance leader can pursue a second opinion from an outside actuary. Obtaining an unbiased, independent estimate in this way may confirm the original estimate or lead to a productive discussion to understanding the differences in the estimates. Finance leaders may decide that getting outside opinions every few years is valuable and worth the effort. When comparing two different estimates, finance executives should keep in mind that the goal is to determine an appropriate accrual amount for the program's exposures.
Healthcare finance executives should have a plan in place to handle program changes during the year and confirm that the accrual estimate is reasonable to meet the expected point estimate of the year-end liability. Program changes should be addressed quickly. By monitoring the accrual during the year, whether internally or externally, and better understanding what factors affect an accrual, finance leaders will be able to make interim adjustments and alleviate the concern of closing adequate year-end financials. The relationship between the finance executive and the actuary should not be underestimated. Each analysis provides both the actuary and management with a better "feel" for the program, which will add value and extra insight to project a more accurate accrual and meet the healthcare organization's financial reporting needs.
Richard C. Frese, FCAS, MAAA, is a consulting actuary, Milliman, Chicago (email@example.com).
Publication Date: Wednesday, August 01, 2012