actuarial considerations of medical malpractice evaluations in M&As

Merger and acquisition (M8.A) transactions currently characterize the business landscape of health care. In the fall of 2013, a survey of HFMA's senior financial members found that more than 80 percent had entered into an acquisition or affiliation arrangement or were actively considering or open to the idea.® With the large amount of dollars involved in such a transaction, the liabilities of the medical malpractice insurance program often are an afterthought. Still, when cash is exchanging hands, it is important to properly determine an amount that will be acceptable to both parties and that represents the true cost of the exposure.

Hospital and health system leaders should seek guidance from their organization's broker, actuary, legal counsel, accountant, and other consultants before starting the M&A process. Each will be able to share different viewpoints and concerns. The following are considerations that deserve leaders' attention as they move forward with securing an actuarial estimate.

Supporting an Unbiased Actuarial Estimate

An unbiased actuarial estimate may be hard to achieve because each side has different motivations. An actuary often represents the interests of his or her client. Because actuarial estimations involve assumptions and judgments, it is possible to end up with two different estimates even when the same data set is provided. This is particularly true in medical malpractice compared with other insurance coverages due to the low-frequency, high-severity, long-tail nature of medical malpractice losses. Leaders also may encounter a situation where the same actuary or firm is on both sides of the deal.

When healthcare leaders have any doubt about transparency, it may be best to hire an independent actuary to allow an additional, outside perspective to quantify any bias in the original actuarial estimates. The independent actuary also may act as a facilitator in any conversations between the organizations' actuaries given that the discussions can become complex if the two actuaries argue in defense of their estimates.

Experience of the Actuary

Medical malpractice is a unique insurance coverage, and not all actuaries have significant experience with this type of coverage. Achieving an understanding of the nature of the coverage and its intricacies takes years. Actuarial models that work well in other insurance coverages may not be appropriate or may need to be altered and tailored. Larger actuarial firms may have more access to resources in both manpower leading up to a quick transaction deadline and in expertise, as they are armed with useful internal databases and information.

Experience in the jurisdictions(s) of the exposure (i.e., the legal environment the hospitals are located in), with the captive domicile (i.e., onshore or offshore) and with prior M&A deals improves the accuracy of the calculations and eases the process. Captive domiciles have different characteristics and requirements, so management may want to fully understand and be familiar with each domicile. In addition, each jurisdiction acts differently, which affects how claims develop and, ultimately, how they get paid. Some states have programs such as tort reform or patient compensation funds. Finally, an actuary who also has been through an M&A transaction can offer insight to healthcare leaders throughout the process.

Availability of Quality Data

An actuarial estimate is only as good as the data provided. Access to complete records means the actuary will have to make fewer assumptions to fill in the holes, thereby increasing the reliability of the estimates. Complete and accurate information also ensures the analysis is performed in a timely manner and makes the audit process easier. Physician rosters often are difficult to obtain because they invariably are in flux, but this information is vital to an actuarial analysis.

The actuary should be able to provide a comprehensive list of required data to management. Sending too much information often is better than not sending enough. The data always should be reconciled with a prior actuarial report to ensure the information is being used correctly and consistently. Leaders should keep in mind that it may be difficult to obtain quality information from the acquired entity and that there will be a learning curve for the actuary because hospitals track information differently.

A Full Picture of the Organization's Malpractice Coverage

Medical malpractice coverage often has a highly complex structure because different hospitals and health systems have varying coverage needs over time and because the availability of commercial insurance varies in different markets. The range of options for insurance vehicles, each with advantages and disadvantages, may further complicate coverage.

Management should present a clear picture of all policies and the type of coverage offered by each. It is necessary to identify which policies offer claims-made coverage (protecting the organization only if the policy was in place both at the time of the alleged malpractice incident and when the claim is filed in court) and which offer occurrence-based coverage (providing coverage for incidents that took place when the policy was in effect, regardless of when the claim reaches the court). Any tail policies-especially those offered to physicians-also should be identified, along with their retroactive dates. Summaries should specify whether the hospital, its employees, or physicians (employed or contracted) are covered. Such summaries should state the retentions that are kept by the hospital, any aggregate limits, and the amount of excess insurance or reinsurance. The broker also is a good resource for this information and should ensure the information is readily available.

A Loss-Development Assessment

An actuary applies mathematical models to estimate unknown losses or future losses based on prior history. Unknown losses are referred to as incurred but not reported (IBNR) losses. IBNR losses include claims that have not yet been reported, further loss development on known claims, claims that will reopen, and claims that may be in the pipeline but have not yet reached the status of a full suit. The sum of the known case reserves and the IBNR equals the liability on the balance sheet.

The actuary tries to use as much of the hospital's or health system's history as is credible in developing a loss-development analysis. When there is not full credibility, an actuary blends in an industry standard or may use only this standard. When assessing future loss development, the actuary makes judgments. Even a slight variation in one of the actuary's selections can have a significant impact on a loss estimate, particularly the tail factor, which explains the longer development of a tail factor in medical malpractice. Loss development will vary significantly between jurisdictions. Healthcare leaders should try to understand the actuaries' thought processes and challenge the actuaries when the analysis does not line up with their assumptions.

In an M&A transaction, it may be appropriate for an acquiring organization to assume the loss development of the acquired entity will follow the loss development of the acquirer. In this instance, leaders for the entity being acquired should be asked to value the reserves and payments so that the methodologies are consistent. Management may also request a scenario that assumes loss development of the acquired entity follows its own historical pattern.

Loss control also becomes a question during an M&A transaction. The acquired organization may lose the motivation to engage in safe practice and defend claims. If the acquired entity has claims-made coverage, the acquirer may require that all claims be reported to the current insurance program.

Frequency and Severity Trends

The costs of claims usually rise over time, but the rate at which they occur can vary. When forecasting losses, actuaries examine both frequency and severity trends. Trends may be estimated based on the hospital's or health system's own data, if credible, or may need to be supplemented with industry information.

A change in trends will affect future loss estimates. Considering that pro forma financial statements may require a projection of the next three years, it is important that the trends examined be appropriate so that the funding is adequate, not deficient or excessive. An actuary also may apply a trend for exposure when projecting future losses (commonly measured in occupied-bed equivalents), but such a projection often is based exclusively on the hospital's or health system's own growth or decrease in utilization and/or physicians.

Accuracy of Utilization Data

An actuary assumes that losses are proportional to the hospital's or health system's utilization-as measured by the number of inpatients beds, procedures, and physicians, for example. An organization's leaders should ensure that metrics are detailed and accurately represent the operations of the hospital or health system. Some data may reflect increases over time, while other data may illustrate reductions that have occurred, so it is important to capture all available statistics.

The definition of utilization metrics may vary by hospital. An organization's leaders should discuss with the actuary what constitutes a record of each metric. This conversation is critical because an actuary will convert the statistics into occupied-bed equivalents and will need to ensure the proper weight or conversion factor is applied. In addition, some actuaries apply an industry cost per occupied bed to the number of occupied beds to arrive at an estimate of losses. This estimation will be skewed if the bed conversion factors that are applied are incorrect.

Information Related to Discount-Rate Assumptions

Liabilities and loss forecasts may be estimated on a discounted or undiscounted basis. Often, management decides whether to employ discounting, but this decision also may be influenced by the domicile of the captive. The higher the discount-rate assumption, the lower the liability or future losses, while the lower the discount-rate assumption, the higher the liability or future losses.

An organization's leaders usually supply the actuary with any discount-rate assumption, but the assumption should be supported. Typical methods of support include the historical return on segregated assets, using a corresponding return from a bond where the duration matches the average payment length, or simply using the risk-free rate. Any change in market conditions may warrant an adjustment to the discount-rate assumption. In an M&A transaction, several different discount-rate assumptions may need to be presented so that leaders better understand the sensitivity of such an assumption.

Quantifying the Contingency Margin

Actuarial estimates tend to err on the conservative side for the purposes of financial reporting. This may not be appropriate, however, during an M&A deal. Loss estimates may be provided at the actuarial central estimate, formerly known as the best estimate, or presented as a percentile. A transaction often will be conducted using the actuarial central estimate level, with percentiles quantified. The higher the percentile, the lower the probability that losses will be greater than the estimate. If conservative estimates at the actuarial central estimate are multiplied by a contingency margin, then the degree of conservatism is further compounded.

Contingency margins are proportional to the number of losses and the size of the hospital or health system. The greater the losses and the greater the consistency in the losses, the lower the contingency margin. During an M&A transaction, an organization's leaders may decide to use the combined contingency margin or the margin from the entity alone.

Communicating Management's Expectations

At the start of the process, management should set expectations with the actuary. The actuary will need to be informed of any strategic goals to ensure all members are on the same page. The scope, deadlines, and role of the actuary should be clearly outlined. The organization's leaders may want the actuary to contact others directly to obtain information, or they may decide to be involved in every step. The actuary and other consultants often need to rely on each other to efficiently obtain the best information.

Management should request that the executive summary of the actuarial report contain exactly what is needed. In addition, leaders may want the actuary to complete an analysis completely ''blind,'' meaning the results of any other actuarial analyses are not shared until after draft results are produced. This strategy often is effective in determining differences between actuarial analyses and may best be discussed face to face.

Putting It All Together

Many factors and decisions go into an actuarial analysis. The actuary should be able to support any assumptions to ensure the analysis is a foundation for fruitful discussion among all parties, without fear of conflicts of interest or hidden agendas.

Guidance from legal counsel, brokers, regulators, and accountants also should support this process. For example, antitrust issues may be encountered very quickly. Rules and regulations may be difficult to understand, as may the accounting treatment of a transaction. Insurance issues can surface, too (e.g., Will reinsurance contracts still be valid and transferable?). Management should try to identify any potential issues early in the process and be prepared to solve them in an efficient manner. Finally, each organization's leaders should create a plan for communicating with stakeholders at various points in the process. *

AT A GLANCE

To best project an actuarial estimate for medical malpractice exposure for a merger and acquisition, an organization's leaders should consider the following factors, among others:

> How to support an unbiased actuarial estimation

> Experience of the actuary

> The full picture of the organization's malpractice coverage

> The potential for future loss development

> Frequency and severity trends

Any tail policies-especially those offered to physicians-should be identified, along with their retroactive dates.

a. Acquisition and Affiliation Strategies: An HFMA Value Project Report, HFMA, June 2014, hfma.org/ valueaffiliations.

Richard C. Frese, FCAS, M AAA, is a consulting actuary, Milliman Inc., Chicago, and a member of HFM A's First Illinois Chapter ([email protected]).