controlling retained insurance costs through an allocation

Regarding professional liability and workers' compensation self-insurance or large-deductible programs, controlling costs and maintaining appropriate budgets for expense reports are primary concerns for hospital finance managers. A properly designed allocation can address both issues, creating insurance expense savings for the entire hospital and for specific departments or physicians and employees who get charged for insurance.

The challenge for managers is in knowing where to begin to design such an allocation or in maintaining a process for routinely reviewing the existing allocation. Physicians-whether employed, or contracted and provided with insurance by a hospital-and other employees may feel their share is too high and that their loss experience is better than others. Management will need a strategy to maintain an efficient structure that works for all parties, whether at a department level or employee level, with the ultimate goal of lowering insurance costs and promoting better risk management.

Benefits of Allocations

Although the primary purpose of an allocation is to distribute costs, there are many additional benefits. Management may be able to better control losses, promote safety, and establish a new culture in the workplace by creating "skin in the game"-i.e., a sense of responsibility among employees. This approach may lead not only to lower self-insurance costs but also to lower excess and reinsurance premiums. Such savings will become critical as the insurance market follows the typical cycle and transitions into a "hard market" where the price of insurance is higher. Management also will be able to learn more about the loss drivers and exposures of the insurance program. When the allocation falls short of initial expectations or changes significantly from the previous allocation, this approach will allow management to determine the reason and, likely, identify areas that need improvement.

Further, a hospital may be able to attract physicians and talent to the organization by having a program that is competitive in the insurance marketplace. If the program insures physicians, an allocation down to the individual physician level will allow physicians to compare the price of coverage with other options.

Setting Goals

When implementing an allocation, it is first necessary to achieve buy-in from members or departments and to define the goals. Allocations often apportion expected future insurance costs, historical unpaid claim liabilities, and tail liabilities (claims that have occurred but have not yet been reported). The finance managers should establish the goals of the allocation process to ensure program needs are met.

These goals should include ensuring that the allocation system encompasses five key features:

* A loss-control incentive that encourages safety among members

* Stability, with no significant fluctuation in annual contributions and liabilities

* Equity, as reflected in the fair treatment of all members (which does not mean that they all pay the same amount or rate)

* Intelligibility, ensuring the allocation is easily understood and readily accepted by members

* Ease of administration, allowing managers to carry out the allocation without difficulty

Some of these features may be more difficult than others to implement, and some may be perceived as contradicting others. For example, making an allocation more equitable usually requires a more detailed method, and thus ease of administration usually decreases along with member comprehension. It is critical that finance managers determine which features should be implemented first. Surveying members to find out which features they value most may be a way to gain buy-in before developing the allocation scheme (and before members know the exact impact on their own costs). Seeking member input in advance will help members better comprehend the allocation and will prevent resistance in the future.

Designing a Basic Structure

Allocations commonly are built on exposure, losses, or a blend of the two. Exposure often is defined as "bed equivalents' for professional liability and as payroll for workers' compensation. Proper weights (i.e., conversion factors) translate-for exampleoccupied beds, outpatient surgeries, emergency department visits, and physicians into bedequivalents. Different risk classes in payroll, such as nurses and clerical workers, also should be adjusted for. An allocation based purely on exposure is easily administered and may help keep the allocation amounts smoother over time.

An allocation using losses will encourage members to minimize losses, but may be more of a challenge to administer and design for several reasons.

First, finance managers may need to include a cap on the losses that are part of the allocation formula, to prevent members from being penalized for random, large losses and also to maintain greater pooling. The challenge is to determine an appropriate cap, if any is merited. A cap may be determined by the working layer-the monetary range in which the insured party is expected to experience a high level of loss frequency-or by more predictable, routine losses. It is critical that the cap be adjusted by inflation because claims tend to increase in severity overtime. The cap may also be applied on a per accident basis or on an annual aggregate basis per member.

Finance managers also will need to determine the length of the experience period to be included in the allocation formula. Professional liability losses typically develop more slowly at first than do workers' compensation losses, but both can have significant tails in the accumulation of losses. An allocation based on the previous five years of losses would be more responsive, but one based on the previous 10 years would be more stable.

When utilizing losses, finance managers also can face difficulties ensuring the losses are credible and appropriately assigned. Physicians may be reluctant to report claims on their own or to accept fault when named. Particularly when a physician is joining a new program, the physician may be named but refuse to accept fault until a verdict or settlement is reachedand even after an unfavorable finding, the physician may still disagree and feel that the claim was not his or her fault. Hospitals often have their own internal challenges in allocating the dollars of a claim when multiple parties are named within a suit.

Another complication is that claims may be limited by the amount of coverage. A hospital may be seen as the "deep pocket" because it may have more insurance coverage than a physician. Allocating losses to a particular department may make the process even more complex.

These issues may make an allocation less reliable- and, thus, not representative of the true exposure of a group or individual. They also may affect workers' compensation if an employee's salary is tied to safety performance: The employee may not report workers' compensation claims, or the definition of what is considered a claim may be altered. For example, a cut finger that requires a Band-Aid may not be considered a claim or be reported.

Tailoring lor Specific Needs

If the more commonly accepted allocation structure based on losses and/or exposures does not fulfill management's goals, more advanced and tailored ideas may be considered. The following approaches have been effective ways to control and allocate losses.

Use of industry standards or commercial quotes. When data may not be fully credible or easily accessible, using an industry standard or commercial quote to estimate costs may be appropriate. If an industry standard is used, it is important to convert it to an 'apples to apples" benchmark to account for any differences in jurisdiction, retention, and class. If a commercial quote is used, management may want to establish pure costs by also removing the portion of expenses, profit, and contingencies included. Certain insurance quotes, such as those for tail liability, could be conservative or high because carriers add extra contingency margins when there is perceived risk. Finance managers may want to remove this contingency or include it, depending on the hospital's goals. Adding a contingency reduces the risk of a potential shortfall in the future, but if a rate more competitive than the expected rate is desired for the program, then removing the contingency would be preferable.

Refined exposure. Finance managers may want to construct a more refined exposure, reflecting additional categories by coverage type (i.e., by line of insurance)-for example, newly tracked procedures for professional losses or employee head counts for workers' compensation. This approach may make an allocation more accurate. A correlation analysis of historical losses and the corresponding exposure base will determine an optimal structure and will show the impact of the exposure category on the allocation.

A system of risk-characteristic credits and debits. Credits and debits (increases and decreases in the assigned expected costs of insurance based on risk characteristics) may help account for factors not currently reflected in the loss data or experience, and may add consistency compared with quotes from carriers. Using such a system may create a more detailed way to reward members for safety initiatives not reflected in the historical data. It also can account for situations where there may be additional risk, such as a large hospital acquisition where the new employees may not be familiar with new program operations.

Schedules of credits and debits may be applied for risk management, loss-free experience, and years in the program. Credits or debits should be determined through a statistical analysis, but an industry standard also may be utilized-especially if the credibility of the data is low.

Quota share allocation system. A quota share allocation incrementally pools individual loss liability. The structure may be designed so that members are responsible for 100 percent of small losses and an increasingly smaller share of larger losses. For example, if a member incurs a $5 million loss, the allocation formula might assign responsibility to the member for all of the first $500,000, 50 percent of the next $500,000,25 percent of the next $1.5 million, and 10 percent of the next $2.5 million, with the remainder of the loss pooled. The exhibit on page 51 shows an example of a quota share system that could be implemented to encourage loss control.

Retrospective allocation system. This system allocates costs for the policy period based on actual experience. With this structure, finance managers would need to determine when to calculate the first adjustment and how often to make subsequent adjustments. The formula for making adjustments should be based on how well the program meets management's goals. This approach creates safety incentives, and members feel like they have more control over their own costs.

Potential issues can arise, such as assessing members with adverse experiences to return that money to members with good experiences-particularly when turnover in a member's management results in disassociation with the prior adverse experience.

Ensuring Continued Success

No matter how an allocation is determined, the sum of member liabilities or contributions must equal the program total. Any debits or credits given to one member must be made up by others. An allocation gives employees an incentive to keep insurance costs low, especially when costs come out their own pocket or a department's budget, but hospital finance managers always should want to reduce total insurance expense.

In today's soft market, when costs of insurance are low, an allocation system may not be a top priority. But finance managers should review the allocation methodology every few years, at a minimum, to ensure goals are achieved. Simple statistics such as claims-to-contribution$ ratios (losses/premiums, where the optimal ratio is at or below 1) of members will indicate whether several members are outliers and the formula needs to be amended. With thorough review, a well-designed allocation can help hospitals control losses and maintain a successful insurance program with satisfied members.

AT A GLANCE

An insurance allocation may help a hospital or health system achieve the following goals for its professional liability and workers' compensation self-insurance or large-deductible programs:

* Loss-control incentive

* Stability

* Equity

* Comprehension

* Ease of administration

In today's soft market, when costs of insurance are low, an allocation system may not be a top priority. But finance managers should review the allocation methodology every few years, at a minimum, to ensure goals are achieved.

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