managing ‘tail liability’

As hospitals seek to more fully integrate with their physicians, whether through employment or partnerships, they should also consider the costs of malpractice insurance associated with increased liability exposure. Many hospitals purchase medical malpractice insurance for their organizations and/or their physicians on a claims-made basis, which in turn creates a tail liability for latereported claims that the entity may need to record in its financial statements.

While an occurrence-based policy will cover claims that arise from incidents that occur during the period coverage is in place, regardless of when these incidents are reported, a claims-made policy will cover only claims that are reported during the policy period and that occurred after a retroactive date (or prior acts date). Therefore, if an incident giving rise to a claim occurs during the insurance policy period, but is not reported until after the policy expires, then it is not covered by the policy. The retroactive date is usually the start date of the first claims-made policy unless tail coverage has been purchased.

It is important that hospitals holding claims-made malpractice policies determine their level of tail liability exposure and implement strategies to reduce or control their exposure-and, thus, related expenses.

Specific Tail-Liability Considerations

Tail liability coverage presents unique issues for healthcare leaders.

First, leaders should understand the level of tail-liability exposure their physicians face, including exposure related to a physician's specialty, FTE value, participation in outside activities (such as moonlighting), and prior insurance coverage. This consideration is particularly important when acquiring physicians and when preparing for a physician exit. For example, it is important to know whether the insurance program will provide coverage for prior acts or tail coverage when a physician leaves, and whether a physician will need to come into a program "clean," with his or her tail liability covered by another organization.

Employed physicians usually are covered under occurrence-based medical malpractice policies. Some organizations may choose to cover employed physicians' liability through a self-insured vehicle, such as a captive or risk-retention group, or through self-insured retention (a dollar amount that must be paid by the organization before the policy will cover a loss). Nonemployed physicians also may be offered such coverage through an insurance vehicle, but they must secure coverage on their own; the hospital itself cannot provide this insurance. In addition, some healthcare entities purchase commercial claims-made coverage for employed physicians, but will offer physicians the option to purchase occurrence coverage. This approach results in tail liability for the organization.

A physician may have earned a "free tail" for death, disability, or retirement (DDR) by being a long-time policyholder of an insurance company. In such instances, the physician will need to determine the value of the free tail when offered coverage under a hospital's insurance program, as the physician will forfeit the free tail by accepting coverage through the hospital. The organization may need to cover prior acts and quantify DDR to entice physicians to leave their current insurance carriers and join a hospital's insurance program. The hospital should engage an actuary in determining a provision for this liability, keeping in mind retention, mortality, and termination rates.

Estimation of Losses

For financial reporting, the potential expense associated with a hospital's tail liability is based on credible loss experience and the history and characteristics of its malpractice program. Generally, a large health system or physician group is considered to have full credibility, while an individual hospital or small physician group is not fully credible by itself. Credibility depends on factors such as the amount of claims data recorded (in frequency and severity), malpractice exposures, and consistency in the loss development. Actuaries will often give full credibility to the working layer, or losses that are considered more predictable. When pricing an individual physician, an allocation based on an entity's entire loss experience may be an option rather than using a commercial quote.

Actuarial tail estimates are dependent on various factors, such as the coverage of the malpractice program, the retroactive date, exposures (e.g., daily occupied acute care beds, number of outpatient visits, and range of physician specialties), and the organization's loss experience. Late reportings are estimated by forecasting how the occurrence losses will be reported, which depends on the selected reporting pattern. Often, an industry reporting pattern may be blended in as well.

The reporting pattern is a crucial assumption on an actuarial model and is dependent on jurisdiction. Over time, the reporting pattern may need to be adjusted, particularly if the organization's leaders wish to handle claims differently than in the past (e.g., reporting claims more quickly).

Another proxy for estimating the tail liability costs is to use a commercial premium and remove the loads included in the rate, such as the carrier's expense, profit, and contingencies, to arrive at the pure losses. Commercial premiums are subject to market cycles and marketplace competitiveness, which adds uncertainty in this method. There also are credits and debits given by insurance companies that may be difficult to identify, particularly because in some states, insurance companies do not release this information. It is always a good idea to compare this analysis with an independent actuarial estimate and seek clarification regarding differences between the two.

Financial Reporting Guidance

Significant confusion remains among healthcare providers regarding recognition, measurement, and disclosure requirements related to contingencies, medical malpractice insurance, and certain tail liabilities.

The FASB standard on liabilities contingencies (FASB ASC 450-20-25) notes that when a probable loss has been incurred and a range of the loss can be estimated, an entity should recognize the loss in the financial statements. When no amount within the range of estimate is a better estimate than any other amount, the minimum amount in the range should be accrued. Once an accrued loss is estimated, the portion of unpaid claims and expenses that are expected to be paid within one year of the balance sheet date should be classified as current liabilities.

Hospitals and health systems often argue that their organizations will always maintain insurance coverage for claims without lapses in coverage; thus, the risk of loss will always be transferred to a third party (i.e., an insurance carrier). In these organizations' view, there would therefore be no need to accrue a liability for malpractice costs, because insurance will ultimately reimburse the organizations for losses paid. However, accounting literature specifically states that the existence of an insurance policy by itself provides no assurance that the risk of loss has been transferred to a third party. Therefore, a hospital or health system that is insured under a claims-made policy should recognize the estimated cost of claims that have been incurred but not reported (IBNR)-tail claims-if those costs are probable and can be reasonably estimated. An actuary can assist with such complex estimations.

There also has been much confusion in the industry with respect to whether these liabilities should be recognized if an organization expects the costs to be reimbursed by the insurance carrier under terms of the insurance contract(s) in place. The FASB Accounting Standard Update 2010-24- an amendment to the Accounting Standards Codification (ASC)-states that the liability for malpractice or similar claims should not be presented net of anticipated insurance recoveries. Rather, providers should recognize an insurance receivable at the same time it recognizes a liability, and thus, the receivable should be evaluated for collectability, with an allowance for uncollectible amounts recognized, if appropriate. It is inappropriate to assume the current amount of coverage will be purchased in the future. Any multiyear policy that has been purchased and fully paid may lower the net tail liability. If a healthcare provider has the sole option to purchase tail coverage for a premium not to exceed a fixed amount, this provider could record an asset for estimated insurance recoveries for the portion of the IBNR claims that would be covered under the future tail coverage. However, in this instance, the provider also would need to record the cost of the expected insurance premium.

A tail liability is permitted-not required-to be presented on a discounted basis to reflect the time value of money. The Financial Reporting Executive Committee (FinREC) states that medical malpractice liabilities may be discounted if the amount of the liability is fixed and reliably determinable, if the amount and timing of payments for these liabilities are based on the organization's specific experience and are fixed or reliably determinable, and if expected insurance recoveries are also discounted. If the liability is discounted, the discount rate should be disclosed in the notes to the financial statements, along with the carrying amount (i.e., undiscounted amount) of accrued claims being discounted. A liability also may be presented using a confidence level-such as a 75-percent confidence level used by many in the industry-as long as it is consistent with how other liabilities are presented.

Controlling Tail-Liability Expenses

Tail liability can be a significant item on the balance sheet. Similar to other insurance liabilities, tail liability may be reduced and controlled using simple tactics.

Use a self-insurance vehicle. Self-insurance is an option, particularly when insurance prices are high during a hard market. Theoretically, an entity experiences savings through the profit, contingencies, and insurer's expenses built into the rate. Selfinsurance also allows an entity to maintain more control of the losses, because the carrier may not be involved until claims reach the excess layer. Pooled physicians might have the additional benefit of obtaining lower insurance rates. But there also is increased risk and variability with self-insurance, because cash flows may not be known up front as they are with commercial insurance. Administrative costs also may increase when claims previously monitored by an insurance company become the responsibility of the self-insured entity. Use of selfinsurance also requires greater knowledge of underwriting, and actuarial estimates will be needed for funding future losses.

Consider combined limits between hospital and physicians. Programs that have separate limits for the hospital and physicians may find savings in having a single combined limit. This practice may not be feasible in some states with medical malpractice funds, depending on the rules, but for other states, there are clear advantages. First, programs that have single combined limits experience reduced legal expenses, because alignment of the hospital's and physicians' goals and incentives allows for joint defense of claims and reduced "gray boxes" of coverage. This approach also avoids internal situations where the hospital and the physicians blame each other for an incident, as well as situations where the hospital may be brought into a claim as a deep pocket. Combined limits also allow for more protection for physicians, because commercial coverage usually has lower limits.

Communicate any program changes to the actuary, underwriter, and auditor. Loss forecasts should be based on the future program. Hospital leaders should inform the actuary, underwriter, and auditor of any change in retention, exposure, loss reserving and payment practices, and risk management. Failure todo so may result in inadequate or excessive funding, with the former causing an unexpected expense at year end.

Continue risk management and safety practices. Successful risk management is key to preventing and controlling malpractice losses. Hospital leaders should create a culture of safety where there is buy-in from upper level leaders on down. Risk managers should proactively monitor the loss drivers and work to better control-if not eliminate-top risks facing the organization. An educated, properly staffed risk management team may be able to outline a safety plan where loss forecasts may be reduced.

Ensure credit is given to the organization's own medical malpractice program. Hospital leaders should have frequent conversations with the broker, underwriter, and actuary to ensure credit is given to their own program's experience. Differentiating the program will lead to consideration in adjustments from industry standards, but may be limited by credibility. Leaders should prepare benchmarks and maintain full transparency to present the organization's story fully and accurately to all parties forecasting losses and pricing insurance. *

AT A GLANCE

To reduce and control their level of tail liability, hospitals should:

* Utilize a self-insurance vehicle

* Consider combined limits between the hospital and physicians

* Communicate any program changes to the actuary, underwriter, and auditor

* Continue risk management and safety practices

* Ensure credit is given to the organization's own medical malpractice program

Learn more about the history of claims-made coverage as well as the effects of switching from occurrence coverage to claims-made coverage for one organization at hfma.org/claimsmadecoverage.

WHAT IS TAIL LIABILITY?

A claims-made policy will cover only claims that are reported during the policy period and that occurred after a retroactive date (or prior acts date). Therefore, if an incident giving rise to a claim occurs during the insurance policy period, but is not reported until after the policy expires, then it is not covered by the current insurance policy. This is known as tail liability.

Richard C. Frese, FCAS, MAAA, is a consulting actuary, Milliman, Chicago ([email protected]).

Ryan J. Weber, CPA, is a partner, <org value="ACORN:1505596761" idsrc="xmltag.org">McGladrey, Fort Lauderdale, Fla. ([email protected]).