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Underwriting
For a health plan to provide appropriate healthcare coverage to individuals or group
members at an appropriate price, the company must determine the degree of risk it will
be assuming by providing coverage. The process of identifying and classifying the risk
represented by an individual or group is called underwriting.
A health plan cannot assume that each proposed risk is the same. Not all individuals of
the same age and sex have the same likelihood of suffering a health-related loss. Nor do
all individuals in the same occupation or the same geographic location. In addition, those
individuals who believe that they have a greater-than-average likelihood of loss tend to
seek healthcare coverage to a greater extent than do those who believe that they have
an average or less-than-average likelihood of loss. This tendency is known as
antiselection or adverse selection. The task of the underwriter is to analyze each
individual or group applying for insurance in order to identify the characteristics that
contribute to risk, measure the amount of risk, and determine whether the amount of risk
is acceptable.
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Successful renewal underwriting requires that a health plan support a database to track
utilization, demographic factors, and other relevant data in order to obtain information on
costs per plan member and the amount and frequency of utilization by type of medical
benefit.
Legal Requirements
State laws define the ways in which health plans can underwrite and price healthcare
products. For example, in some states a health plan may increase its price to an
employer if the health plan determines that the employer represents a greater risk than
that assumed in calculating the base rates. Similarly, the health plan would be able to
price the product lower than its base rate if the health plan determines that the employer
represents a lower risk than that incorporated into the base rate.
On the other hand, some states prohibit a health plan from charging more than the base
rate listed in its rate manual for specified products or plans, such as HMOs. In such
cases, the health plan may be able to decline coverage for a group if the groups
expected risk is greater than that assumed in calculating the base rates. However, some
states do not allow HMOs to deny coverage for any group, regardless of a groups
expected risk level, so an HMOs base rates must reflect this increased risk.
Rating
Once a health plan has assessed the risks that an individual or group presents and has
identified which risks are acceptable, it can determine the cost of covering those risks.
Rating is the process of calculating the appropriate premium to charge purchasers,
given the degree of risk represented by the individual or group, the expected costs of
delivering medical services, and the expected marketability and competitiveness of the
health plans plan. A premium is typically a prepaid payment or series of payments
made to a health plan by purchasers, and often plan members, for medical benefits.
The insurance professionals who perform the mathematical analysis necessary for
setting insurance premium rates are called actuaries. A health plans actuaries are
responsible for ensuring that the plans operations are conducted on a financially sound
basis. The actuaries goal, therefore, is to ensure that the premium rates that the health
plan charges purchasers are adequate to cover expected plan costs. Premium rates,
however, must also be competitive, to encourage a large number of healthy individuals
to enroll in the plan. The balance between the actuarial function (ensuring that the plan
is financially sound) and the marketing function (ensuring that the plan is marketable) is
a critical component of product development. Regular review of its rating method
provides a health plan with information on whether the plan is achieving both actuarial
and marketing goals.
Health plans use a variety of rating methods in developing premiums. In this section we
will discuss four of the most commonly used methods: community rating, manual rating,
experience rating, and blended rating.
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Community Rating
Community rating is a rating method that sets premiums for financing medical care
according to the health plans expected costs of providing medical benefits to the
community as a whole rather than to any subgroup within the community. Both low-risk
and high-risk classes are factored into community rating, which spreads the expected
medical care costs across the entire community. If claim costs exceed the premiums
received, the plan is financially responsible for the additional costs.
Community rating is seldom used for large groups, except where required by state law,
because other rating methods are more competitive. However, the premium rate
obtained by the community rating method is often calculated first as a point of reference
for calculating the premium rate under other rating methods. On the other hand, several
federal and state initiatives have mandated community rating methods for small groups.
Small groups benefit from community rating because they incur less fluctuation in
premium rates and more stable health plan contract relationships.
Standard Community Rating and Tiers
Under standard community rating (also called pure community rating), a health plan
considers only community-wide data and establishes the same financial performance
goals for all risk classes. Therefore, the health plan charges all employers or other group
sponsors the same dollar amount for a given level of medical benefits or health plan,
without adjustments for age, gender, industry, experience, etc.
Health plans can vary the rates within a single plan, however, by dividing members into
tiers (classes) according to the number of individuals covered. No other factors are used
to distinguish among the members in each tier. Two-tier arrangements, with an
employee-only tier and a family tier (the employee and one or more dependents) are
commonly used under all rating methods. Three tiers (employee only, employee and one
dependent, and employee and two or more dependents) are also common. Sometimes
four or five tiers are used. The premium a plan member pays depends on the tier into
which she fits. For instance, in a two-tiered system all members who enroll in Tier 1
(employee only) pay the same monthly premium, which differs from the premium paid by
all members who enroll in Tier 2 (family).
Health plans can also adjust the total premium amount charged to a group to reflect the
number of covered members in each tier. For example, if Employer A has four covered
members per family contract, the health plan can charge it a higher premium than it
charges Employer B, which has 3.5 covered members per family contract. The premium
rate applied to each group, however, must be the same.
Other Community Rating Methods
In 1991 the National Association of Insurance Commissioners (NAIC) adopted a Small
Group Model Act that allowed health plans to use a modified form of community rating
to underwrite small groups. This modification, referred to as community rating by class
(CRC), allowed a health plan to divide its members into up to nine rating classes based
on demographic factors, industry characteristics, or experience. In this context
experience means a specific groups historical healthcare costs and utilization rates.
Each of the rating classes had prescribed minimum and maximum premium rates and all
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members of the same class or group paid the same premium. The average premium in
each class could not be more than 120 percent of the average premium for any other
class.
A 1995 amendment to the NAIC Small Group Model Act eliminated the class rating rules
and required plans to use adjusted community rating. In the context of small group
coverage, adjusted community rating (ACR), also called modified community rating,
is a rating method under which a health plan divides its members into classes or groups
based on demographic factors such as geography, family composition, and age, and
then charges all members of a class or group the same premium. The plan cannot
consider the experience of a class, group, or tier in developing premium rates. The 1995
amendment, however, did not require states to change existing laws. Laws based on the
1991 Model Act that allowed rating classes based on experience factors still exist in
many states.
Manual Rating
When an underwriter has no recorded or reliable claim experience for a group, she
typically uses manual rating to establish the groups premium. Manual rating is a rating
method under which a health plan uses the plans average experience with all groups
(and sometimes the experience of other health plans), rather than a particular groups
experience, to calculate the groups premium. Manual rates are sometimes called book
rates because a health plan often lists them in a rate book, underwriting manual, or rate
manual.
Health plans often use manual rates to set premiums for groups that have had no
previous health coverage. Underwriters also use the manual rate as a starting point
when using other rating methods.
Experience Rating
Underwriters typically use experience rating to calculate the premiums for groups that
have a credible claim history. Experience rating is a rating method under which a
health plan analyzes a groups recorded healthcare costs by type and calculates the
groups premium based partly or completely on the groups experience. Under
experience rating, a health plan charges lower premiums to groups that have
experienced low utilization of healthcare services and higher premiums to groups that
have experienced high utilization. Because a groups experience changes over time, a
health plan typically uses at least two years of a groups experience to calculate
experience rates.
In most cases the size of the group is important in determining the degree to which
experience rating applies. Health plans typically experience-rate large groups. Note that
the definition of what constitutes a large group varies among health plans. A health plan
may define a large group as consisting of anywhere from 50 to 1,000 members.
However, most health plans experience-rate groups that have 1,000 or more members.
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Legal Requirements
Federal or state laws may require that health plans use a particular rating method in
determining premium rates. In some cases regulation depends on plan structure. For
example, amendments to the HMO Act of 1973 permit federally qualified HMOs to use
community rating, community rating by class, or adjusted community rating, but not
retrospective experience rating, in determining premium rates for health plans. State
requirements may define the specific community rating method that federally qualified
HMOs may use. Federally qualified HMOs must obtain approval for using adjusted
community rating, and they cannot charge more than 110 percent of the rate charged
under pure community rating to groups with 100 or fewer members.
Individual states also establish requirements for HMOs that are not federally qualified
and for other health plans. The rating methods that non-qualified HMOs, preferred
provider organizations (PPOs), and point-of-service (POS) option plans use are similar
to those used for indemnity plans and are usually subject to state insurance regulations.
Federally qualified HMOs that offer a POS option must comply with federal requirements
for rating the HMO and state requirements for rating the POS option.
In other cases regulation is based on the specific population or group served. Some
states require all health plans to use community rating for individuals and small groups.
Other states require community rating for individuals and all groups, regardless of size.
A health plan that pursues government contracts must use rating methods that are
permitted under federal law. For example, the Centers for Medicare and Medicaid
Services (CMS) require all health plans that assume Medicare risk to use adjusted
community rating. Also, to obtain contracts for the Federal Employee Health Benefits
(FEHB) program, a health plan cannot charge the federal government more than it
charges other groups of a similar size. State and county requirements establish
Medicaid reimbursement rates and limit rate setting to a specified maximum percentage
of provider fees. (We discuss government healthcare benefits programs toward the end
of the course.)
In addition to specifying the rates health plans can charge small groups, the NAICs
Small Group Model Act limits the rate spread, which is the difference between the
highest and lowest rates that a health plan charges small groups, to a ratio of two to one.
For instance, if the lowest rate that an HMO charges a small group is $62.50, the highest
rate it charges for the same set of medical benefits cannot be greater than $125. Forty
states have enacted laws that are variations of the NAICs Small Group Model Act.
A health plan may be required to file yearly reports outlining the rating method used to
establish premium rates with the insurance department in each state in which it conducts
business. Any changes made to the rating method or rate schedule must also be
submitted for regulatory approval.
PPACA will also have an impact on rating. As of 2014, there will be limits on differences
in rates charged different individuals. Such differences may be based only on age,
geographical area, family size, and tobacco use. In age-based rating the highest rate
cannot be more than three times the lowest rate, and a higher rate imposed for tobacco
use can be no more than 150 percent of the standard rate.
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Financial Management
For most health plans financing includes financial management and plan funding. In this
section we discuss financial management, which is the process of managing a health
plans financial resources, including management decisions concerning accounting and
financial reporting, forecasting, and budgeting. We examine plan funding in the next
section.
Laws and Regulations
Health plans must comply with accounting standards and financial reporting
requirements established by law or regulation. For example, public corporations must
publish an annual report and must file corporate income tax returns on a timely basis. A
companys annual report must include audited financial statements, including a balance
sheet, income statement, cash flow statement, and statement of stockholders equity,
among other financial data.
As noted in an earlier module, some HMOs and other health plans may have to comply
with financial reporting requirements established by state insurance regulators.
Sometimes a large health plan may consist of one or more subsidiaries or other legal
entities that are subject to state insurance regulations even if the health plan is not.
Some health plans may have to file an annual statement with the NAIC and the
insurance regulatory body in each state in which they conduct business. The annual
statement consists of numerous financial statements, exhibits, and schedules. In
addition to the above financial reporting requirements, health plans that are for-profit
public corporations must be concerned with meeting stockholder expectations about
corporate earnings, profits, and stock price.
Key Elements of Accounting and Financial Reporting4
Two major accountsrevenues and expensesappear on an MCOs income
statement, which is the financial statement that summarizes an MCOs revenue and
expense activity during a specified period. Also included in the income statement is net
income, also call profit, which is the excess of total revenues over total expenses. If
total expenses exceed total revenues, the result is a net loss.
Revenues are the amounts earned from a companys sales of products and
services to its customers. Typical revenues for an MCO include premiums and
fees generated from plan members and group sponsors (generally employers)
and the interest earned on premiums and fees. Premiums comprise the greatest
percentage of a health plans revenues.
Expenses are the amounts spent or committed to pay for covered benefits and
their administration. Typical expenses for an MCO include administrative
expenses, stop-loss insurance premiums, provider reimbursement costs, and
plan utilization costs. Administrative expenses include marketing and selling
costs, salaries of health plan employees, advertising, and benefits administration.
Provider reimbursement costs include physician salaries or capitation payments
and hospital and ancillary service provider fees.
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budgeting process provides the MCO with timely reports that enable it to monitor
variances between expected and actual revenues and expenses. Variances are
the difference obtained from subtracting actual results for expected (budgeted)
results.
Comparing the amounts in the expected budget with those in the actual budget provides
a variance for each budgeted item. Most health plans monitor variances on a monthly or
more frequent basis. Analyzing the source of the variances provides management with
the information it needs to make rating decisions and adjust the budget accordingly.
Typically, a health plan analyzes its variances for medical expenses by type, such as
primary care, specialty care, inpatient hospitalization, pharmacy benefits, and so on.
Alternatively, a health plan may analyze its variances by population and by health plan.
For example, a health plan may not only separately analyze variances for primary care
expenses for large employer groups, Medicare populations, and Medicaid populations,
but also according to type of plan, such as HMO, PPO, and HMO with a POS option.
A financial manager uses variances to refine the budget for the next period. Analyzing
variances also enables managers to monitor and evaluate a health plans overall
financial performance. Large variances between expected and actual revenues or
expenses usually result in revised budgets or operational changes. For example,
significant increases in expenses for specialty care may result in a revision to the
incentive plan for PCPs to decrease specialist referrals.
Another critical factor in a health plans survival and success is the health plans ability to
manage its flow of funds (money). Fund inflows primarily include revenues and fund
outflows generally include expenses. Therefore, accounting for revenues and expenses
on a timely basis is critical to monitoring the flow of funds in any organization. A health
plan must make strategic and operational decisions to ensure a positive flow of funds,
which means that the health plans funds inflows are greater than its funds outflows.
Plan Funding
Plan funding is the method that an employer or other payor or purchaser uses to pay
medical benefit costs and administrative expenses. A health plan may be financed or
funded in a variety of ways, subject to federal and state requirements. In this section we
describe two common types of plans: fully funded plans and self-funded plans. We also
briefly discuss third party administrators.
Fully Funded Plans
In a fully funded plan an insurer or health plan bears the responsibility of guaranteeing
claim payments, paying for all incurred covered benefits, and administering the health
plan. If the dollar amount of claims or administrative expenses exceeds the dollar
amount of premiums collected, the health plan or insurer is responsible for the
difference. On the other hand, if the group has fewer claim expenses than anticipated,
the health plan or insurer has an opportunity to make a profit that is greater than
anticipated. A fully funded plan is the traditional funding arrangement for a group health
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Alternatively, the employer may hire an independent third party to administer the plan. A
third-party administrator (TPA) is an organization that administers group benefit plans
for self-funded groups, but that does not have the financial responsibility for paying
benefits. The employer retains the financial responsibility for paying claims for the selffunded group.
Examples of administrative services that TPAs provide to self-funded groups include
claims administration and membership services. A TPA may also offer advice to clients
on the purchase and design of employee benefits programs. The contract between an
employer and an insurer or other TPA is called an administrative services only (ASO)
contract. Third-party administrators are usually paid a fixed fee per employee for
administering the terms of the ASO contract.
Conclusion
In this module we have learned about three important health plan functions:
In underwriting a health plan assesses the risk it will assume by providing
coverage to an individual or group. The underwriter identifies factors that
contribute to risk, estimates the amount of risk, and determines whether the risk
is acceptable.
In rating a health plan calculates the premium it should charge an individual or
group for coverage. The amount is based on the risk presented by the individual
or group, the expected cost of medical services, and marketability and
competitiveness.
In financial management a health plans monetary resources are administered,
monitored, and coordinated. This includes accounting, reporting, forecasting, and
budgeting.
We also examined plan fundinghow an employer pays for employee healthcare
benefits and related administrative expenses. An employer-sponsored health plan may
be fully funded, with claims and administrative costs and liability borne by a health plan
or insurance company, or self-funded (self-insured), with the employer bearing those
costs and liability.
Notes
1
Harriett E. Jones and Dani L. Long, Principles of Insurance: Life, Health, and Annuities, 2nd ed.
(LOMA ), 1999.
2
Adapted from Blue Cross and Blue Shield Association, Pricing and Financing the Product, 1992.
Used with permission, all rights reserved.
3
Adapted from Gene Stone, Insurance Company Operations (LOMA), 2000. Used with
permission; all rights reserved.
4
Adapted from Elizabeth A. Mulligan and Gene Stone, Accounting and Financial Reporting in Life
and Health Insurance Companies (LOMA), 1997. Used with permission, all rights reserved.
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