Health Plan Financials Explained

AHM 520
Health Plan Finance and Risk Management

AHM 520 – Risk Management
Table of Contents
1A Health Plan Financial Information
2A Types of Risk
2B Risk Management in Health Plans
3A Provider Reimbursement and Plan Risk
3B Provider Reimbursement Methods
4A Capitation in Provider Reimbursement
4B Risk Transfer in Health Plans
5A Health Plan Funding
5B Alternative Funding Methods
6A Financial Aspects of Medicare and Medicaid for Health Plans
7A The Relationship Between Rating and Underwriting
7B Group Underwriting
8A Small Group and Individual Underwriting
9A Pricing a Health Plan
9B Rate-Setting in Health Plans
10A Accounting Principles and Concepts
10B Principles for Maintaining Accounts
10C Financial Statements
11A The Strategic Plan
11B The Strategic Financial Plan
11C Case Study: Lifelong Health, Inc.
12A Financial Statement Analysis
12B Fundamentals of Ratio Analysis
12C Health Plan-Specific Ratio Analysis
13A Management Accounting
13B Cost Accounting
13C The Budgeting Process
14A Cash Management
14B Capital Budgeting
Chapter 1 A
Heath Plan Financial Information
Course Goals and Objectives
After completing Health Plan Financial Information, you should be able to
• Define financial information and list examples of a health plan’s financial

information
• Identify the internal users and external users of a health plan’s financial
information
• Distinguish between for-profit and not-for-profit health plans
• Discuss the common types of health plans
Health Plan Finance and Financial Information
In the context of this course, finance is the effective and efficient management of money
to achieve a health plan’s strategic goals and objectives. A primary strategic goal of a
health plan is to offer one or more health plans that meet the healthcare needs of
employers and other purchasers or payors.
Many health plans offer one or more products. Although in some contexts the term
health plan refers to healthcare benefits provided through an employer or other group, in
the context of this course, a health plan is the delivery and financing system of
healthcare benefits, rather than the benefits themselves. Health plans expect to receive
regular premium payments in exchange for assuming the risks associated with the
uncertain costs of healthcare.
To meet its goals and objectives, a health plan must be able to:
• Pay providers
• Bear or share the risk of not having enough money to support its ongoing
operations
• Determine the rates to charge purchasers of its products and services
• Plan strategically for growth and expansion of products and services
• Analyze financial markets and information
• Manage the flow of funds into and out of the health plan
• Raise and manage capital
All these functions comprise health plan finance. To understand health plan finance, you
must be able to interpret financial information. Financial information includes any
numerical data compiled for and from a company’s records. Health plans analyze
financial information as part of the decision-making process involved in generating
enough funds to conduct ongoing business and to expand operations. Examples of a
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health plan’s financial information are listed in Figure 1A-1. We discuss many of these
reports in later lessons.
Characteristics of Financial Information
Simply obtaining financial information is of little use to a health plan. The health plan’s
employees must be able to interpret financial information to attain the health plan’s
goals. Key characteristics of useful financial information include timeliness, quality,
accuracy, and clarity of that information. Also, financial information must be appropriate.
In other words, financial information is appropriate when it serves the needs of those
who use the information. We discuss the impact of these characteristics on a health
plan’s strategic planning process in The Strategic Planning Process in Health Plans.
A health plan’s accountants, actuaries, underwriters, financial analysts, investment

analysts, sales forecasters, and other staff members have a decision support role in
developing and providing the plan’s managers and executives with appropriate financial
information. Compilers of a health plan’s financial information also serve in a decision
support role for regulators, investors, and others outside the plan who make decisions
about the plan from their interpretation of the plan’s financial information. In addition,
financial information developed for health plan managers and executives must be
"actionable". That is, it must provide what is necessary for a health plan’s managers to
make decisions about the plan’s direction, growth, and ongoing survival.
Users of Financial Information 1

Many organizations and people rely on the financial information contained in a

company’s accounting records and reports. These interested parties generally consist of
two groups: internal users and external users of financial information
Internal Users
Internal users of a health plan’s financial information are those individuals within the
health plan who make decisions that affect plan operations. These individuals include
the health plan’s directors, officers, managers, and others involved in planning,
controlling, monitoring, and evaluating the financial implications of their decisions.
Figure 1A-2 lists several key positions typically found in a health plan and the general
responsibilities of these positions within the plan’s financial functions. Note that actual
health plans may have different internal corporate structures than those presented. For
example, one health plan may outsource its actuarial and underwriting functions; another
health plan may have one or more actuaries on staff and an underwriting department.
External Users
External users of a health plan’s financial information include those individuals and
organizations outside the health plan who need financial information about the plan to
make personal, corporate, investment, or regulatory decisions about the health plan.
Most external users of financial information rely on financial reports provided by the
health plan. External users typically have either (1) a direct financial interest or (2) an
indirect financial interest in the health plan.
External Users: Direct Financial Interest
Any external user who stands to gain or lose money as a result of a health plan’s
financial performance is said to have a direct financial interest in that plan. Health plan
members, providers, outside agents and brokers, creditors, stockholders, and potential
investors are examples of external users with a direct financial interest in the financial
performance of a health plan.
Figure 1A-3 summarizes typical interested parties with a direct financial interest in a
health plan’s financial performance. Plan members have a general interest in a health
plan’s reliability in paying claims. Providers are interested in a health plan’s financial
condition because they want to be reimbursed promptly for medical services rendered.
External Users: Indirect Financial Interest
External users with an indirect financial interest seek financial information on behalf of
others. This type of external user includes federal and state regulatory and tax
authorities, external auditors, independent financial analysts, rating agencies,
economists, attorneys, consumer groups, financial publications, and the health plan’s
competitors. Figure 1A-4 summarizes the primary activities or scope of interest
associated with external users that have an indirect financial interest in a health plan’s
financial condition or performance.
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Review Question
The Danner Bank loaned money to the CareWell Health Plan to fund an expansion of a
healthcare facility. With respect to the type of financial information user Danner
represents to CareWell, it is correct to say that Danner is an:
internal user with a direct financial interest

Incorrect. A lender (bank) is an example of an external user
internal user with an indirect financial interest
Incorrect. A lender (bank) is an example of an external user with a direct
financial interest.
external user with a direct financial interest
Correct. A lender is an external user with a direct financial interest.
case-mix adjustment
Incorrect. Dover Bank stands to gain or lose money as a result of the health
plan’s performance.
Uses of Financial Information

Different users of financial information often have different needs and uses for a health
plan’s financial information. Financial information is often used to make key decisions
related to a health plan’s long-term and short-term business objectives. Figure 1A-5
summarizes several questions that internal and external users hope to answer by
reviewing a health plan’s financial information. We discuss these concerns, including
how a health plan’s financial information can be analyzed and interpreted, later in this
course.
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Legal Forms of Organization That Affect Health Plan Finance 13
Recall from Healthcare Management: An Introduction that there is a wide variety of

health plan structures and arrangements. In addition to having many options for their
structure, health plans also have several options related to their legal form of
organization. These options may affect sources of capital, financial reporting
requirements, tax payments, and distribution of profits. Next, we discuss for-profit status
and not-for-profit status of health plans and review common types of health plans.
A health plan can be established on either a for-profit basis or a not-for-profit basis.

Profit is the excess of a health plan’s total income (the amount of money it takes in) over
its total expenses (the amount of money it spends). All health plans, regardless of
organizational structure, seek to generate profits in order to fund ongoing operations and
future growth. The choice of for-profit or not-forprofit status determines to a great extent
the way a health plan approaches critical financial decisions, such as funding, allocation
of profits, and tax payments.
For-Profit Health Plans
A for-profit health plan seeks to produce profits for its owners to provide them with a
satisfactory return on their equity investment in the health plan. An equity investment
typically consists of shares of stock that a health plan sells to owners or investors. If
shares of stock are offered to the general public, then the health plan is a publicly
traded corporation, also called a stock company. A publicly traded corporation’s shares
of stock are traded in the financial markets. If shares of stock are not offered to the
public, then the health plan is called a privately held corporation. A privately held
corporation has the option of "going public" if it decides that this would be in its best
interest. For example, a privately held corporation may need to generate funds quickly
for expansion into new markets or to improve its information management capabilities by
investing in new automated systems.
Not-For-Profit Health Plans
A not-for-profit health plan, which is organized and operated in the public interest,
cannot distribute its profits to individuals for personal gain, but must instead use its
profits for the benefit of the health plan and its purposes. The distinguishing
characteristic of a not-for-profit health plan is that it has no ownerinvestors, as does a
for-profit health plan. Not-for-profit health plans sometimes are referred to as non-profit
health plans, but this term is misleading. As noted earlier, both for-profit and not-for-profit
health plans aim to generate profits.
Although nearly all for-profit health plans are taxable organizations, certain not-for-profit
health plans qualify under the Internal Revenue Code for tax-exempt status. Tax-exempt
organizations do not pay federal, state, or local taxes on earnings, although some of
them may be required to pay certain other taxes such as premium taxes. The criteria for
qualifying for tax-exempt status under the Internal Revenue Code are beyond the scope
of this course.
Funding Sources
A health plan can use profit to obtain additional funds, because the health plan’s ability
to generate profit instills confidence in potential investors and lenders who provide
access to additional funds. If a health plan is unable to convince investors and lenders of
its ability to operate profitably, then the health plan is likely to lose access to outside
funds that are often critical to its ongoing operations.
In the health plan industry, for-profit health plans and not-for-profit health plans compete
in the same marketplace for funding sources. A critical success factor for any health plan
is its ability to access funds needed to establish, maintain, and expand operations.
Typically, health plans acquire funds through one or more of the following sources of
funding:
Funding Sources
All health plans have potential access to the first two funding sources. However, not-for-
profit companies do not issue stock. Some not-for-profit health plans are converting to
for-profit status or entering into joint ventures with for-profit companies to enable them to
obtain needed funds from investors. In some cases, not-for-profit health plans have
access to private donations, whereas for-profit health plans rarely receive donations.
Figure 1A-6 summarizes the options available to for-profit and not-for-profit health plans
for obtaining operating funds.
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Review Question
Health plans have access to a variety of funding sources depending on whether they are
operated as for-profit or not-for-profit organizations. The Verde Health Plan is a for-profit
health plan and the Noir Health Plan is a not-for-profit health plan. From the answer
choices below, select the response that correctly identifies whether funds from debt
markets and equity markets are available to Verde and Noir:
Funds from Debt Markets: available to Verde and Noir

Funds from Equity Markets: available to Verde and Noir
Incorrect. While funds from debit markers are available to both, funds from
equity markets are not available for not-for-profit plans.
Funds from Debt Markets: available to Verde and Noir
Funds from Equity Markets: available to Verde only
Correct. Funds from debit markets are available to both for profit and not-
for-profit health plans. Funds from equity markets are only available to for-
profit plans.
Funds from Debt Markets: available to Verde only
Funds from Equity Markets: available to Noir only
Incorrect. Funds from debit markets are available to both for profit and not-
for-profit health plans. Funds from equity markets are only available to for-
profit plans.
Funds from Debt Markets: available to Noir only
Funds from Equity Markets: available to Verde only
Incorrect. While funds from equity markets are available only to for profit
plans, funds from debit markets are available to both for profit and not-for-
profit health plans.
Types of Health Plans
Figure 1A-7 provides a brief review of many of these structures and arrangements. Note
that, within a given geographic area, some, none, or all of these organizations may exist.
For a complete discussion of the advantages and disadvantages and the legal structures
associated with each type of health plan, refer to AHM 510, Health Plans: Governance
and Regulations.
Note that several of the health plans identified in Figure 1A-7 have overlapping features.
A key factor that distinguishes the various types of health plans is the type and amount
of risk that a health plan assumes with respect to the delivery and financing of
healthcare benefits. In the context of this course, risk-bearing health plans, including
HMOs, PPOs, and PSOs, assume the financial risks of delivering healthcare benefits to
plan members. Generally, medical foundations, PBMs, UROs, TPAs, and MSOs are
examples of health plans that do not bear the particular risks associated with the
financing and delivery of healthcare benefits. We discuss the concept of risk in Risk
Management in Health Plans.
Through its wide variety of structures and organization types, health plans seek to align
the often differing goals of plan members and their dependents, employers and other
group plan sponsors, healthcare providers, the owners of the healthcare delivery
systems and financing systems, and regulatory agencies. Financial information plays a
vital role in this process, because most types of financial information either measure
performance toward goals, or predict the effect of choosing one means of achieving a
goal over another means of achieving the goal.
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Legal Forms of Organization That Affect Health Plan Finance

The purpose of financial information is to help the people who use it achieve their goals.
Earlier, we discussed characteristics of financial information that make it useful. Now we
look at some of the participants in health plans and how financial factors—such as the
cost of services, provider reimbursement, return on assets, and return on investment—
affect the goals they are seeking to achieve through health plans:
• Health plan members

• Health plan members and their dependents would like to receive the best
possible care in the event of illness or injury. Many also expect that preventive
care will be provided. At the same time, they would like to minimize the risk
that the cost of receiving care in the event of a serious illness or injury would
be financially devastating. Also, plan members typically want to pay the
lowest possible premium.
• Employers
• Employers and other group plan sponsors would like to enable group plan
members to access the highest quality healthcare at the lowest possible cost.
They also prefer simplified record keeping and minimal complaints from plan
members about access, quality, service, or cost.
• Healthcare Providers
• Healthcare providers—including physicians, hospitals, and ancillary service
providers (for example: laboratory, diagnostic, pharmacy, physical therapy,
and mental health services)— want to use their specific expertise and skills to
provide healthcare services as efficiently as possible. Also, providers want
access to plan members in order to maintain or increase their market share,
and providers want to be rewarded financially for offering healthcare services.
• Owners of a health plan
• Owners of a health plan, whether they are individual or institutional
stockholders or another corporation, want the health plan to be solvent,
profitable, and poised for future growth. In return, owners and investors seek
to be rewarded financially for their investment in the health plan.
• Regulatory Agencies
• Regulatory agencies ensure that health plans adhere to the law and remain
solvent so that the health plans can provide the promised healthcare benefits.
Regulatory agencies also want health plans to provide all plan members with
the highest possible quality healthcare and access to that care at a reasonable
cost.
Fast Definition
Economies of scale are cost reductions obtained when all functions are performed on a
large scale.
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These participants all have different goals. In some cases, the goals are clearly
complementary. For instance, a plan member who is acutely ill is not likely to have the
funds to pay for a major medical procedure. By providing healthcare for a large number
of healthy people, a health plan is able to both take advantage of economies of scale
and spread out the financial risk that any one plan member will suffer an illness or injury.
Plan members want to avoid financial risk, and health plans and insurers are in the
business of assuming and managing this risk.
Thus, a health plan gives a plan member, who is the ultimate recipient of healthcare, a
means of balancing the goals of low expense, access to quality care, and reduced
financial risk. In doing so, the health plan has an opportunity to conduct a profitable
business. In other cases, goals are not obviously complementary, but many of the
features of or practices employed by health plans help align the goals of the various
participants. Let’s look at two examples of how health plan goals integrate to benefit
more than one type of participant.
Suppose an employer becomes the plan sponsor of a group health plan offered by a
health plan. Because one of the health plan’s goals is to manage costs, this particular
health plan has a copayment feature. Recall from Healthcare Management: An
Introduction that copayment is a specified charge that a plan member must pay out-of-
pocket for a service at the time the service is rendered. For example, each time the
member visits physician, the member may have to pay $10 copayment.
In the short run, copayments might appear to interfere with the plan member’s goal of
receiving healthcare at the lowest possible cost, because the plan member will have to
pay the copayments. However, copayments lower the premiums that health plan must
charge for a given level of healthcare benefits. Also, in the long run, the copayment
feature lowers the cost of healthcare because copayments give plan members a reason
to help control the number of unnecessary visits to the doctor a copayment feature helps
to lower the health plan’s costs. Thus the goals of the plan member are aligned with the
goals of the employer and the health plan’s owners. At the same time, the plan member
receives quality healthcare and avoids the risk that illness will cause financial hardship.
In another example, suppose a physician owns her own practice. She finds that,
although she enjoys helping plan members by practicing medicine, she spends much of
her time on the administrative aspects of her practice. Administrative tasks include
payroll, accounting, purchasing supplies, and other business functions. A PPM company
provides physicians with administrative support services, which the PPM company can
more efficiently perform, leaving the physician more time to practice medicine and
thereby better serve plan members.
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By using financial information to calculate the expenses and projected income involved
in offering such services to providers, a health plan may ultimately take advantage of
economies of scale by offering administrative services to a large number of physicians.
Economies of scale result in a decrease in the cost per plan member of administering
healthcare. In turn, the health plan’s owners may receive a higher return on their
investment. Also, through the health plan, both plan members and physicians benefit:
the plan members benefit because their access to the physician has been improved, and
the physicians benefit because they are able to see more plan members than before.
Perhaps the best example of aligned incentives is a risk-sharing arrangement in which a

health plan and its providers share the risks and rewards of higher- or lower- than
expected medical expenses. We discuss risk management in Risk Management in
Health Plans and provider reimbursement arrangements in Provider Reimbursement
Arrangements and Capitation and Plan Risk.
Course Overview
Health Plan Financial Information introduced the functions that comprise health plan
finance and described some types, users, and uses of a health plan’s financial
information. Throughout the remainder of this course, we discuss various financial
aspects of health plans and their impact on planning and operations. This discussion
includes the following topics:
• Risk management tools • Accounting and financial

• Legal and regulatory requirements reporting
• Self-funding • Strategic planning
• Medicare and Medicaid programs • Financial analysis
• Underwriting and rating • Cost control
• Cash management
• Provider reimbursement, with a particular
focus on capitation • Capital budgeting
Chapter 2 A
Types of Risk
After completing Types of Risk, you should be able to
• Distinguish between pure risk and speculative risk

• Define risk management
• Define the risks included in risk-based capital (RBC) requirements for health
plans
• Explain how C-risks and RBC risks relate to health plan solvency
• Discuss the three broad strategies health plans use to deal with risk
To understand many aspects of healthcare financing, you must first understand the risks
the various participants in health plans face. Generally speaking, risk has a direct
association with cost—that is, in the long run the greater the exposure to risk, the greater
the costs that follow from that risk. In the following sections, we explain the concept of
risk and explore the methods that health plans use to manage the risks associated with
the financing and delivery of healthcare.
The Concept of Risk 1
Risk exists when there is uncertainty about the future. Individuals and businesses both
experience two kinds of risk—speculative risk and pure risk.
Speculative Risk
Speculative risk involves three possible outcomes: loss, gain, or no change. For
example, after an investor purchases stock in a publicly traded health plan, the
stock price will either rise, fall, or stay the same. The investor’s financial returns on
that stock will follow the stock price plus whatever dividends the health plan issues.
Thus, the owner of the stock faces speculative risk to the extent that the future returns
on the stock are uncertain.
Likewise, when a health plan purchases a new information system, the health plan’s
owners hope that the initial investment in the system will result in an increase in
operational efficiency and in the level of customer service—factors that will help the
health plan earn a profit (if the health plan is for-profit) or a higher level of retained
earnings (if the health plan is not-for-profit). Furthermore, the health plan’s owners hope
that the total benefits that derive from the health plan’s investment in the information
system—benefits such as increased income and market share—exceed the benefits the
health plan or its owners could have received by investing the same amount of money in
a different information system.
Speculative Risk
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Again, uncertainty and risk are present in this investment decision because there is a
possibility that this particular information system will not work as hoped, and that the
health plan will incur greater expenses and fewer benefits than anticipated from the
system, thereby losing money on its investment. There is also a possibility that the
investment will neither lose nor gain a significant amount of money—that is, the benefits
of the system as measured by increased revenue are essentially equivalent to the
increases in costs associated with that system.
In this regard, many expenditures made by a health plan are much the same as an
investment—the health plan is investing in itself. The health plan’s owners or
stakeholders are in a position similar to owners of other investments such as stocks or
bonds: owners invest their money and accept some financial risk in the hopes of seeing
some benefit that translates into financial gain.
Pure Risk
Pure risk involves no possibility of gain; there is either a loss or no loss. An example of
pure risk is the possibility that you may contract a serious illness. Such unforeseen
illnesses will result in economic loss in the form of lost wages and increased medical
expenses. If, on the other hand, you do not become seriously ill, then you will incur no
losses from that risk. For a health plan, examples of pure risk include the possibility that
its home office building will be damaged by fire, or that the health plan will be a victim of
fraud, or that an employee will act in a negligent manner and in so doing expose the
health plan to financial liability. Notice that like speculative risk, pure risk contains an
element of uncertainty, but unlike speculative risk, pure risk contains no possibility of
gain.
The possibility of economic loss without the possibility of gain—pure risk—is the only
kind of risk that healthcare coverage is designed to help plan members avoid. The
purpose of healthcare coverage is to compensate, in part or in full, a plan member,
either directly or indirectly, for financial losses resulting from unintentional illness or
injury.
Pure Risk
The coverage is not designed to provide an opportunity for the plan member to obtain a
financial gain from his or her healthcare needs. In other words, healthcare coverage is
not designed to be a means of engaging in speculative risk for plan members. Instead,
plan members transfer to the health plan the pure risk of medical costs arising from plan
members’ unforeseen illnesses or injuries.
Notice that healthcare coverage does not necessarily prevent events that are associated
with pure risk: many plans include wellness programs to reduce the frequency of
illnesses, but neither participation in the wellness program nor the coverage itself
necessarily prevents any one illness. Instead, the plan member transfers the pure risk of
facing large and unexpected medical bills to another party—for example, the health plan.
The health plan itself, by charging actuarially derived premiums for accepting this risk,
engages in speculative risk, because it may either experience a gain or a loss from its
business, depending on the rate at which plan members utilize services and the health
plan’s administrative and other business costs.
Review Question
The following examples describe situations that expose an individual or a health plan to
either pure risk or speculative risk:
• Example 1 — A health plan invested in 1,000 shares of stock issued by a

technology company.
• Example 2 — An individual could contract a terminal illness.
• Example 3 — A health plan purchased a new information system.
• Example 4 — A health plan could be held liable for the negligent acts of an
employee.
The examples that describe pure risk are
examples 1 and 2
Incorrect. Pure risk involves no possibility of gain.
examples 1 and 4
examples 2 and 3
examples 2 and 4
Correct. Pure risk involves no possibility of gain.
Risk Management
Individuals and businesses are surrounded by risks. Accepting risk is a key business
function of health plans, and a vital part of a health plan’s business activity involves
managing those risks. Risk management is the process of identifying risk, assessing
risk, and dealing with risk. Broadly speaking, the goals of risk management for a health
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plan involve assuring that the organization survives, operates efficiently, sustains growth
and effectiveness, and, in the case of publicly owned for-profit health plans, increases
shareholder value. Health plan finance is concerned not only with pure risk, but with a
specific type of speculative risk called financial risk. Financial risk is the possibility of
economic or monetary loss—or gain—in undertaking or neglecting to undertake a certain
action. Figure 2A-1 asks you to consider the risks in a typical health plan situation.
In situations such as the one discussed in Figure 2A-1, the health plan, employer,
provider, and plan member can benefit from using risk management to deal with the risk
each faces. Because health plans are presented with a large number of financial risks in
the course of conducting business, health plans use a variety of risk management
techniques to minimize the possibility of undesirable financial outcomes.
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However, in order to achieve a return on financial resources, a health plan must accept
the financial risk of engaging in business activities. Similarly, an investor typically
accepts some risk in order to achieve a return in, for example, the stock market. For
businesses and investors, risk and return are therefore closely related.
Another way to look at the risk-return relationship is that the greater the risk associated
with an investment or business activity, the greater the potential return must be in order
to offset the risk the investor is taking. This direct relationship between the amount of
risk and the amount of the potential return required to make the risk financially
acceptable is known as the risk-return trade-off. The risk-return trade-off is a basic
consideration in decisions concerning many core business activities health plans
undertake. For example, where regulations allow, an HMO will charge higher premiums
to a high-risk group of enrollees than to a low-risk group of enrollees, because as the
risk-return trade-off suggests, the HMO will only accept greater risk in exchange for
greater potential returns.
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In this lesson and many that follow, we will discuss ways in which health plans manage
the risks that they face. First, however, we continue with an overview of the specific
types of risk generated by a health plan’s business, and the relationship between those
risks and the health plan’s solvency.
Risk Categories Faced by Health Plans
In the most general sense, any activity undertaken by a business entails some risk, and
ultimately every risk has the potential to impact the business financially. Health plans, for
example, face risks when entering a new market, exiting a market, or deciding to
continue to operate in a given market. The health plan faces other risks in plan design
activities, benefit coverage decisions, pricing products, choosing an information system,
hiring employees, reacting to the regulatory environment, or developing provider
reimbursement contracts.
To manage and understand risk, managers have divided risk into different categories.
The first categories of risk we will discuss are called contingency risks, or C-risks.
C-Risks and Solvency
Contingency risks, usually called C-risks, are general categories of risk that have direct
bearing on both cash flow and solvency. Solvency is generally defined as a business
organization’s ability to meet its financial obligations on time. To continue operations, for
example, a health plan must be able to pay those medical costs it is contractually
obligated to pay as those costs come due. Thus, financial risks have a direct bearing on
an health plan’s ability to stay solvent, and the ability of a health plan to stay solvent is a
minimum requirement for the health plan’s continued operation.
In accounting terms, solvency in a health plan is closely related to the amount of capital
and surplus (also called owners’ equity) that the health plan has on hand. Capital and
surplus is, at the most basic level, the difference between a health plan’s assets and its
liabilities:
Assets – Liabilities = Capital and surplus
For a business to be solvent, it must have sufficient liquid assets to meet liabilities that
are due. Liquid assets are those assets that are either held in cash or can be easily and
quickly converted into cash. Money market funds and checking accounts are examples
of liquid assets, but an office building is not a liquid asset.
For health plans, solvency also refers to the legal minimum standard of capital and
surplus that every health insurance company must maintain. The issue of health plan
solvency is extremely important from a regulatory point of view, because the ability of
health plans to pay the covered medical benefits of enrollees is a public policy priority.
We will discuss regulatory standards for solvency in the next lesson.
There are four C-risks. Each measures aspects of a health plan’s financial and
management operations that can influence its solvency. Although C-risks were
developed to apply to the life and health insurance industry, they have also influenced
the development of methods that managers and regulators use in assessing the level of
risk faced by health plans. Following is a brief discussion of each type of C-risk:
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• C-1, or asset risk, is the risk that a health plan will lose money on its assets,
including investments in stocks, bonds, mortgages, and real estate.
• C-2, or pricing risk, is the risk that the health plan’s experience with morbidity
or expenses will differ from the assumptions that were used in pricing the
health plan’s products. For health plans, this risk is typically the most
important factor in determining whether or not a plan is solvent.
• C-3, or interest-rate risk, is the risk that interest rates will shift, causing the
health plan’s invested assets to lose value.
• C-4, or general management risk, is the risk that financial losses will result
from business management decisions.
Fast Definition
Morbidity is sickness, injury, or failure of health. 4
Businesses that have significant assets face these C-risks to varying degrees, but the
relative importance of each C-risk varies from business to business. For example, a
typical health plan faces much different levels of exposure to asset and interest-rate
risks than do life insurers or banks. Life insurers usually collect premiums on a life
insurance policy for many years before paying a claim on that policy. Thus, life insurers
typically maintain a significant portion of their assets in long-term investments, which
causes both asset and interest-rate risks to be very important factors in their profitability.
In contrast, a health plan will begin paying for medical costs relatively soon after first
receiving premiums from, for example, a group health policy. Because the health plan’s
medical payments come much sooner and more frequently than a life insurer’s payment
of a claim on a life insurance policy, a larger portion of a health plan’s assets will flow
into and out of short-term, liquid investments. Because these assets are liquid, they can
be sold for cash more easily than many long-term investments, which, generally
speaking, makes liquid assets less subject to asset risk than long-term investments.
Thus, the health plan faces relatively smaller asset risk than businesses such as banks,
because banks tend to hold long-term investments such as mortgages.
In certain business activities, however, health plans can face significant asset risk. For
example, health plans typically use sophisticated computer technology to track utilization
data, provider reimbursement, enrollee information, customer service, and medical
costs. Tracking data is a crucial part of an health plan’s ability to manage costs and risk
exposure. Additionally, many types of data must be tracked accurately for a health plan
to meet regulatory requirements. Consequently, any threat to the value of the computers
used for tracking and analysis is an asset risk.

Although health plans face relatively less exposure to interest-rate risk and asset risk
than do banks or life insurance companies, health plans face considerable pricing risk
under almost all health plan contracts. For most health plans, pricing risk is the most
important risk the organization faces. Pricing risk is so important because a sizable
portion of the total expenses and liabilities faced by a health plan come from contractual
obligations to pay for future medical costs, and the exact amounts of those costs are not
known when the healthcare coverage is priced.
For example, suppose a health plan enters into a group contract that is renewable on a
yearly basis. The health plan will set a price (premium) in advance for the expenses it
expects to incur in delivering healthcare services to the group’s plan members. Although
medical costs will be paid throughout the year, the premium cannot be renegotiated until
the end of the contract year. The plan faces considerable pricing risk during the contract
because the possibility exists that assumptions made in pricing the plan benefits at the
beginning of the contract will not necessarily match the actual medical costs.
In any market where health plans face constraints in pricing their services, these health
plans also face pricing risk. In competitive markets such as those in which health plans
typically operate, competition itself is usually the most important constraint on pricing,
because in such markets health plans will compete with each other for market share
partly by attempting to keep their prices (premium rates) low.
Additionally, government activities also place constraints on pricing in some markets. For
example, as we discuss later in another lesson, the federal government develops
payment schedules for federal healthcare programs, most notably for the Medicare and
Medicaid markets. Health plans operating in these markets may find it impossible to
adjust the payments they receive for the healthcare coverage they provide. At the same
time, health plans in many markets are subject to mandated benefit laws. These laws
add to the expenses health plans incur while operating in the market because such laws
require health plans to cover healthcare expenses for certain treatments or benefits.
Thus, health plans may be constrained in both setting the payments they receive and in
the methods they have for reducing expenses. Both conditions can serve to increase the
pricing risk health plans face.
Finally, general management risk is also an important issue for health plans, because
management decisions are critical to a health plan’s financial outcomes. Decisions
related to controlling costs, improving customer service, designing plan benefits, and
structuring provider reimbursement contracts are all critical management decisions.
Management risk also includes the risk that actual expenses will exceed the amounts
budgeted for those expenses. Accurate estimates of future expenses and liabilities allow
health plans to retain sufficient liquid assets to meet obligations. Beyond solvency
concerns, accurate budgets also allow management to use resources efficiently so that
the assets generate the greatest possible return. If the management of a health plan
underestimates expenses for an upcoming financial period, the health plan may either
fail to retain sufficient assets to cover current obligations, or be forced to sell long-term
assets at a loss to meet those obligations, or take other financially costly steps to stay
solvent.
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Management risk is always present in a business, because management constantly

faces choices concerning how to allocate financial resources to achieve the best
financial outcomes. For example, after satisfying regulatory requirements for solvency,
an HMO’s management must decide the specific level of capital and surplus the HMO
will maintain. If management fails to retain a sufficiently high level of surplus, then the
HMO may not be able to absorb losses incurred from other financial risks.
On the other hand, holding excessive amounts of surplus is not risk-free, because this
excess is not being earmarked for core business functions such as developing a greater
market share. Furthermore, the optimum level of surplus for any HMO will change over
time as internal and external conditions change. Consequently, management risk is
present at any level of surplus.
Some of the variables that management must take into consideration when making
financial decisions are wholly or partly within the health plan’s control. For example, an
health plan’s management has considerable control over whether or not to contract with
a given provider, and whether or not to include that provider on the health plan’s list of
primary care providers. However, the health plan has only partial control over the
reimbursement rate it pays the providers in its network, because the health plan must
negotiate that rate with providers.
Many other variables, such as government laws and regulations, the general rate of
inflation in the economy, and the general rate of increase in medical costs, are often
beyond the health plan’s control. Thus, the risk that a management decision will result in
unfavorable financial outcomes increases whenever changes in general business
conditions increase in frequency or severity.
Regulatory and Antiselection Risks
In our discussion of general management risk, we pointed out that health plans have
varying degrees of control over internal business decisions and external business
conditions. For the health plan industry, a very important source of external risk is
regulatory risk. Regulatory risk is the risk that changes in regulations or laws may
adversely affect the financial condition of an health plan. We will discuss some of the
laws that carry regulatory risk in Risk Management in Health Plans and Provider
Reimbursement and Plan Risk, but for now you should know that there are a number of
regulatory risks faced by health plans.
Chief among these risks is the possibility that healthcare reform may result in rate caps
or mandated benefit laws. Rate caps, which are most common in markets such as
Medicare where the government itself is the payor, limit a health plan’s ability to increase
revenue in response to rising medical costs, and therefore increase the risk that a health
plan will become insolvent. Laws mandating certain health plan benefits or contractual
obligations have the effect of increasing expenses for a health plan operating in that
jurisdiction. Although regulatory risks such as premium caps and mandated benefits are
particularly important to health plans’ risk management function, health plans also face
regulatory risks that are not unique to the healthcare industry. Tax laws, regulations and
laws governing employment, building and safety codes, and other laws have a tendency
to change over time, and the possibility of regulatory change carries with it regulatory
risk.
Regulatory and Antiselection Risks
In a health plan environment, antiselection is the tendency of people who have a

greater-than-average likelihood of loss to seek healthcare coverage to a greater extent
than individuals who have an average or less-than-average likelihood of loss.
Antiselection risk for health plans is the possibility that a higher-than-anticipated
percentage of people who need greater-than average healthcare benefits will sign up
with a healthcare plan.
Antiselection can occur because individuals often know much more about their health
than a health plan can know. People who know they are ill or believe that they are likely
to become ill tend to more actively seek health coverage—particularly coverage with
enhanced benefits—than do healthy people who believe they will not become ill. If an
health plan has designed its health plan and premium rates assuming a utilization rate
based on an average population, but attracts enrollees who are less healthy than
average, the health plan faces higher-than-expected utilization rates because of
antiselection.
Review Question
Contingency risks, or C-risks, are general categories of risk that have a direct bearing on
both the cash flow and solvency of a health plan. One of these C-risks, pricing risk (C-2
risk), is typically the most important risk a health plan faces. Pricing risk is crucial to a
health plan’s solvency because:
a sizable portion of any health plan’s assets are held in long-term investments and
any shift in interest rates can significantly impact a health plan’s ability to pay
medical benefits
Incorrect. A large portion of a health plan's assets flow in and out of short-
term liquid investments.
a health plan relies heavily on the sound judgment of its management, and poor
management decisions can result in financial losses for the health plan
Incorrect. This is an example of a C-4 or general management risk.
a situation in which actual expenses exceed the amounts budgeted for those
expenses may result in the health plan failing to retain assets sufficient to cover
current obligations
Incorrect. Deciding the specific level of capital and surplus is an example of
C-4 management risk.
a sizable portion of the total expenses and liabilities faced by a health plan come
from contractual obligations to pay future medical costs, and the exact amounts of
those costs are not known at the time a product’s premium is established
Correct. A sizable portion of the total expenses and liabilities faced by a
health plan come from contractual obligations to pay future medical costs,
and the exact amount of these costs are not known at the time a product’s
premium is established.
Antiselection also occurs when people choose between competing plans. For example,
suppose a large employer offers two health plans to its employees. Both plans cover the
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same range of medical treatments, but Plan A has relatively high deductibles and
relatively low monthly enrollee contributions. Plan B has relatively low deductibles and
relatively high contributions. Enrollees who anticipate that they will make frequent and
expensive trips to their doctors may be willing to make high monthly contributions if their
deductibles are low, but enrollees who anticipate little need for medical treatment will be
more likely to sign up for a plan with low monthly contributions. Thus, Plan B may, on
average, attract less healthy enrollees than Plan A. Actuaries play an important role in
recognizing the risk of antiselection and judging the financial impact of that risk in such
situations.
Regulatory Solvency and Risk-Based Capital Requirements
As we mentioned earlier, all businesses, including health plans, are concerned about
their own solvency. In addition, health plans are interested in the general financial
condition of the healthcare industry for at least two reasons. First, all health plans are
better off if the public has faith and confidence that health plans are financially stable
and reliable. Second, health plans recognize that regulators and elected officials see
financial stability and reliability in the healthcare industry as a public policy goal. In
pursuit of this goal, lawmakers and regulators have established legal solvency standards
that directly impact how health plans manage risks.
However, solvency standards themselves vary widely depending on the type of health
plan being regulated. HMOs, for example, are typically regulated as insurers, and as
such must comply with state insurance laws. On the other hand, federal law exempts
self-funded employer-sponsored health plans from state insurance laws and regulations.
Recall from Healthcare Management: An Introduction that under self-funded plans an
employer or other group sponsor, rather than a health plan or insurer, is responsible for
paying plan expenses.
Because employees typically contribute to the financing of employer-sponsored health

plans, much of the federal regulation governing the financial aspects of these self-funded
plans is more concerned with defining the fiduciary duties of those who exercise control
over the plan, rather than concern with setting solvency standards for the plan sponsor.
We will discuss self-funding in more detail in Fully Funded and Self-Funded Health
Plans.
In the next sections of this lesson, we examine two solvency standards regulators use to
set financial requirements with respect to risk for health plans. The first standard is from
the HMO Model Act as developed by the National Association of Insurance
Commissioners (NAIC). The second standard is known as risk-based capital (RBC).
HMO Model Act and Solvency 5
The HMO Model Act is a model law, developed by the National Association of Insurance
Commissioners (NAIC), that is designed to aid state governments in regulating the
licensure and operations of HMOs. More than half of the states have adopted the HMO
Model Act or substantial portions of this model law. 6
Under the HMO Model Act and most state laws, an entity that wishes to operate as an
HMO must obtain a certificate of authority, often called a license. A certificate of
authority (COA) is a certificate issued by the state authority that regulates HMOs; the
COA certifies that all requirements have been met for the establishment of an HMO in
accordance with the state’s HMO laws. Generally, the purpose of licensing is to ensure
that an HMO is a solid, dependable organization, fiscally sound, and able to meet
specified quality standards for healthcare delivery.
Fast Definition
With respect to self-funded plans, a fiduciary is a person, regardless of formal title or
position, who exercises discretionary authority and control over the operation of a plan,
exercises any control over plan assets, or renders investment advice for a fee7
HMO Model Act and Solvency
Among other requirements, the HMO Model Act sets financial requirements for HMOs
seeking to obtain COAs. An HMO must have an initial net worth of $1.5 million and
thereafter maintain the minimum net worth described in Figure 2A-2. In this context, net
worth is an organization’s total admitted assets minus its total liabilities (its debts and
obligations, including obligations to pay for in-network and out-of-network care for its
providers). An admitted asset is an asset that state HMO or insurance laws permit on
the Assets page of a company’s Annual Statement.
We discuss financial statements in more detail in Accounting and Financial Reporting,

but you should recall from Healthcare Management: An Introduction that the Annual
Statement is a financial report that most health plans have to file to comply with state
insurance regulations.
From a business and financial management standpoint, the ongoing net worth
requirements listed in Figure 2A-2 contain some important elements. First, the net worth
requirements set a minimum fixed level of capital and surplus for all HMOs.
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Second, after an HMO has reached a certain size, as measured by premium income and
medical expense payments, the capital and surplus requirements will vary according to
the size of the HMO. HMOs that receive more premiums or have experienced higher
healthcare expenditures than other HMOs must have a higher net worth, and each
HMO’s net worth requirement increases as the HMO grows larger.
Third, an HMO must be able to accurately track and report the financial results of a
number of its operations. These results include, but are not limited to, premium
revenues, uncovered healthcare expenditures, total healthcare expenditures less those
paid on a capitated (typically a per member, per month) basis.
The HMO Act net worth requirements for HMOs attempt to reflect an important principle
of risk exposure for health plans: The larger the number of enrollees in the plan, the
greater the health plan’s net worth requirement should be, assuming coverage levels
remain the same. The higher net worth requirement makes sense intuitively, because in
the long run a large group of enrollees will generate more healthcare costs than a small
group will generate. Therefore, an HMO providing coverage for the large group must
have greater surplus to pay those expenses as they come due.
A second principle reflected in the HMO Model Act is that the larger the number of
enrollees covered by an HMO, the more predictable the morbidity experience of the
covered group should be. For HMOs with a large number of enrollees, predictable
morbidity experience tends to result in more predictable claim expenses. This increase
in predictability decreases the chance that expenses will be so unexpectedly high in any
one period that the HMO will experience insolvency, assuming that the premiums are set
on an actuarially sound basis. The HMO Model Act therefore requires that plans meeting
the net worth requirement through the percent-of-premium method must maintain 2% of
premium revenues for the first $150 million in premium revenues, but only 1% of the
premium revenues greater than $150 million
Review Question
The HMO Model Act sets certain requirements that an entity that wishes to operate as
an HMO must meet. These requirements include:
having an initial net worth of at least $5 million

Incorrect. The HMO Model Act requires an intial net worth $1.5 million.
maintaining a net worth equal to at least 5% of premium revenues for the first $150
million in premium revenue
Incorrect. The requirement states 2% of annual premium revenue on the first
$150 million.
using a prospective method to estimate future risk
Incorrect. The HMO Model Act is restrospective in its assessment of risk.
obtaining a certificate of authority (COA) before beginning operations
Correct. Under the HMO Model Act, an HMO must obtain a COA before
beginning operations.
Regulatory Solvency and Risk-Based Capital Requirements

Disadvantages of the HMO Model Act Solvency Standards
The HMO Model Act represents one approach to developing solvency standards. This
kind of approach mandates a minimum level of capital and surplus for any health plan
that falls under a law based on this model act. One drawback to this type of solvency
regulation is that other than adjusting for the size of the HMO’s premiums and
expenditures, this approach mandates the same solvency requirement for all
organizations that must comply with the regulation. In other words, the size of an HMO’s
premiums and expenditures is assumed to reflect accurately the level of risk the HMO
faces. Our discussion of C-risks, however, suggests that two health plans that receive
the same premium income may be exposed to very different levels of financial risk
depending on their approaches to pricing their products, investing their assets, and
managing their utilization costs.
Furthermore, the HMO Model Act is retrospective in its assessment of risk. That is, it
uses past expenditures and premium income to estimate future risk. For plans that are
growing or shrinking, past data may be a less accurate predictor of risk than the same
data would be for plans that have stable enrollment figures.
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Disadvantages of the HMO Model Act Solvency Standards
Another problem exists in terms of the assumption that the amount of premiums an HMO
charges always directly corresponds to the level of the risk an HMO faces. In some
cases involving plans that are experiencing difficulty remaining solvent, this is a false
assumption.
For example, suppose an HMO had experienced low claims in the recent past and was
meeting its net worth requirements through the 2-percent-of-premium method. Under the
HMO Model Act, this HMO’s net worth requirement would fall slightly as a result of the
HMO’s lowering its premium revenue (that is, as a result of the HMO’s decreasing its
rates to policyholders). However, lowering rates without decreasing the benefit coverage
actually increases the HMO’s exposure to risk.
Thus, under these circumstances, the model act’s method of determining net worth
would not necessarily require an HMO that increased its risk of future insolvency to
increase its net worth requirement. Typically, HMOs are prudently managed, and will not
lower premium rates so much that insolvency occurs. However, in cases where
insolvency has occurred, extremely competitive pricing in the HMO’s market is often a
key contributing factor in the insolvency. Retrospective net worth methods, such as the
HMO Model Act method, can under some circumstances fail to anticipate this increased
risk.
The Development of Risk-Based Capital Requirements
To tie the capital and surplus requirements more closely to the actual level of risk faced
by different health plans, the NAIC began, in the early 1990s, to develop risk-based
capital (RBC) formulas for all life and health insurance companies. However, NAIC
members recognized that this formula did not adequately reflect the range of risks
present in the health insurance business. Further, the financial standards contained in
the HMO Model Act and various states’ HMO and insurance statutes may not apply to
some provider organizations or certain other risk-bearing entities. Recognizing the
limitations of relying upon a single minimum fixed level of capital and surplus
requirements, the NAIC then began a process to create a separate RBC formula for all
health insurers and health plans that accept risk.
The RBC formula for health plans (health plan-RBC) is a set of calculations, based
on information in the health plan’s annual financial report, that yields a target
capital requirement for the organization. The RBC formula applies to health plans
in states that have adopted legislation to implement RBC requirements. The
Centers for Medicare and Medicaid Services (CMS), the federal agency that
oversees the Medicare program, requires PSOs to be state licensed, and has
therefore become interested in RBC requirements as a secondary regulator.
The RBC formula assesses the specific level of risk faced by each health plan. Under
RBC requirements, a health plan’s target surplus is not simply a function of the
premiums it receives or the costs it has incurred in the recent past, but also reflects the
underlying risks the health plan faces and how the health plan manages those risks. For
example, as we will see in Provider Reimbursement Arrangements and Capitation and
Plan Risk, health plans can use provider payment methods to transfer some utilization
risk from themselves to the providers who make treatment decisions. In a healthcare
context, utilization risk is the possibility that the rate of use of medical services by a
given enrolled population will exceed the predicted rate. Higher-than-expected rates of
utilization tend to result in higher-than-expected costs for the entity at risk for utilization.
For health plans, utilization risk is a critical factor in the financial outcome of the health
plan’s business, because a large portion of an health plan’s total expenditures involve
medical expenses. Higher-than-expected rates of utilization can occur simply because a
given population’s legitimate need for medical services is greater than the actuarially
predicted need. However, utilization risk is increased in situations where overutilization
occurs. Overutilization is the use of medical services or procedures that are not
medically necessary. Because providers make many treatment decisions, one of the
central financial strategies in health plans is the use of provider reimbursement systems
that motivate providers to avoid treatment decisions that result in overutilization.
Consequently, the RBC requirement is adjusted for any provider payment methods the
health plan has in place that reduce the health plan’s risk.
The health plan-RBC formula takes into account five different kinds of risk:
• Affiliate risk—the risk that the financial condition of an affiliated entity

causes an adverse change in capital
• Asset risk—the risk of adverse fluctuations in the value of assets
• Underwriting risk—the risk that premiums will not be sufficient to pay for
services or claims
• Credit risk—the risk that providers and plan intermediaries paid through
reimbursement methods that require them to accept utilization risk will not be
able to provide the services contracted for, and the risk associated with
recoverability of the amounts due from reinsurers
• Business risk—the general risk of conducting business, including the risk
that actual expenses will exceed amounts budgeted
You should notice that many of these RBC risk categories parallel the C-risks we
discussed earlier. The system of C-risks was developed before RBC, and formed the
basis for the development of RBC risk categories and the RBC formula. For this reason,
the C-4 (general management risk) is related to the RBC’s business risk category. Both
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systems also include a category for asset risk. Finally, the C-2, or pricing risk, is
paralleled by the RBC’s underwriting risk.
However, RBC also contains differences that reflect the nature of the health plan
industry. For example, as we have mentioned, interest-rate risk for health plans is
relatively small, so the RBC does not have a separate interest-risk category. Also, the
RBC categories reflect the fact that the level of risk faced by health plans is significantly
impacted by provider reimbursement methods that shift utilization risk to providers. We
will discuss provider reimbursement methods in later lessons, but for now you should
know that such reimbursement methods, in which providers assume at least some
utilization risk, have two effects on RBC risks.
First, these reimbursement methods decrease the risk that the health plans will be
exposed to higher-than-expected levels of utilization. By decreasing this utilization risk,
the health plan is decreasing its underwriting risk. Consequently, a health plan’s
underwriting risk can be significantly reduced when the health plans use these
reimbursement methods.
Underwriting risk is the greatest risk component of a typical health plan’s RBC formula,
and often largely determines the health plan’s net worth requirement. The structure of
provider reimbursement methods used by health plans therefore becomes a key strategy
for risk management in health plans. The RBC formula explicitly recognizes this. The
strategy of using provider contracts to manage risk is also valid for health plans that are
not subject to RBC requirements, because the underlying utilization risk is important to
all health plans, no matter what method is used to determine their minimum net worth
requirements.
The second influence of provider reimbursement contracts on a health plan’s RBC

formula is reflected in the credit-risk category. The credit-risk category recognizes that
transferring utilization risk to providers does not eliminate the health plan’s responsibility
to arrange for medical services covered by its health plan. If these providers accept too
much risk and become insolvent, the health plan will incur a number of expenses,
including those associated with having to develop new provider contracts, or even new
provider networks.
Review Question
The risk-based capital formula for health plans defines a number of risks that can impact
a health plan’s solvency. These categories reflect the fact that the level of risk faced by
health plans is significantly impacted by provider reimbursement methods that shift
utilization risk to providers. The following statements are about the effect of a health plan
transferring utilization risk to providers. Select the answer choice containing the correct
statement:
The net effect of using provider reimbursement contracts to transfer risk is that the
health plan’s net worth requirement increases.
Incorrect. The net effect of using provider reimbursement contracts to
transfer risk is that the health plan’s net worth requirement decreases.
Once the health plan has transferred utilization risk to its providers, it is relieved of
the legal obligation to provide medical services to plan members in the event of
the provider’s insolvency.
Incorrect. Tranferring utilization risk to providers does not eliminate the
health plan's responsibility to arrange for medical services for members,
even if the provider becomes insolvent.
The greater the amount of risk the health plan transfers to providers, the larger the
credit-risk factor becomes in the health plan’s RBC formula.
Correct. The greater the amount of risk the health plan transfers to
providers, the larger the credit-risk factor becomes in the health plan’s RBC
formula.
By decreasing its utilization risk, the health plan increases its underwriting risk.
Incorrect. By decreasing utilization risk the health plan decreases its
underwriting risk.
Even if providers do not become insolvent, but simply refuse to renew contracts at old
reimbursement rates, then the health plan’s cost of paying these providers would
increase if the health plan wished to continue contracting with the providers. The greater
the amount of risk the health plan transfers to providers, the larger the credit-risk factor
becomes in the health plan’s RBC formula. Thus, transferring risk to providers through
reimbursement contracts decreases the health plan’s underwriting risk, but increases the
health plan’s credit risk. However, because the underwriting risk is by far the largest risk
in the RBC formula for health plans, the net effect of using provider reimbursement
contracts to transfer risk is that the health plan’s net worth requirement will decrease.
Health plans also use several other strategies to transfer certain risks. Transferring risk
using these strategies can also increase an health plan’s credit risk. For example, health
plans can purchase various types of insurance to protect themselves against losses that
would result if an unexpectedly large number of plan members incur catastrophic
medical expenses. Credit risk captures the risk that the entities selling insurance to the
health plan will be unable to make the agreed-upon payments should the insured-
against event occur. We discuss these forms of insurance in more detail in a future
lessons.
The Structure of the RBC Formula
The RBC risks for a given health plan are assigned numerical values. These values are
arranged in a formula that generates the total amount of risk faced by the health plan.
The mathematical modeling used to develop this formula is beyond the scope of this
text, but there are two characteristics of this formula that you should understand.
First, numerical values for all the risks are eventually added together, because RBC
attempts to capture the total risk of financial failure faced by the health plan. Second, the
formula performs mathematical operations on the separate risks before adding the risks
together. The result of these operations is that if one of the risks is greater than the
- 35 -
others, the influence of that large risk on the health plan’s financial strength is
emphasized. Because underwriting risk is typically the most important risk faced by
health plans, the underwriting risk’s influence on the health plan’s financial strength is
often much greater than any of the other risks, and the RBC formula reflects this relative
importance.
Strategies for Controlling Risk
The categories of risk that we have discussed so far can be used by managers and
regulators to analyze the ways in which an health plan’s operations influence the health
plan’s financial strength. In this portion of the lesson, we will examine three general
strategies for controlling various types of risk. These three strategies are to avoid risk,
transfer risk, and accept risk.
Health plans must identify and assess both their exposure to risks and the possible
responses to those risks. A basic, but important, economic principle—opportunity cost—
applies to any financial decision that a health plan makes in choosing among the three
risk control strategies, as well as in choosing among specific courses of action once a
strategy is selected. Opportunity cost is the benefit that is given up when limited
resources are used to achieve one goal rather than another. health plans, like all
8
businesses, have limited resources, and in choosing risk management strategies, also
have to make decisions to allocate those resources.
Avoiding the Risk
Avoiding the risk involves either taking action or discontinuing an action in order to avoid
or limit exposure to the risk. Many businesses avoid financial risks by choosing either not
to enter certain markets or to exit markets in which risk is increasing.
Suppose, for example, that a health plan believes that changes in federal regulation
increase the risk that payment rates in a certain Medicare market will cause that market
to become unprofitable. A health plan may choose to avoid the risk of operating in that
market by either withdrawing from or not entering that Medicare market.
An important point here is that health plans do not simply avoid all risks, because their
core business involves accepting financial or business risks of one type or another in
exchange for premiums or other payments. In other words, avoiding risk is a useful
management technique in reducing expenses and risk exposure, but in cases of
speculative risks, avoiding risk also results in decreased chance of potential financial
gains.
In our example, a decision to avoid the risk of entering a new market would allow an
health plan to avoid the start-up costs of developing that market and the operational
costs of doing business in that market, but would also mean that the health plan would
give up the potential income it would receive from operations in that market. In situations
involving speculative risk, opportunity costs are always associated with any decision
involving the strategic allocation of funds.
From a financial management point of view, a decision to avoid a risk often involves two
analyses: first, an analysis of the savings that can be had by avoiding the risk, and
second, an analysis of the amount of revenue or other financial gain that that could be
had by accepting and managing the risk. Generally speaking, the smaller the likely
benefits of accepting a risk, and the lower the costs of avoiding that risk, the greater the
likelihood that a health plan will elect to avoid the risk.
If a risk is a pure risk from the point of view of the health plan, then there will be no
possibility of gain in retaining the risk, and the health plan will likely attempt to avoid the
risk. For example, healthcare fraud is potentially a substantial risk for health plans, and
all health plans expend some resources in attempting to avoid being subject to fraud.
The decision to avoid or accept any given risk, however, often varies not only according
to the activity that generates the risk, but also the qualities of the specific health plan that
is contemplating the risk. For example, beginning operations in a new market always
involves risk for a health plan, but the same market may be more risky for one health
plan than for another. The degree of risk the individual health plan faces will depend on
a great many factors, such as whether or not the health plan already operates in the
market’s geographical location, whether or not the health plan has experience operating
profitably in similar markets, and whether or not the health plan has sufficient capital
available for the purpose of entering the market.
Transferring the Risk
Transferring the risk involves shifting some or all of the financial responsibility connected
to a risk from one party to another. As the concept of risk-return trade-off suggests, the
party that agrees to accept the financial risk usually does so in exchange for some type
of financial incentive.
A common form of risk transfer for both individuals and businesses is insurance. Under
an insurance contract, the insurer agrees to pay a specified amount of money if certain
events occur in exchange for receiving a payment (usually called a premium) from the
party seeking the insurance. For example, most physicians purchase malpractice
insurance. A physician purchasing malpractice insurance pays a premium to an insurer
that agrees to pay a specified amount of money (or to cover certain costs incurred) if the
physician is sued for malpractice.
Health plans themselves may purchase insurance for a variety of risks, ranging from
property insurance to insurance that provides financial protection against catastrophic
and unexpected claims rates. In general, health plans can use this last type of insurance
to reduce the health plan’s exposure to the risk of having to pay larger-than-expected
medical expenses, and in doing so, the health plan reduces its underwriting risk. We
discuss the forms of insurance important to health plans in more detail later.
As important as insurance is as a means of transferring risk, health plans almost always

use other types of contractual, non-insurance risk transfer as well. For example,
suppose a large employer is willing to self-fund the healthcare coverage it offers to its
employees. Recall from Healthcare Management: An Introduction that under a self-
funded plan, an employer, rather than a health plan or insurance company, remains
financially responsible for paying plan expenses, including claims made by enrollees. In
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this case, the employer also decides to contract with a health plan to provide the
administrative services necessary for operating the health plan.
If the employer agrees to pay the health plan for these services based on the number of
employees that sign up for the healthcare coverage, then the employer is transferring to
the health plan some of the business risk of operating complex administrative functions.
In exchange for payment, the health plan accepts the risk that administering the plan will
be more expensive than anticipated. In this case, although there has been a transfer of
risk, the health plan is not functioning as an insurer because the employer is retaining
the responsibility to pay for the medical costs of the plan under its employee benefit
program, and no insurance contract has been made.
Another important area in which health plans use contracting rather than insurance to
transfer risk is the area of provider reimbursement. As we will see in the next few
lessons, hospitals and individual physicians can be compensated in ways that transfer
some of the risk of unexpectedly high rates of utilization from the health plans to the
providers. For example, a health plan retains utilization risk if it pays physicians on a per-
treatment basis, because the more treatments a physician provides to plan members,
the greater the medical expense liabilities the health plan faces. However, if the health
plan pays the physician a rate that is based on the number of plan enrollees that choose
the physician as their primary care doctor (rather than the number of treatments the
physician supplies to those patients), then the physician assumes some or all of the
utilization risk.
The greatest risks faced by health plans involve utilization rates. The premium payments
an health plan receives are based in part on projected utilization rates. A central financial
risk that health plans face, then, is that the utilization rates will be higher than expected,
and the cost of providing healthcare coverage to plan members will exceed the revenue
the health plans receive from premiums or other payments. health plans almost always
transfer some of this risk to other parties through a number of plan design elements and
provider reimbursement methods.
For example, deductibles and copayments are common elements in health plans. By
including these elements, the plan transfers a small portion of the utilization risk from the
health plan to the plan member. This transfer of financial risk is important to health plans
primarily because it motivates plan members to avoid seeking unnecessary medical
treatments, and thus makes the plan member a partner with the health plan in controlling
utilization rates. Similarly, some types of provider reimbursement contracts contain
elements elements that financially motivate providers to avoid supplying medically
unnecessary treatments. We discuss these reimbursement contracts in the next few
lessons.
Accepting the Risk
The final general strategy for controlling risk that businesses as well as individuals use is
to accept the risk. To accept the risk means to assume financial responsibility for the
risk. In a health plan environment, health plans typically accept the risks we have
discussed in this lesson, particularly underwriting risk, utilization risk, and various types
of business risk. A health plan that provides a healthcare plan to a group often accepts
some or all of the utilization risk within the terms of that group contract. In this case, the
group seeking coverage is transferring risk, but the health plan is accepting risk.
By definition, accepting risk exposes an health plan to the possibility of losses. The
financial outcome of accepting risk in exchange for premiums or other payments largely
depends on how well the health plan is able to predict the costs associated with the risk,
and how well the health plan is able to manage those costs. In the next few lessons, we
discuss the means by which health plans adjust the total amount of risk they are
exposed to and some of the methods health plans use to manage the costs of those
risks. We also discuss how health plans predict the costs of the risks they agree to
accept, and set premiums at an appropriate level.
Early in this lesson we noted that the general goals of risk management for an health
plan involve assuring that the organization survives, operates efficiently, sustains growth
and effectiveness, and, in the case of publicly owned for-profit health plans, increases
shareholder value. While risk managers seek to achieve each of these goals, they must
also balance the actions of the organization so that the achievement of one goal does
not prevent the achievement of the others. A health plan that seeks to maximize growth
and profit will spend considerable effort in controlling costs at all operating levels, but will
not cut expenses that are vital to the health plan’s continued survival. For example, a
health plan will bear the expense of verifying that the healthcare providers with which it
contracts have proper credentials, because for regulatory and liability-exposure reasons
a health plan would not survive if it negligently contracted with unqualified providers.
Similarly, a for-profit health plan will retain sufficient liquid assets to remain solvent
rather than distribute all earnings to shareholders, because remaining solvent is a
necessary condition of the health plan’s survival.
In general, the acceptance of risk by an health plan implies that the health plan is
prepared to manage that risk. Risk management is a process in the sense that, for many
risks, the health plan’s management must expend resources on the control of that risk
for as long as the risk is present. The next lesson will explore this process in more detail.
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Chapter 2 B
Risk Management in Health Plans
After completing this lesson, you should be able to
• List some of the factors that may give rise to the assumption of an agency
relationship between health plans and their providers
• Discuss some measures a health plan might take to limit the liability
associated with credentialing its providers
• Explain some of the ways a risk manager can reduce or eliminate risk
exposures related to utilization review
• List some of the actions that a risk manager can take in managing the
process of providing healthcare in a health plan environment
Risk Management in Health Plans

Risk management has been in a period of evolution almost since it first became an
important function in the healthcare setting. In the mid-1970s, the healthcare risk
management profession emerged in response to the malpractice crisis surrounding the
availability of liability insurance. Although the basic concepts for healthcare risk
1
management were adopted from the insurance industry, over the past two decades the
discipline of healthcare risk management has taken on many important characteristics
and unique functions. Although there are clear risks associated with benefits
administration, contracting, and other activities, the bulk of risks in health plans is
associated with the provision of healthcare services and coverage decisions surrounding
that care. In addition, providers face risks associated with health plans beyond those
faced by health plans. Therefore, this lesson focuses particularly on those issues.
Risk management has changed from an activity that sought solely to transfer risk
through the purchase of commercial insurance or the financing of risk through the
establishment of a self-insured trust or investment fund to a profession where education,
proactive risk control and risk modification, and risk financing and risk transfer are
merged into a partnership. The overall goals of the partnership enable the organization
to be responsive to the needs and demands of the healthcare industry and to provide
safe and effective care to patients. The organizational goals of ensuring financial stability
in the event of an adverse outcome are still consistent with the goals of the healthcare
risk manager, but risk managers also find that their work takes them out of the finance
department and into those clinical and operational areas where the risks are created.
Specific objectives in risk management programs relate to the organization’s desire to

ensure survival, maximize efficiency, and sustain growth and effectiveness. This is
accomplished through the identification, control, management, elimination, transfer, or
financing of risk. Achievement of these objectives is accomplished by interacting with
internal and external customers of the organization that demand low-risk, high-quality,
cost-effective service. Management may have different priorities in seeking efficiency
and growth, particularly as health plans continue to dominate the marketplace.
The primary targets or strategies of management could relate to gaining market share,
increasing the overall number of relationships and contracts with payers, increasing
sales or service volume, ensuring continuity of performance, maintaining the quantity of
controlled resources, or other items expected to produce desired long-term financial
results. These targets may be sought without appropriate consideration of the inherent
risks that may also be assumed by adopting those strategies.
The goals identified to achieve market success may not be the most efficient or effective
strategies from a risk management perspective. To achieve favorable results from both a
risk management and an organizational perspective, the risk manager must recognize
how the internal and external changes in healthcare created by managed care influence
or enhance risk. The risk manager should begin to plan a strategy by first identifying how
the organization is influenced from a risk perspective due to managed care (Figure 2B-1
and Figure 2B-2). After this assessment, the risk manager should work with
administration to determine critical success factors that will define risk management
success for the organization (Figure 2B-3).
- 41 -
- 43 -
Once the key measures of success have been agreed upon, the risk manager can
develop a plan to protect the organization and help it progress. The risk manager’s role
and the challenges posed by that role will not differ significantly if the risk manager is
employed by a health plan, a hospital that seeks to be the hub of an integrated delivery
system, or a network that forms to be able to compete under health plans. Thus this
lesson has been written to focus on the key risk management issues created by health
plans as opposed to a specific job that a risk manager might assume given potentially
differing structures. Many of the legal and risk management challenges created by
managed care will exist regardless of the employer. The customers of the risk manager
will include not only those in administration and finance but also physicians, nurses, and
external customers. As health plans become more prevalent, risk managers must
develop new knowledge and utilize existing and new skills and techniques to identify the
new risks created, design creative strategies for managing those new risks, and provide
education and information to an ever increasing and divergent customer base.
Changes in the Healthcare Organization Related to Health Plans

Health plans initially started out as "discount medicine," but it has now evolved to actual
management of medical care by providing the patient with the appropriate level of care
in the appropriate setting. In his book Making Managed Health Care Work: A Practical
Guide to Strategies and Solutions, Peter Boland states the following: "Managed care
alter the decision making of providers of healthcare services by interjecting a complex
system of financial incentives, penalties, and administrative procedures into the doctor-
patient relationship. Managed care often attempt to redefine what is best for the patient
and how to achieve it most economically." 2
This statement implies altering and directing care to gain a cost advantage, which is
risky if it is at the real or even perceived sacrifice of quality. Health plan administrators,
insurance providers, and risk managers are becoming increasingly aware of the
development of new case law associated with managed care, particularly how quality or
access is limited by strict utilization or financial restrictions and how that limitation can
pose a significant financial risk to the organization. Learning how to identify proactively
these and other potential new exposures associated with managed care and how to
control or eliminate them will be a challenge and will be at the core of the risk manager’s
responsibility.
Historically, health plans have faced minimal professional liability exposure, especially
compared with other healthcare organizations. In large part, this is the result of the broad
and well-publicized protection provided by the Employee Retirement Income Security
Act of 1974 (ERISA). That protection includes barring jury trials and punitive damage
3
awards, limiting compensation to medical expenses, and preempting actions against a

health plan for the "administration" of an ERISA-qualified employee benefit plan. The4
Federal Employee Health Benefits Act can also afford some protection for federal
employee benefit plans. These statutory protections have their limits, however, and the
5
risk manager must develop a clear understanding of the new risks that may be created
under managed care and are not afforded statutory protection and must develop
strategies to manage them.
The changes in the organization relative to health plans created new operational and
clinical risks and opportunities for risk management. No longer are the risks contained
within the walls of a provider organization; rather, the risks now follow the patients to
whom the health plan has agreed to provide services. This may result in making the
environment more difficult to control for the risk manager. In addition, with the movement
away from high-technology specialties, many organizations may find the need to identify
and engage providers with a focus on primary care and prevention. This group of
professionals may include physicians but may also include nurse practitioners, physician
assistants or extenders, social workers, and other healthcare professionals.
Credentialing, reappointment, privilege delineation, and definition of the scope of service
for an enhanced range of caregivers will be essential components of the risk manager’s
job.
Operational Risks Under Managed Care
Operational risks are enhanced under managed care. For example, a provider
organization becomes more complex as it attempts to compete by becoming part of an
integrated delivery system. New business risks can create corporate liability, both direct
and indirect (vicarious). A risk manager whose responsibility is to manage the risks of
the health plan must be mindful of the business and clinical risks created. Health plans
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can pose the following risk concerns that will be new challenges for the organization’s
risk manager:
• Coordinating the appropriate amount and level of care, by appropriate

providers, through utilization management activities.
• Negotiating arrangements with selective providers with proven skills and
competence to provide comprehensive services identified in the contracts.
• Ensuring that the financial incentives provided by the contract are sufficient to
sustain the organization and that the potential for catastrophic financial risk is
understood and appropriately funded for or transferred. (Relative to financial
risk management, the risk manager should also be cognizant of the potential
double-edged sword created by the use of financial incentives to providers. In
a positive sense, these types of incentive structures can help support the
provision of efficient, effective, and appropriate service. They can also,
however, be seen as a reward system that inappropriately incents physicians
to deny needed care to patients in exchange for increased compensation.)
• Understanding the nature of the new clinical risks created and proactively
designing systems or structures to eliminate or control them.
Figure 2B-4 illustrates the relative risk for health plan structures based upon the degree
of influence and relationships that the health plan maintains with its providers. It is only
6
through an analysis of the health plan’s business and an understanding of the relative
risk associated with that business that one can develop a comprehensive risk
management plan to ensure that all risks created are eliminated, managed, controlled, or
transferred.
Review Question
The amount of risk for health plan products is dependent on the degree of influence and
the relationships that the health plan maintains with its providers. Consider the following
types of managed care structures:
• Preferred provider organization (PPO)

• Group model HMO
• Staff model health maintenance organization (HMO)
• Traditional health insurance
Of these health plan products, the one that would most likely expose a health plan to the
highest risk is the:
preferred provider organization (PPO)

group model HMO
staff model health maintenance organization (HMO)
traditional health insurance
A Incorrect. A PPO product is a lower risk, based on the relationship the health
plan maintains with the providers
B Incorrect. Given the relationship the health plan maintains with the providers,
this is a higher risk, but not the highest
C Correct. Given the relationship the health plan maintains with the providers, this
is the highest risk
D Incorrect. A Traditional health insurance product exposes the plan to the least
amount of risk.
Managing Corporate Negligence

Direct Liability
Corporate negligence claims arising from health plans pose new risks for the risk
manager. Corporate liability claims are based on the premise that the healthcare entity
or health plan has a legal duty to protect the patient from harm. This responsibility can
be deemed to be abrogated when negligent providers are employed by the health plan
and render care to patients that is determined to be negligent. The need to develop
rigorous screening procedures for potential staff members and to follow those
procedures is an important risk management function in this new environment and
should be carefully monitored to verify adherence.
Under the doctrine of corporate negligence, a health plan and its physician
administrators may be held directly liable to patients or providers for failing to investigate
adequately the competence of healthcare providers whom it employs or with whom it
contracts, particularly where the health plan actually provides healthcare services or
restricts the patient’s/enrollee’s choice of physician. Health plans and their physician
administrators may be held liable for bodily injury to patients/enrollees resulting from
improper credentialing of physicians or for economic or compensatory damages to
providers as a result of credentialing activities (e.g., unlawful exclusion from provider
networks or staff decertification). The doctrine of corporate negligence may also apply to
other health plan activities besides credentialing, such as performance of utilization
review.
- 47 -
Under the theory of negligent or improper design or administration of cost control

systems, a health plan and its physician administrators may be held liable when they
design or administer cost control systems in a manner that interferes with the rendering
of quality medical care or corrupts medical judgment. To date, most litigation involving
allegations of negligent administration of a cost control system have involved utilization
review activities of health plans.
Direct Liability
Health plans and their physician administrators are also susceptible to antitrust liability
for violations of federal and state laws, which generally prohibit the unlawful restraint of
trade, monopolies, price fixing and discrimination, group boycotts, illegal tying
arrangements, exclusive dealing, and other arrangements that are anticompetitive.
Antitrust problems may arise when entities engage in collective actions that reduce
competition in a given market. Antitrust problems can arise early in a market where
health plans encourage the combining of the services of former competitors to facilitate
service delivery. A balancing test must be performed to ensure that the benefits gained
by combining outweigh the danger posed by limiting competition of those entities outside
the agreement. Health plan networks are also likely to face an increased number of
antitrust lawsuits from providers and competitors as they gain increased market share.
The larger a health plan becomes in a particular area, the fewer opportunities available
to the provider who is not part of the network.
Direct Liability
In addition, health plans and their physician administrators face corporate exposure to
direct liability for various forms of discrimination, for example discrimination in benefit
design, underwriting, claims adjudication, credentialing, treatment, employment, and
contracting. The following pieces of legislation may give rise to of discrimination in
specific health plans:
• The Family and Medical Leave Act of 1993

• The Americans with Disabilities Act of 1992
• The Civil Rights Act of 1991
• The Age Discrimination in Employment Act of 1967, including the Older
Workers Benefit Protection Act of 1990
• Title VI of the Civil Rights Laws of 1964, as amended (1983), including the
Pregnancy Discrimination Act of 1978
• The Civil Rights Act of 1966, Section 1981
• The Fifth and Fourteenth Amendments of the U.S. Constitution
In addition, health plans and their physician administrators face corporate liability for
invasion of privacy of providers for improper dissemination of information regarding
credentials or competence to the National Practitioner Data Bank or other third parties or
of patients/enrollees for improper dissemination of their records or information pertaining
to their health. They may also be sued by providers, patients, or employees for
defamation, particularly in connection with their peer review activities. In such an event,
however, they may be entitled to qualified immunity under the Health Care Quality
Improvement Act of 1986 (HCQIA).
Vicarious Liability
Under the theory of vicarious liability or ostensible agency, hospitals have been held
vicariously liable for the acts, errors, and omissions of their independent contractors. By
definition, a provider is an independent contractor in independent practice associations
and direct contract models. Therefore, the health plan should not be responsible for
negligent acts unless the health plan has given the impression that these providers are
acting as agents of the health plan. The decisions of the courts to uphold claims based
on ostensible agency depend on many factors, applicable state statutes, the ability of the
plaintiff’s attorney to demonstrate the apparent agency relationship, and other aspects of
the provider-health plan relationship as viewed by the courts.
Because "appearance" or perception seems to be the major issue driving the ostensible
agency argument, it might be wise for the risk manager to consider some of the
circumstances that might lead the public to assume that an agency relationship exists
and to make the necessary arrangements to control these potential exposures. Factors
that may give rise to the presumption of the existence of an agency relationship include:
• Supplying the provider with office space

• Keeping the provider’s medical records
• Employing other healthcare professionals, such as nurses, laboratory
technicians, and therapists, to support the physician provider
• Developing promotional or marketing materials that allow a relationship to be
inferred
The risk manager may wish to review documents provided to patients to ensure that the
physician is described as an independent practitioner and that there is a clear distinction
between those services provided by the health plan and those provided by the physician.
Review Question
The theory of vicarious liability or ostensible agency can expose a health plan to the risk
that it could be held liable for the acts of independent contractors. Factors that may give
rise to the assumption that an agency relationship exists between a health plan and its
independent contractors include:
requiring the providers to supply their own office space

employing nurses and other healthcare professionals to support the physician
providers
requiring providers to maintain their own medical records
all of the above
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Incorrect. Supplying a provider with office space would give rise to the
assumption that an agency relationship exists between a health plan and its
independent contractors.
Correct. This is a factor that would give rise to the assumption that an agency
relationship exists between a health plan and its independent contractors.
Incorrect. Keeping a provider's medical records would give rise to the assumption
that an agency relationship exists between a health plan and its independent
contractors.
Incorrect. Several of the above responses are incorrect.
Clinical Risks
Managing clinical risks has been an activity of pivotal importance for the healthcare risk
manager. This activity continues to be important, but there have been changes in its
complexity under health plans. Specific risks that require control and relate to the
provision of clinical care include risks associated with credentialing, risks associated with
clinical decision making (e.g., rationing of care), risks associated with utilization review,
and risks associated with adhering to externally imposed standards of care.
Clinical Risks
Credentialing
Credentialing is a risk management function that considers who the healthcare provider
is in the health plan and what the provider can do. In an effort to facilitate the
7
credentialing process and reduce administrative burdens and costs, some entities may
choose to participate in a joint credentialing process. This process might include a
consolidation of credentialing procedures and a sharing of the information requested as
part of the process. It will be important to have appropriate releases signed by the
professional being credentialed so that there can be no subsequent claims for breach of
confidentiality.
In general, a credentialing process must be developed that allows for the successful
selection and retention of high-quality providers who understand and support the mission
and vision of the organization or network with which they work.
Credentialing
Measures that might be instituted to prevent or limit liability associated with credentialing
include establishing realistic criteria, ensuring that the data being measured and
evaluated are accurate, conveying and evaluating the criteria on a consistent basis, and
creating a paper trail clearly tying quality to the economic credentialing process. The
8
following is a checklist for risk managers to keep in mind when setting up a credentialing
process: 9
• Review Credentialing Policies and • Require Practitioners To Report
Procedures • Ensure HCQIA Compliance
• Review Application Forms • Establish Rapport
• Review Protocols • Review Policies, Procedures, Bylaws,
• Observe Methods and Contracts
• Evaluate Organizational Structure
• Review credentialing policies and
• Review Due Process Provisions Procedures
Review credentialing criteria for compliance with state statutes, standards for health
plans, Joint Commission on Accreditation of Healthcare Organizations standards,
Medicare conditions of participation, National Committee for Quality Assurance, and
court decisions.
Review application forms for compliance with standards and local, state, and federal
regulations.
Review protocols for investigating and verifying an applicant’s credentials. Do these

protocols minimize the risk of inadequately screening and verifying the credentials of
practitioners?
Observe the methods by which these protocols are applied in reviewing individual
applicants. Are protocols applied equally to all applicants whether they are well known or
not?
Evaluate the organizational structure of the credentialing process. Are checks in place to
minimize the involvement of direct economic competitors in the credentialing process?
Does the structure minimize the risk of creating antitrust liability?
Review due process provisions to ensure that practitioners who are denied medical staff
membership or have had privileges restricted are afforded a fair hearing in accordance
with federal and state laws and standards.
Require all practitioners to report claims, disciplinary proceedings, or adverse actions

taken against them at other facilities or hospitals. Ensure risk management access to these
records.
Ensure that HCQIA regulations are complied with and that information from the National
Practitioner Data Bank is used appropriately in credentialing and privileging
determinations.
Establish rapport with practitioners to facilitate open communication, education, and

resourcefulness regarding risk management issues.
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Review policies, procedures, bylaws, and contracts to ensure that all credentialing criteria
are clearly stated.
Review credentialing policies and procedures of other hospitals, facilities, and

credentialing services whose credentialing decisions are used instead of an internal
process.
Clinical Risks
Clinical Decision Making
One of the most frequently verbalized fears relative to health plans is that it will create a
system whereby care is predicated on a person’s ability to pay or upon an externally
imposed system of values that dictates which medical conditions are appropriate for
specific types of intervention. In general, when these issues and concerns are voiced
they relate to the denial of interventions deemed to be extraordinary or experimental to
patients with terminal conditions or conditions where the treatment may not result in a
cure but may only serve to delay inevitable furtherance of the disease. Although much of
the discussion thus far seems to be fueled more by fear than fact, making care decisions
based on reasons other than best medical judgment is risky and thus should be avoided.
Risk managers can assist in limiting these types of risks by determining that policies are
in place that clearly indicate that care decisions are not predicated on the ability of the
patient to pay or the willingness of the payer to reimburse but rather are based on sound
medical judgment that is rendered consistent with appropriate professional standards of
care. Many of these decisions also are linked to an area of well-developed case law in
health plans, that law related to utilization review activities.
Clinical Risks
Utilization Management Issues
Controlling the parameters of care through a well-detailed utilization review process is an

important component of cost controls associated with health plans. Court cases have
demonstrated that a plan’s utilization review process is an operational exposure with the
potential for considerable financial risk. A well-structured utilization review program is
designed to limit the potential risks associated with attempts to structure care around
predetermined criteria. The program should allow for retrospective, concurrent, and
prospective review of care provided under the health plan. It should be remembered that
underutilization presents real threats to quality and risk just as overutilization presents
threats to cost control.
Clinical Risks
Emerging Case Law
The seminal case describing the liability that can attach to an organization with
inappropriate utilization criteria is Wickline v. State of California. This case addressed
10
the legal implications of preadmission certification of treatment and length of stay

authorization. In this case, suit was brought against the state of California alleging that
its agency for administering the medical assistance program was negligent when it only
approved a 4-day extension of the plaintiff’s hospitalization when an 8-day extension
was requested by the physician. Plaintiff’s attorney alleged that the discharge was
premature, resulting in the ultimate amputation of the plaintiff’s leg. The physician
requesting the 8-day extension did not appeal the decision of the state agency. Neither
the hospital nor the physician was the defendant in this decision.
A jury returned a verdict in the plaintiff’s favor on the grounds that the plaintiff had
suffered harm as a result of the negligent administration of the state’s cost control
system. The trial court’s decision was reversed by the appellate court, which found that
the state had not been negligent and therefore was not liable. The court held that the
state was not responsible for the physician’s discharge decision and that a physician
who complies without protest with limitations imposed by third party payers when the
physician’s medical judgment dictates otherwise cannot avoid ultimate responsibility for
the patient’s care. The court did acknowledge, however, that an entity could be found
liable for injuries resulting from arbitrary or unreasonable decisions that disapprove
requests for medical care. The court emphasized that a patient who requires treatment
and is harmed when care that should have been provided is not provided should recover
for the injuries suffered from all those responsible for the deprivation of such care,
including, when appropriate, healthcare payers. The court went on to say that third party
payers can be held legally accountable when medically inappropriate decisions result
from defects in the design or implementation of cost containment mechanisms. The
court concluded from the facts at issue in this case that the California cost containment
program did not corrupt medical judgment and therefore could not be found liable for the
resulting harm to the plaintiff.
In another case, Wilson v. Blue Cross of California, plaintiffs alleged that their son’s
suicide was directly caused by the utilization review firm’s refusal to authorize additional
days of inpatient treatment. The patient had been admitted for inpatient psychiatric care
11
for depression, drug dependency, and anorexia. His physician recommended 3 to 4

weeks of inpatient care, but the utilization review firm only approved 10 days. The
patient was discharged and committed suicide less than 3 weeks later by taking a drug
overdose. The trial court granted summary judgment in favor of the defendants. The
appellate court reversed this decision, concluding that the insurer could be held liable for
the patient’s wrongful death if any negligent conduct was a substantial factor in bringing
about harm. Testimony of the treating physician indicated that, had the decedent
completed his planned hospitalization, there was a reasonable medical probability that
he would not have committed suicide. The court concluded that whether the conduct of
the utilization review contractor’s employee was a substantial factor in the patient’s
suicide was a question of fact precluding summary judgment and remanded the case for
further review. On retrial, the jury entered a verdict in favor of the defendants.
Litigation for utilization review decisions may also be brought under theories of bad faith
and breach of contract based on the contractual nature of the relationship between the
health plan and its patient members.
Clinical Risks
Reducing Utilization Management Exposure
The risk manager attempting to work with providers in the organization can provide the
following advice to assist physicians in the reduction or elimination of exposures related
to utilization review:
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• Devise a comprehensive utilization management program.

• Physicians must exercise independent medical judgment that meets with the
standard of care.
• Providers must advise the health plan of their medical judgment.
• Develop a "fast-track" second opinion program.
• The patient should be informed of any issues that are being disputed.
• Exhaust the appeals process.
• Ascertain that insuring agreements include coverage for utilization review
activities.
Devise a comprehensive utilization management program that integrates with quality and
risk management. Individuals performing utilization management functions should utilize
patient outcome indicators as a means of identifying quality of care or risk problems.
Physicians must exercise independent medical judgment that meets with the standard of
care. Utilization management decisions should not influence the physician’s clinical
decisions in any way that the physician would consider truly harmful to the patient.
Providers must advise the health plan of their medical judgment. The physician needs to
be aware of each plan’s utilization review process and to advise the plan of his or her
medical judgment in clear terms. If a disagreement arises, the physician may need to
support the validity of the clinical recommendations with documentation as to the
medical necessity. Including diagnostic test results and providing an opinion as to the
possible adverse outcomes should the request be denied will also be helpful.
Develop a "fast-track" second opinion program. Providers need to support the

development of a system that can quickly render a second opinion in case of
disagreement surrounding clinical judgment. Ideally, the second opinion should be
rendered by a healthcare professional whose skill and training are commensurate with
those of the provider whose judgment is being questioned.
The patient should be informed of any issues that are being disputed relative to the
physician’s recommended treatment plan and the health plan’s coverage decision.
Alternative approaches and the potential cost and outcome of those approaches should be
discussed with the patient. Also, the patient should be informed that, if the plan continues
to deny coverage, the patient may be responsible for payment. The patient should
continue to be informed throughout the appeal process.
Exhaust the appeals process. In the event that the treating physician firmly believes that
the health plan has made an incorrect decision, then the best defense in cases of treatment
denials is staunch patient advocacy. The physician should request to speak to the medical
director in charge of the utilization decision and explain the rationale behind the intended
treatment. If a plan continues to deny coverage for a service that the physician feels is
necessary, the process that allows for a second opinion fails to support treatment, and the
physician continues to believe that the denial of coverage is in error, then the decision
should be appealed aggressively. All avenues of appeal should be exhausted. If
unsuccessful, the physician should inform the patient of treatment opinions without
regard to coverage. The patient must ultimately decide whether to continue treatment at
his or her cost. If the patient should wish to proceed at his or her own expense, the
physician should have the patient sign an informed consent signifying awareness that
such expenses may not be covered by the health plan.
Clinical Risks
Externally Imposed Practice Guidelines or Standards of Care
Many clinicians are particularly concerned about the development of practice guidelines
that seek to define appropriate services that should be provided to a patient given a
specific condition. In some instances, these guidelines are used to support utilization
management decisions; in others, they may be developed in attempts to define best
practice. Although developers often argue that best practice determinations are
predicated on an evaluation of effectiveness, some providers believe that under health
plans best practice really means lowest cost. To avoid the risks that are likely to be
associated with the use of guidelines, clinicians should be assured that the existence of
a guideline does not in and of itself create a standard of care and that guidelines,
although they may be instructive, do not set standards of care (although well-developed
guidelines should articulate agreed-upon standards of care). Risk managers should
advise clinicians that, despite the existence of a guideline, their skill and judgement
based on a careful assessment of the patient’s condition can and should preempt the
recommendations of a guideline. Case law, at least to date, supports this position.
Review Question
Many clinicians are concerned about the development of practice guidelines that seek to
define appropriate healthcare services that should be provided to a patient who has
been diagnosed with a specific condition. To avoid the risk associated with using such
guidelines, health plans should advise clinicians that the existence of such a guideline:
1. Establishes standards of care to be routinely utilized with all patients presenting a

specific condition
2. Preempts a physician’s judgment when assessing the specific factors related to a
patient’s condition
Both 1 and 2
1 only
2 only
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Neither 1 nor 2
Incorrect. An existence of a guideline does establish a standard of care, and

clinicians should rely on their skill and judgement to determine the best course
for their patient, even pre-empting the recommendations of the guideline.
Incorrect. Guideline are instructive, and most guidelines articulate agreed-upon

standards of care, they are not a standard of care in and of themselves
Incorrect. While a guideline can help support utilization management decisions,

physcians should independently determine the best course for their patient, even
pre-empting the recommendations of the guideline.
Yes!
Multisite Challenges
The sheer number of sites where clinical care may be provided or that have affiliation or
network agreements makes it essential that the risk manager create tools that can
empower staff at these sites to understand and manage their own risks. Risk
management will increasingly become a responsibility of all staff who will rely on the risk
manager for support and advice but will ultimately be responsible for on-site control of
risks inherent in the operation of their business. Tools that are developed should focus
on those proactive strategies that enable all healthcare professionals working in a
particular area to identify issues unique to their area that may give rise to risk and to
modify those risks in a manner that will allow for a safer environment with staff
increasingly aware of the risks inherent in providing care in a specific area or setting.
Tools that contain specific questions about an area can be developed and are useful for
assisting manager and clinicians in recognizing and managing their own risks.
The Convergence of Financial and Risk Management

Capitation
Health plan contracts create both opportunity and risk for healthcare organizations.
Under many contracts the reimbursement from payers is capitated, with the healthcare
organization receiving a fixed sum per member per month regardless of the intensity of
services that the member receives. Understanding the financial risks assumed under
these contracts and either funding for those risks or transferring them to a third party
require many of the same skills that the risk manager uses to manage the clinical risks
that are part of all healthcare organizations. Once the total risk being assumed is
quantified, the risk manager, working with the chief financial officer or helath plan
administrator, can evaluate the best ways either to fund for or to transfer this risk.
The Convergence of Financial and Risk Management

Financial Incentives and Cost Control Programs
Incentive payment systems link provider compensation to the provision of costeffective
healthcare. An incentive system is meant to encourage providers to render only care that
is necessary and appropriate. Financial incentives can take a variety of forms, and
depending on the outcome of care patients may view the incentive programs as having
influenced their providers’ medical decision making.
Cases are beginning to emerge that allege that physicians whose salaries are based in
part on an incentive structure that predicates payment for services based on utilization of
services make treatment decisions based more on their financial reward than on the
well-being of the patient. It is imperative that financial incentives be structured in such a
way that they do not have the appearance of encouraging this type of behavior.
Whether the cost control program of the health plan creates a financial incentive for
physicians to provide inadequate treatment was raised in a recent legal opinion. The
12
case involved a delay in the diagnosis of cervical cancer due to the failure of the primary
care physician to order a Pap smear. In this case, a health plan participant brought suit
against the health plan alleging that the contractual agreements between the health plan
and its providers encouraged physicians not to refer patients to specialists. The court
found that the plaintiff had offered evidence establishing that the cost control system
contributed to the delay in diagnosis and treatment. A formal opinion on this issue was
never rendered, however, because the case was settled during trial for an undisclosed
amount.
In another well-publicized case, Fox v. HealthNet, a California jury awarded nearly $90
million to the estate of a breast cancer patient arising from the refusal of the health plan
to pay for a bone marrow transplant: $77 million was awarded as punitive damages. 13
The health plan considered this procedure experimental and would not pay for any
experimental treatment until it was proven effective. According to reports in the press,
testimony at trial included that of two women for whom the health plan had approved
identical treatments as proof that the treatment might have worked. Furthermore, it was
14
shown that the physician executive who denied payment for the bone marrow transplant
received bonuses based on the denial of costly medical procedures. The jury concluded
that the health plan acted in bad faith, breached its contract of care with its subscriber,
and intentionally inflicted emotional distress.
This case represents a good example of how denial of access to treatment can expose a
health plan to liability. It also demonstrates how the emotional impact and negative
publicity associated with the denial of treatment, even if the treatment has not been
proven effective, can influence the ultimate decision and the damage award. In a health
plan environment, the primary care physician, in conjunction with the health plan, acts as
a gatekeeper in determining what hospital or specialty physician services should be
provided. The failure to meet the applicable standard of care in making these decisions
can expose the primary care physician and the health plan to liability. In the Fox case,
the treating physician recommended the treatment with the support of the two other
health plan physicians who had used it for the two witnesses in the case, and the health
plan, as gatekeeper, refused to pay for it.
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These cases reveal that courts are willing to impose liability on health plans when
inappropriate medical decisions result from defects in the design or implementation of
the cost containment programs, breach of contract, or bad faith in the denial of payment.
The impact of a health plan’s financial incentives to contain costs has also been tested.
If financial incentives result in inadequate treatment being rendered, the health plan
could be held liable. These cases indicate that members will seek redress if harmed as a
result of the administration of cost control programs which deny them access to care,
which delay care, or which deny payment for necessary care.
Avoiding Liability Associated with Cost Control Programs
The design and administration of cost control programs should promote efficient care but
must not corrupt the medical judgment of the physician. If a health plan overrides the
medical judgment of the physician, it could be held liable for the consequences of the
treatment or discharge decision. To avoid liability in this regard, a health plan needs to
ensure that its financial incentive and cost control programs include procedures that
accomplish the following:
• Utilize medical necessity criteria that meet acceptable standards of medical

practice
• Review all pertinent records in determining the necessity of treatment
• Contact the treating physician before certification is denied
• Allow sufficient time to review the claim before denial
• Ensure that medical personnel approving payment denials are appropriately
trained, have met established minimum qualifications, and have the requisite
knowledge to assess the appropriateness of care
• Maintain policies and procedures that ensure that operations do not interfere
with the physician-patient relationship regarding the duration and level of
medical care
• Carefully document procedures used to deny certification of care (coverage
restrictions need to be adequately described in materials given to health plan
members, especially with respect to experimental or investigational
treatments)
• Devise a mechanism for communication of programs to members, especially
financial incentive programs
Risk Financing
The professional liability and business risks that are associated with health plans have
fairly consistently been insurable under standard insurance contracts. Many creative
products and concepts are being developed for the control or minimization of the
financial risks that are inherent in capitated contracts or for the balance sheets
fluctuations that are possible during a period of time when there is considerable volatility
in the financing of healthcare services. The concepts underlying the financing of all these
risks are the same and are consistent with the risk financing skills that were practiced by
many risk managers before the emergence of health plans.
Utilizing the Risk Management Process to Control the Risks of
Health Plans
The risk management process is generally structured around loss reduction techniques
(which include the identification of risk, the elimination of risk whenever possible, and the
control or management of risk when it cannot be entirely eliminated) and loss transfer
(techniques which include determining the economic risk associated with various types
of loss and selection of the best methods either to finance risk internally or to transfer
those risks to a third party, generally through the purchase of insurance). These
processes can be successful in managing the emerging risks that are created by a
managed healthcare system. Obviously, the techniques will need to be tailored to the
specific needs of each organization, particularly as health plans become increasingly
dominant.
Utilizing the Risk Management Process to Control the Risks of

Health Plans
Because it is essential that the risk manager understand the scope of potential risk in the
hospital, health network, or integrated delivery system, the first step will be to develop
effective communication links with those parts of the organization that are responsible
for the strategic growth of the hospital into a health plan partner or into the hub of a
health plan network. Anticipating risk and being able to plan for it will greatly enhance
the likelihood that risks created by the new delivery model will be capable of being
controlled. Educating all staff, including administration and healthcare providers, about
the emerging risks that are associated either with the delivery system created by health
plans or with the clinical delivery system that is more decentralized because of health
plans will be an important function for the risk manager. The risk manager may achieve
the greatest success by developing tools that can be used by others to assess and
manage their own risk. Making each member of the healthcare team responsible for
managing the risks created by this complicated new healthcare delivery model will be
the only way to ensure success.
Conclusion
Risk managers must continually monitor emerging risks and design comprehensive
strategies for managing them. Unlike the traditional role of the risk manager in a hospital,
where a single person or a designated risk management staff is central to the risk
management effort, in a health plan or integrated delivery system everyone will have to
become engaged in the process of proactively identifying and managing risks. A brief
checklist follows that will assist the risk manager in managing the process of providing
healthcare in a health plan environment:
• Design department-, unit-, or function-specific assessment tools that can be used

easily by managers and clinicians to assess risks associated with specific
environments or activities. Make risk management everyone’s responsibility!
• Continually monitor case law and developing trends in health plans and design a
system to provide information about new developments to all staff working in the
health plan or network.
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• Never underestimate the importance of a rigorous credentialing process that

allows for the careful screening of all healthcare providers—physicians and
advanced practitioners. Make certain that this process is in compliance with state
and federal law and that it measures both credentials and competence.
• Verify that a comprehensive process exists for utilization management activities.
Ascertain that decisions about patient care are based on the best interest of the
patient, not primarily the financial interest of the provider or the health plan.
• Develop a system that allows risk managers to be involved in the assessment of
potential new business opportunities or entities before their becoming part of the
organization or network. This will allow for a clear understanding of the risks to
be assumed and for the development of a plan to control, eliminate, or transfer
those risks.
• Develop the risk management role as one of a consultant whose advice and
expertise are sought whenever issues of potential liability arise.
Chapter 3 A
Provider Reimbursement Methods
After completing this lesson you should be able to
• Discuss the advantages and disadvantages of traditional, salary, fee-for-

service, and discounted fee-for-service provider reimbursement methods
• Explain how utilization risk is distributed in each of the provider
reimbursement methods
• Define churning, upcoding, and unbundling and recognize which provider
reimbursement systems are designed to solve these problems
• Explain the purpose of using the relative value scale and resource-based
relative value scale systems
• Define global fees, withholds, risk pools, and bonuses and explain how they
are used by health plans to motivate providers to manage overutilization
• Discuss the methods that health plans use to reimburse hospitals
Provider Reimbursement Methods

Although laws and regulations influence the structure of provider reimbursement
contracts in health plans, laws and regulations are by no means the only influence on
these contracts. Provider contracts in managed care have also evolved over time in
response to market forces. Market forces include the presence of competitors in the
market, the level of demand for healthcare services, and the availability (or level of
supply) of those services. Market forces, in turn, are driven by the goals of the various
parties involved in healthcare: the people who receive the care, the providers of the
care, the entities that pay for the care, and the entities that manage the delivery of that
care. In the long run, each of these must interact with the others to attain its goals.
Within this context, the managed healthcare market has generated many different ways
of balancing the cost of healthcare with access to care and the comprehensiveness of
health benefits. Ultimately, variety in healthcare plans is a response to the demands of
plan members and sponsors. Not all sponsors and plan members demand the same
level of comprehensiveness; consequently, different groups of consumers will find
different plans attractive. All other factors being equal, however, plan sponsors and
members prefer to pay the lowest possible price for the healthcare benefits they receive,
and the market will tend to reward health plans and providers who can achieve the same
long-term goal: cost efficiency in delivering quality healthcare.
Not all provider reimbursement methods are equally efficient in aligning all of the short-
term goals of the participants with this long-term goal of cost efficiency. When the short-
term financial goals of the participants are in conflict with this longterm goal, health plans
face various inefficiencies that can ultimately lead to higher costs and lower quality care.
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Because different healthcare consumers have different needs, however, there is no one
reimbursement system that works most efficiently for all providers and types of health
plans in all health plans. Each reimbursement system has strengths and weaknesses.
Health plans arose as a system for aligning the financial goals of the participants, with
each type of reimbursement method implicitly addressing the weaknesses of other
methods. This lesson describes common types of provider reimbursement methods in
health plans and outlines the advantages and disadvantages of each type.
The rapid growth and dynamic market conditions within the health plan industry have
caused the development of a large number of provider reimbursement methods. New
variations on these methods are developed (or mandated by regulatory bodies) each
year. Generally, physician reimbursement in health plans is typically based on one of the
following methods:
• Salary
• Per treatment or per service fee schedule (commonly known as fee-for-
service)
• Per plan-member rate (that is, the provider is paid a certain amount for every
plan member during a defined period)
• Percent-of-premium schedule (the health plan pays providers a percentage of
all the premiums received in exchange for covering plan members, and
providers agree to provide all necessary medical treatment for those plan
members)
In this lesson, we discuss a number of health plan reimbursement methods both in terms
of these categories, and in terms of how these methods divide financial and utilization
risks between providers and health plans. We begin by outlining how physicians and
hospitals were traditionally paid before managed care, because the weaknesses of
traditional physician reimbursement led to rising healthcare costs. These rising costs led
to a market response: health plans. Health plans are, in this sense, a response to some
of the inefficiencies of traditional medicine’s financial structures, including physician
reimbursement.
Traditional Provider Reimbursement
Before health plans became widely established, provider reimbursement typically

involved an individual patient paying an individual provider after the provider rendered
healthcare services. Typically, patients with health insurance first had to pay their
providers, and then submit a claim to the insurer. If the insurer denied the claim, the
responsibility for paying for the care remained with the patient. Although this traditional
method of payment allowed individuals who sought healthcare considerable freedom of
choice in physicians and treatment options, it also presented several financial
disadvantages
Financial Disadvantages of Traditional Physician Reimbursement
From a financial point of view, traditional physician reimbursement is subject to three

types of disadvantages. First, this reimbursement method concentrates, rather than
spreads, the financial risk for a patient and that patient’s physician when the patient
faces a serious illness, particularly in cases where the patient either has no insurance or
is underinsured. By concentrating risk, this method, in effect, concentrates the costs of
healthcare. In other words, an underinsured individual who had a serious illness often
faced a choice of either receiving inadequate care or suffering severe financial hardship
in paying for treatment.
Providers themselves risked not getting paid for their services. Providers under this
reimbursement system also faced a potential ethical and financial dilemma. These
physicians had to decide either to provide (1) different levels of treatment, based not on
the seriousness of the illness, but on the wealth of the patients with the illnesses, or (2)
the same level of treatment to all patients, but charge different rates to different patients
for the same treatment.
Second, traditional physician reimbursement fails to reward physicians who attempt to

contain healthcare costs, even in cases where the patient has adequate indemnity
insurance. Thus, healthcare costs tend to increase relatively rapidly under this system.
As long as a patient can afford additional care, a physician is financially rewarded for
providing more and more services, even if the costs of those services outweigh their
benefits. Most patients do not have the expertise to judge the benefit of a treatment in
relation to the cost of the treatment, so patients who can afford extra services are
motivated to purchase the services “to be on the safe side.” In the long run, those
patients may pay for and undergo treatments or tests that are unnecessary. In addition,
such choices increase the total cost of healthcare in the economy and cause the
resources within the healthcare system as a whole to be allocated inefficiently.
Third, traditional provider reimbursement often involves operational inefficiencies. To

provide the best possible care, a physician must stay current with professional advances
in medicine. At the same time, a physician would have to perform or manage all
administrative and marketing functions of the practice. Few physicians do all of these
things equally well, so the practices of even skilled physicians are subject to
administrative inefficiencies that can result in either increased costs to patients or
decreased profit for the physicians. Physicians who practice alone or in small clinics also
may have difficulty achieving economies of scale in their administrative and fixed costs,
which drives up the cost of providing each treatment.
Health plans seek to avoid these three problems through the use of managed care
techniques. The structure of provider reimbursement methods in health plans involves a
large number of complex details, particularly with respect to determining a fair rate of
reimbursement, given that the exact level of care required by a population of plan
members cannot be known in advance.
However, the methods themselves are easier to understand if you keep in mind that
each method addresses some or all of the three problems that we have just discussed.
To solve these problems, provider reimbursement methods seek to align the long-term
goal of financial efficiency with the short-term financial goals of those involved in the
healthcare system. In most cases, managed care achieves at least part of the
realignment of participants’ goals through the use of strategies that redistribute risk
among the participants in healthcare plans.
Salary Reimbursement Method
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Under a salary reimbursement method, or budget method, providers are paid an

agreed-upon salary in exchange for providing healthcare services. Such a system
requires an administrative entity to pay the salaries. Staff model HMOs, many
government healthcare facilities, and some hospitals use salaries as a way of paying
physicians.
Compared to traditional physician reimbursement, the salary system automatically

carries with it several potential benefits. First, it separates some of the administrative
functions of healthcare from the practice of medicine, at least to the extent that the
physicians and other providers do not have to perform all of the business functions
necessary in private practice. These administrative functions can be done efficiently for a
large number of providers at once, thus lowering the administrative cost per plan
member and achieving economies of scale.
Also, salaries eliminate much of the financial incentive providers might otherwise have to
perform services that are not medically necessary. In other words, because the
physician is not being paid on a per-treatment basis, simply performing more services
will not financially benefit the physician. In addition, because provider reimbursement is
a sizable portion of a health plan’s total costs, salaries help to stabilize expenses for the
health plan or other entity employing the providers, and at the same time stabilizes the
income of the providers.
Cost stabilization is often a feature of prospective reimbursement, which is any system

that pays providers at a predetermined rate in advance of the providers’ supplying
treatments or services. A salary is a prospective reimbursement method, as are many of
the health plan reimbursement methods we will discuss. Traditional provider
reimbursement and other forms of paying providers per treatment are not prospective.
Many prospective reimbursement methods tend to give providers incentives to avoid
overutilization, because under these types of prospective reimbursement providers are
typically not paid more simply for providing more services.
Fast Definition
A staff model HMO is an HMO whose physicians are employees of the HMO.
Salary Reimbursement Method
A salary system also has some disadvantages. Although cost stabilization prevents
unexpectedly high reimbursement costs, it may also hinder cost reduction. Unless the
salary system is augmented with another type of incentive plan, providers who work
efficiently and effectively are not necessarily paid more than those who do not. Some
providers under a salary system may feel motivated to do less work, because the
incentive system itself provides no motivation to work harder. Therefore, positive levels
of quality, productivity, and resource utilization have to be encouraged in other ways.
One method of doing so is to create a salary range for providers, so that all provider-
employees are paid at least a minimum amount, and can earn up to a maximum amount
by being more productive or efficient. Similarly, providers or groups of providers can be
given a bonus in addition to their salaries after a profitable period. In this way the
providers’ employer encourages high productivity and efficient practices by returning
some of the income and cost savings to the providers who are successful in achieving
desirable results. Such incentive methods can also be administratively complex. They
must be designed carefully so that providers are not simply paid more to do more, but
are paid more to work more effectively.
For example, an incentive program that measures the level of a physician’s workload by
counting the number of diagnostic tests the physician orders is encouraging the
physician to order diagnostic tests, which may or may not indicate that the physician is
practicing more effective medicine. Both salary and nonsalary reimbursement systems
can share this problem. Often, the problem is addressed in part by having physician
review panels analyze the effectiveness of treatments rendered by individual physicians.
Under a straight salary system, providers accept some service risk. Service risk is the
risk that plan members will demand more services from the physician than had been
anticipated when the salary schedule was designed.
For the most part, however, the risk in a salary system rests with the entity paying the
providers. Providers avoid the risk that their incomes will fluctuate, and they avoid many
of the business and financial risks they would face as independent practitioners.
Furthermore, they avoid the risk that unexpectedly high utilization rates will drive costs
above the income generated by the health plan’s premiums. The providers’ employer,
whether a health plan, a governmental entity, or a hospital, in effect accepts the risk that,
in the short term, costs will exceed cash flows. Like any other business entity, the health
plan or other healthcare employer will still be obligated to pay provider salaries for as
long as the employer is operating. Similarly, if plan premiums or membership levels fall
below the plan’s targets, the health plan or other employer must, at least in the short
term, continue meeting the same labor costs.
The health plan that operates a salary system also faces an increase in risk of liability in
many jurisdictions: as employees, the physicians are the agents of the health plan.
Because an employer is typically seen as having greater control over the actions of its
employees than it would have over the actions of independent contractors, a health plan
that employs physicians may face greater liability for its physician-employees’ acts of
negligence.
Fee-for-Service Reimbursement Methods
In fee-for-service (FFS) reimbursement methods, providers are paid per treatment or

per service that they provide. After providing a given service or treatment, the provider
bills the plan for that treatment. Typically, FFS payment agreements contain a no-
balance-billing clause. No balance billing means that the physician agrees to accept
the payment made by the health plan as full payment for the service and will not bill the
plan member for that service. No balance billing is also often used in combination with
reimbursement systems other than FFS. No balance billing is attractive to plan members
and plan sponsors because it reduces the possibility they will face unexpected
healthcare costs. Instead, their healthcare costs are defined through premiums,
copayments, and other elements that are specified in the contract offered by the health
plan.
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One of the benefits of FFS reimbursement is that it is relatively easy to initiate, especially
in markets where health plan penetration is low. Using FFS can allow an health plan to
acquire a large panel of providers, which allows plan members considerable freedom to
choose their personal physicians or other providers. This freedom is highly valued by a
sizable portion of the population. Especially in markets where a health plan is attempting
to establish itself, the health plan will appear more attractive to potential plan members if
becoming a member does not require them to switch doctors. We discuss the
disadvantages of FFS in the next section.
Review Question
In a fee-for-service (FFS) reimbursement method, providers are paid per treatment or

per service that they provide. One typical benefit of FFS reimbursement is that it:
is highly effective in preventing excessive services that take the form of churning,
unbundling, and upcoding
provides physicians who attempt to control costs with a higher rate of
compensation than is provided to physicians who make the effort to control costs
is relatively easy to initiate, especially in markets where managed care penetration
is low
guards against the practice of defensive medicine
Incorrect. Churning, unbundling and upcoding are all disadvantages of the FFS
payment method.
Incorrect. Under FFS there is no incentive for providing cost effective care.
Correct. FFS reimbursement is easy to initiate, especially where market

penetration is low.
Incorrect. FFS does not guard against defensive medicine, which is an attempt to
minimize malpractice risk by supplying extra services of little benefit to the
patient.
Discounted Fee-for-Service
One of the first methods developed to control the costs of traditional provider
reimbursement was to determine what the usual, customary, and reasonable (UCR) fees
were for each type of treatment, then negotiate with providers to pay a discount on the
UCR fee. Although UCRs were developed by indemnity insurers, a discount on standard
fees is also used by health plans. In discounted fee-for-service (discounted FFS)
reimbursement methods, the health plan reimburses the provider on a per-treatment
basis at a level below the provider’s usual charge for that service. Variations on this
basic arrangement are common today.
The advantage for the health plan under discounted FFS reimbursement is that the fees
are discounted. The discounted FFS concept can also be coupled with a fee schedule.
Under fee schedules, the health plan determines a maximum value for each procedure
or treatment, and pays the provider the lesser of the providers’ requested fee or the
maximum value. Fee schedules offer the advantage of allowing the health plan to
develop uniform fees for the same service delivered by different providers.
Providers are willing to accept a discounted or negotiated fee that is less than their usual
fee because doing so allows them access to the health plan plan members—that is, a
larger customer base. Even providers who are not seeking to expand their plan member
bases may join panels to avoid losing plan members that they already have. Finally,
unlike salary reimbursement systems, providers who supply more services under FFS
automatically receive higher reimbursement, thus removing any motivation the provider
might have to provide too few services.
From the health plan’s point of view, the main disadvantage with FFS reimbursement
methods is that, while physicians are financially rewarded for providing more services,
there is no guarantee that more services necessarily translate into better plan member
care in all cases. Although the number of physicians or other providers who engage in
fraud by supplying excessive services is relatively small, physicians or other providers
who are rewarded for supplying more services will tend to supply them. For this reason,
an FFS reimbursement system will encourage providers to bill more services, leading to
greater healthcare costs.
Both FFS and discounted FFS systems may fail to prevent excessive services—and
therefore excessive costs—when those excessive services take one of three forms:
churning, upcoding, and unbundling. Churning involves a physician or other provider’s
either seeing a plan member more often than is necessary, or providing more treatments
and tests than are necessary. Churning ultimately adds to the costs of the plan and
therefore increases the cost of healthcare coverage to the plan member and the
employer (or other payor). A plan member therefore has motivation to avoid churning,
but may not have the knowledge necessary to tell whether or not a treatment or return
office visit is necessary. Thus, churning almost always has to be prevented by the health
plan’s management practices. Health plans often do so by tracking claims frequency by
treatment code and by individual providers. When some treatments appear to be billed
at greater-than-expected rates, the cause can be investigated.
Upcoding is the practice of a provider’s billing for a procedure that pays more than the
procedure actually performed by the provider. The tendency to upcode can result in
1
code creep, which is the condition of frequently billing for more lucrative services than
those actually performed. If upcoding becomes common within an health plan’s health
plan, the health plan’s costs can rise significantly.
Unbundling is the practice of a provider’s billing for multiple components of a service

that were previously included in a single fee, when the total reimbursement for the
multiple component services would be higher than the single fee. Many health plans use
claims software that can recognize unbundling and will automatically rebundle the
component services. Like churning, upcoding and unbundling are essentially impossible
for the plan member to detect and may be difficult for employers or other payors to
detect as well. Therefore, health plans seek to prevent practices such as churning,
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upcoding, and unbundling through quality control and cost control management
functions.
Another motivating factor in some cases of overutilization involves the risk of malpractice
liability that physicians face. The risk of being found guilty of malpractice is a pure risk
for a physician—it is a loss without possibility of gain. The presence of pure risk
motivates those who face it to try to avoid that risk. Some providers will be motivated by
malpractice liability risk to practice defensive medicine. Defensive medicine is an
attempt to minimize malpractice risk by supplying extra services, such as multiple
diagnostic tests, even if those services are not likely to benefit the plan member. As
payment methods, neither FFS nor discounted FFS guard against the practice of
defensive medicine.
Discounted FFS and FFS reimbursement methods also are subject to another
disadvantage that we discussed under traditional reimbursement methods. Providers
who are compensated under these systems and who attempt to control costs may find
themselves paid less than physicians who make little effort to control costs. Thus, the
health plan can in some cases find itself compensating inefficient providers at a higher
rate than it compensates efficient providers.
Relative Value Scale
Under any FFS system, a health plan will be motivated for administrative and financial
reasons to develop uniform fees to reimburse all providers who perform the same
service. An important method of determining uniform fee reimbursement is the use of
relative value scales (RVS). Under a relative value scale (RVS) system, a health plan
assigns weighted values to each medical procedure or service performed by a provider
based on the cost and intensity of that service. Each type of procedure is given a code
number.
For example, an appendectomy would have a different code from a tonsillectomy, and
an appendectomy without complications of a peritonitis infection would have a different
code from an appendectomy performed on a plan member with severe peritonitis.
Usually, RVS code numbers are based on the current procedural terminology (CPT)
codes, which were developed by and are updated annually by the American Medical
Association. To determine the actual payment (in dollars) to a provider who performs a
service defined by a CPT code, the weighted value of the code is multiplied by a money
multiplier. In practice, RVS codes have tended to reward procedural services, such as
surgical procedures, more than cognitive services, such as office visits or research done
by a physician on a plan member’s condition.
To address the potential imbalance in the RVS payments for procedural versus cognitive
services, a variation of the RVS system was developed. The resource-based relative
value scale (RBRVS) system is a means of determining provider reimbursement that
attempts to take into account all resources that providers use in providing care to plan
members, including procedural, educational, mental, and financial resources. The2
Centers for Medicare and Medicaid Services (CMS) requires the use of RBRVS for
Medicare billing. This requirement has encouraged the use of RBRVS as a uniform
billing methodology, even outside Medicare markets.
Both RBRVS and RVS share with UCR fees an administrative advantage when used as
part of an FFS reimbursement system. Because physicians using these systems bill for
their services according to precise codes, tracking treatment rates is much easier and
more exact for the health plan’s quality and cost management functions. The use of
RBRVS also provides a coherent starting point for fair compensation to various providers
who may be providing different types of services. Therefore, RBRVS can be useful to a
health plan that is developing reimbursement schedules for various types of providers in
a comprehensive health plan.
One disadvantage that RBRVS shares with other FFS systems is that RBRVS rewards
providers for rendering more services, but does not put them at financial risk for
overutilization. The health plan retains overutilization risk under a reimbursement system
that uses RBRVS in the absence of any other incentive system. Consequently, the
health plan must manage the risk of overutilization either through a separate incentive
system that motivates providers to control costs, or through administrative measures,
such as clinical practice guidelines, that seek to manage provider behavior. The health
plan must also establish safeguards to minimize upcoding under RBRVS systems.
Global Fees
Another method of provider reimbursement uses global fees. A global fee is a single fee
that the provider is given for all services associated with an entire course of treatment
given to a plan member. For example, global fees are common in obstetrics. The global
fee would be payment for prenatal visits, the delivery itself, and a defined period of post-
delivery care. Global fees also can be set up for non-emergency surgical procedures, or
certain types of office visits where the service or treatment is well defined. Thus, the
provider or providers (for example, a hospital in the case of surgeries) must manage the
costs of the components of a plan member’s course of treatment, because the cost of
these components cannot be billed separately to the health plan.
A global fee therefore transfers some of the risk for overutilization of care from the health
plan to the providers. In doing so, a global fee rewards providers who deliver
costeffective care. Global fee systems do not completely eliminate all motivation a
provider may have to engage in churning, because the provider is still being paid
according to the number of treatments performed. However, global fees do eliminate
unbundling and upcoding within specific treatments, because the single global fee
covers the entire course of treatment.
Global fees can be more administratively complicated to develop initially than

straightforward FFS systems, particularly when global fees provide compensation to
more than one provider. For example, if a global fee is paid for an appendectomy, then a
fair method must be devised for dividing that fee among the surgeon, anesthesiologist,
and other providers involved in that treatment. Global fees for physician services or for
individual providers, however, are similar to bundling. To operate efficiently, global fees
require that a health plan have a claims system that recognizes the component services
contained within the global fee, so that the health plan will not pay both the global fee
and make individual payments for the same component services billed under individual
codes.
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The global fees themselves must reflect how difficult and time-consuming each course of
treatment is relative to other courses of treatment. The health plan and the provider, as
parties to the reimbursement contract, will have fewer conflicts if the global fee for a
given treatment is fair— that is, neither excessively high nor too low to cover the costs
the provider incurs in providing the treatment. Ideally, the global fee system balances the
reimbursement for each treatment with the relative reimbursement for other treatments.
This balance is important in terms of managing utilization, because if the global fee for
one procedure is financially more attractive than the fee for a second procedure, then
the fee system may inadvertently encourage upcoding.
Global fees expose providers to the risk that the cost of treatment for some plan
members may exceed the global fee. Under such conditions, a provider may be reluctant
to provide additional services. Consequently, a system must be in place to assure that
plan members receive appropriate care. Two commonly used systems are quality
management on the part of the health plan, and various forms of insurance or
contractual elements that protect the provider against financial losses in cases that
require exceptionally expensive treatment. We discuss these forms of insurance and
contractual elements in more detail in future lessons.
In the long-run, a global fee system, like any other provider reimbursement system,
works best if it aligns the financial goals of the providers with the financial goals of the
health plan, employer, and plan member. The financial goals must also be aligned with
the central goal of providing excellent care. Some characteristics of provider
reimbursement systems that help achieve these alignments are listed in Figure 3B-1.
Chapter 3 B
Provider Reimbursement and Plan Risk
• Discuss the three main drivers of complexity in the healthcare regulatory

environment
• Describe the influence of the Department of Health and Human Services, the
Department of Labor, the Office of Personnel Management, and the
Department of Defense on the healthcare environment
• Explain the financial effects that mandated benefit laws and regulations have
on health plans
Our discussion of provider reimbursement and plan risk begins with a review of the
overall regulatory environment in which health plans operate. Next, we discuss specific
federal and state laws and regulations that affect the healthcare environment.
The Regulatory Environment
The regulatory requirements that apply to healthcare financing, contracting, and delivery
in the United States are numerous and complex. Many general business laws and
regulations governing labor, taxes, and contracts apply to health plans much as they
apply to other businesses. In addition, healthcare in general, and health plans in
particular, are subject to a vast array of industry-specific laws and regulations. Broadly
speaking, there are three main drivers of complexity in the healthcare regulatory
environment.
1. The number of agencies that are sources of regulations or that have regulatory
authority over health plans.
Agencies in both the federal and state governments regulate various aspects of
healthcare in the United States, and in each level of government, multiple agencies have
at least some regulatory authority. State departments of health and departments of
insurance typically share responsibility for regulating many aspects of healthcare. The
division of this responsibility between the two agencies, however, varies from state to
state. Various agencies typically administer federal programs that affect health plans.
For instance, the Department of Health and Human Services, through the Centers for
Medicare and Medicaid Services (CMS), administers Medicare and Medicaid. A
comprehensive list of government agencies that regulate health plans on all levels would
be extremely long, because health plans are subject to tax, labor, and other general laws
just as any business is. Generally, the larger the number of agencies that have
regulatory authority over an industry, the more complex the industry’s regulatory
environment. The more complex the regulatory environment, the more expensive a
business’s compliance operations, all other factors being equal.
2. The relative complexity of both the practice of medicine and the management of
health plans.
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The complexity of modern medicine directly affects the ways in which health plans are
regulated. Because health plans are corporations, they cannot practice medicine in most
states. Thus, health plans provide health plans that bridge the gap between providers,
payors, and members. In doing so, health plans must consider the regulations that affect
each of these groups and the goals that these groups have. For instance, the Food and
Drug Administration (FDA) has a great deal of influence on the use of specific drugs and
on federal health law. As a result, the FDA influences health plans by determining the
medical options available to the health plans’ providers. In some markets, laws mandate
that specific benefits be covered by health plans in those markets. Health plans that are
subject to those laws must cover the cost of the mandated benefits, and these mandates
must be reflected in provider contracts. Furthermore, health plans operating in more than
one state must comply with the regulatory and licensing requirements of each state in
which they operate.
3. The importance of healthcare to the public.
The public has an interest in healthcare and the contracts that provide it. Legislative and
regulatory bodies reflect these public concerns about healthcare. Generally, the greater
the public interest in an industry, the more likely it is that legislative bodies will design
and pass laws to regulate that industry.
Ideally, healthcare laws and regulations serve the public interest by performing two
broad functions.
First, they provide protection to consumers of healthcare. Individuals seeking healthcare

are often not in a strong position to judge the financial stability of a health plan, and
sometimes lack the information necessary to compare the various health plans available.
Many regulations are designed to protect consumers from these disadvantages. For
example, as we saw in Risk Management in Health Plans, solvency regulations are
designed to help assure that health plans are sufficiently financed to meet their
obligations to plan members.
Second, laws and regulations that are both well designed and consistently applied set
standards of conduct for the parties involved in the business of healthcare, and these
standards foster a competitive, but fair, marketplace environment.
From a financial standpoint, however, the laws and regulations that achieve these ideal
goals generate costs. For example, licensing requirements for providers and health
plans protect consumers and foster public confidence in the healthcare professions. Part
of the cost of this protection is that health plans face licensing requirements—and
licensing costs—in every state in which they enroll plan members.
Complex regulatory environments also generate multiple markets, and therefore multiple
healthcare delivery systems. For example, in a given geographical area, Medicare,
Medicaid, commercial, large group, small group, and individual markets will be
influenced, and in some cases created, by government laws and regulations. Changes in
laws and regulations in such areas can cause healthcare resources to shift in and out of
health plans or shift from less attractive health plan markets to more attractive markets.
Beyond generating administrative and compliance costs for health plans, laws and
regulations also frequently increase the risk for one party or another in a health plan
contract. For example, mandatory coverage of certain illnesses in effect mandates the
transfer of the financial risk associated with that illness from the individual plan member
to one or more other parties involved in the healthcare contract.
Generally, the distribution of risk among the health plan, the plan sponsor, and the
providers is one of the central processes of risk management in health plans. The
method that a health plan uses to reimburse its providers is a key factor in determining
the amount of financial risk that a provider assumes and the amount by which the health
plan reduces its underwriting risk. In this sense, provider contracting is closely tied to risk
and to risk management tools, such as those we discussed in previous lessons.
The concept of the risk-return trade-off causes health plans’ financial risk managers to
seek an appropriate balance between achieving returns that meet its owners’ (or
stockholders’) expectations and maintaining appropriate levels of solvency. Healthcare
providers and health plans both face financial risk in the course of conducting business.
As businesses, health plans invest financial capital with the expectation of achieving a
return. Similarly, providers invest their labor, and often some capital of their own in the
course of providing care, and in return expect to be financially rewarded.
The various types of provider reimbursement methods therefore indicate not only how
the provider will be paid for providing services, but also who will bear the risk that
providing these services will be more expensive than anticipated, and who will benefit if
expenses are lower than anticipated. There are almost as many provider reimbursement
methods as there are provider contracts, but reimbursement methods do fall into general
categories. We discuss these categories in this assignment and a future lesson. Keep in
mind that what often distinguishes these provider reimbursement methods from each
other is how risk is divided among the parties to the health plan contract.
Regulations addressing the delivery of healthcare services mandate many of the

elements that must be included in contracts between health plans and providers and, in
doing so, often serve to assign the risks associated with providing these services. In the
following sections, we present an overview of the sources of health plan regulation and
some of the mandates imposed by regulations.
Sources of Laws and Regulations 1
Laws and regulations applying to health plans come from both the federal government
and state governments. At both the federal and the state level, legislatures enact
statutes, governmental agencies develop regulations, and courts interpret laws and
establish case law, all of which affect health plans.
Federal Government
At least four federal agencies establish rules and requirements that affect health plans:
1. the Department of Health and Human Services,

2. the Department of Labor,
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3. the Office of Personnel Management, and

4. the Department of Defense.
The Department of Health and Human Services (HHS)
Acting primarily through the Centers for Medicare & Medicaid Services (CMS), HHS
serves as a purchaser and regulator of healthcare. In addition, CMS is responsible for
administering the Medicare program and the federal government’s role in the Medicaid
program. We discuss Medicare and Medicaid in more detail in future lessons.
The Department of Health and Human Services is also responsible for issuing
regulations pertaining to the Health Insurance Portability and Accountability Act (HIPAA)
of 1996. These regulations directly affect health plans that offer insured products to
employer group health plans and individuals. Recall from Healthcare Management: An
Introduction that HIPAA standardizes an approach to the continuation of healthcare
benefits for individuals and members of small group health plans and establishes parity
between the benefits extended to these individuals and those benefits offered to
employees in large group plans. This act also contains provisions designed to ensure
that prospective or current enrollees in a group health plan are not discriminated against
on the basis of health status.
The Department of Labor (DOL)
The DOL is the federal agency with primary responsibility for administering the
Employee Retirement Income Security Act (ERISA) of 1974, including recent
amendments made by HIPAA. Although ERISA set the standards for the health benefit
plans that many employers and some unions establish for their employees or members,
ERISA does not directly regulate health plans. Because employer group plans often
contract with health plans to provide health benefits to the plans’ enrollees, health plans
that sell to this market must design health plan benefits that meet ERISA requirements.
Under ERISA, various documentation, appeals, reporting, and disclosure requirements

are imposed on employer group health plans. For example, every employer group health
benefit plan that is subject to ERISA must have a written plan document that describes
in detail the benefits covered by the plan as well as the rules governing eligibility and the
procedures by which the plan may be modified.
In addition, ERISA requires plans to furnish every participant with a summary plan
description (SPD), which outlines the most important parts of the lengthier plan
document. Plan descriptions are often at the heart of disputes over whether a health
plan is obligated to cover a particular service or course of treatment. For this reason, the
plan documents of a health plan may have important legal and financial consequences
for the plan.
The Office of Personnel Management (OPM)
The OPM administers the Federal Employees Health Benefits Program (FEHBP), which
provides voluntary health insurance coverage to federal employees, retirees, and
dependents. The FEHBP is the largest employer-sponsored health plan in the United
States. The OPM sets threshold standards that plans must meet in order to participate in
the FEHBP.
The Department of Defense (DOD)
The DOD administers the Military Health Services System (MHSS), which provides
medical care to active-duty military personnel, their families, and retirees not yet eligible
for Medicare. Although its budget is substantial, the MHSS is not yet a major force in the
regulation of HMOs and PPOs because of the structure of its health plan contracting
initiatives and the limited number of contractors involved in its programs.
State Governments
As we mentioned earlier, health plans are often regulated by more than one agency in a
given state. Typically, a department of insurance oversees the financial aspects of health
plan operations for those health plans that do not fall under the ERISA preemption. In
some states, the state department of health regulates the healthcare delivery system,
including oversight of access to and quality of care. Other state agencies also may be
involved in setting standards for some health plans, because states are also purchasers
of healthcare for their own employees and for low-income state residents through
Medicaid contracts.
The National Association of Insurance Commissioners (NAIC) is a non-

governmental organization that consists of the commissioners or superintendents of the
various state insurance departments. The NAIC assists states in their attempts to
2
achieve some uniformity of laws and regulations applying to health plans and health
insurance. The NAIC does this through the development of model acts. The model acts
themselves do not carry the force of law, but state legislatures often pattern their own
laws or regulations after the NAIC model laws.
States may, however, alter any portion of a model law or regulation before it is adopted.
Consequently, details of licensure and other requirements frequently vary from state to
state, and health plans operating in more than one state must design their plans and
provider contracts to comply with applicable laws in each jurisdiction in which the health
plans operate.
Provider Contracting Laws and Regulations
The federal and state agencies and regulators discussed earlier in this lesson set the
regulatory environment in which providers and health plans must negotiate contracts. In
this regard, healthcare laws and regulations that require health plans to pay certain
benefits or cover certain conditions or treatments have an impact on the health plan-
provider contracts. The costs of complying with such laws and regulations affect provider
contracts at least indirectly in a competitive market, because resources used to meet
compliance costs are no longer available as potential surplus for either providers or
health plans.
In addition, many laws more directly affect provider contracts by mandating elements
within those contracts. The large number of legislatures and agencies involved in
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passing and enforcing these laws make a full discussion of them beyond the scope of
this text. However, the following sections briefly discuss some of the types of laws
affecting provider contracts.
Credentialing Standards 3
An important feature of many health plans is that health plans either limit plan members’
choice of provider or give incentives for plan members to select from panels of preferred
providers. Because plan members may be injured if a health plan selects providers who
are incompetent or unqualified to provide quality care, courts have held that health plans
have a duty to use reasonable care in credentialing providers.
Recall from Healthcare Management: An Introduction that credentialing is a review

process conducted to determine the current clinical competence of providers and to
ensure that providers meet the organization’s criteria. Various organizations, including
the National Committee for Quality Assurance (NCQA), URAC and the American
Association of Preferred Provider Organizations (AAPPO), have adopted standards for
conducting provider credentialing. These standards are not mandatory for health plans,
but courts sometimes find that health plans have satisfied their duty to use reasonable
care in their credentialing activities if they comply with these standards.
Credentialing Standards
The NCQA standards list the kinds of information health plans should obtain about
providers during the initial credentialing process and suggest that health plans
recredential all providers every two years. The NCQA has also established standards for
health plans that contract with third parties to credential or verify the credentials of
providers. In addition, some states have enacted laws that specify the criteria health
plans should consider in making credentialing decisions. Compliance with these laws
may help an health plan show that it has satisfied its standard of care.
Fair Procedure Laws
Fair procedure laws, also called due process laws, are laws that require health plans to
disclose the criteria they use in
1. selecting or deselecting the providers with which they contract, and

2. explaining to rejected or deselected providers why they were not selected, and
the process by which a provider can challenge the health plan’s decision.
Direct Access Laws
Several states have passed direct access laws, which are laws that allow health plan
members to see certain specialists without first being referred to those specialists by a
primary care provider. Direct access laws specify which type of specialist plan members
must be allowed to see without referral. As of 1997, 14 states had direct access laws,
and 9 of those states specified obstetricians/gynecologists. Other direct access laws
allow visits to dermatologists (Florida and Georgia) and chiropractors (New York). 4
Even in jurisdictions where there are no direct access laws, some plans allow enrollees
to see certain specialists without referral. However, in the absence of direct access laws,
plans can require such referrals. In such cases, primary care provider contracts can
require the primary care provider to manage some portion of the plan members’
utilization of such specialists. Direct access laws reduce the primary care providers’
ability to manage utilization of these specialists. Because both the specialists and the
primary care providers have different roles under these laws than they might otherwise
have, direct access laws can influence the content of contracts between the health plan
and providers.
Any Willing Provider Laws
About half of the states have passed any willing provider (AWP) laws, which require
that health plans allow any provider to supply services to plan members, so long as the
provider is willing to meet the same terms and conditions that apply to the providers that
are in the health plan’s network. In other words, AWP laws mandate that an health plan
allow providers to become part of its network or reimburse those providers at the health
plan’s negotiated-contract rate, so long as the non-contract provider is willing to perform
the services at the contract rate.
Any willing provider laws vary by state. Some state AWP laws allow plan members to
choose any provider, whether the provider is in the health plan’s network or not. Several
AWP laws require that a health plan send contract proposals to all providers in the
health plan’s service area. Other AWP laws confine themselves to relatively narrow
categories of providers—pharmacies, for example— or they include a much wider range
of providers.
Review Question
The Jamal Health Plan operates in a state that mandates that a health plan either allow
providers to become part of its network or reimburse those providers at the health plan’s
negotiated-contract rate, so long as the non-contract provider is willing to perform the
services at the contract rate. This type of law is known as:
a fair procedure law

a direct access law
an any willing provider law
a due process law
Incorrect. Fair procedure law, or due process law requires health plans to disclose
criteria they use for selection or deselection and to provide a process to challenge
decisions
Incorrect. A direct access law allows health plan members to see certain
specialists without referral
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Correct. An any willing provider law allows any qualified provider, willing to
perform services at the contracted rate, become part of the network
Incorrect. Due process law requires health plans to disclose criteria they use for
selection or deselection and to provide a process to challenge decisions
Any Willing Provider Laws
Provider groups tend to be in favor of AWP laws. They maintain that health plans that
control a high percentage of the healthcare market in local areas may put providers who
do not contract with them at a competitive disadvantage, and may further reduce
competition by reducing the number of providers in the market.
In contrast, health plans are opposed to AWP laws because such laws tend to remove
any motivation a provider may have to contract with the health plan. A health plan can
significantly reduce healthcare costs in a health plan’s population by contracting with
providers who agree to provide services to the health plan’s plan members at reduced
rates. In exchange, the health plan effectively makes available to the provider a larger
volume of patients than the provider would otherwise have.
Particularly in the case of hospitals, which have high fixed costs, and in the case of
physicians who are in individual practice and may not have marketing expertise, a
dependably large volume of patients can be a valuable benefit. The greater the
perceived benefit of patient volume, the more motivated providers will be to agree to
reduce their fees, and the greater the cost reductions the health plan will be able to
achieve for its plan members, all other factors being equal. Further, health plans seek to
enter into contracts with providers who share the health plan’s utilization management
philosophy and who provide excellent care.
By allowing all providers access to the health plan’s patient base, AWP laws remove
providers’ incentive to contract with the health plan at reduced rates and make more
difficult the health plan’s attempt to build a provider panel that includes only the top-
quality providers in a given market. As a result, health plans have challenged AWP laws
in court. Usually the legal basis for these challenges is that an applicable federal law,
such as ERISA or the HMO Act, pre-empts state statutes. Insight 3A-1 highlights the
recent finding of the US Supreme Court regarding the apllicability of ERISA to AWP
challenges.
In Kentucky Association of Health Plans v. Miller, the issue the Supreme Court decided
is whether Kentucky’s broad law violates the Employee Retirement Income Security Act
(ERISA) or whether the state law is a valid regulation of the business of insurance. In the
January 14, 2003 hearing before the court, the attorney for the Kentucky Association of
Health Plans argued that health plans need to use limited provider networks to deliver
quality health care at a reasonable cost. The state argued that the Kentucky law is a
legitimate consumer protection measure that gives consumers access to providers of
their choice.
On April 2, 2003, the US Supreme Court, in a unanimous decision, affirmed the Sixth
Circuit decision that found that Kentucky’s “any willing provider" laws are saved from
ERISA preemption by the ERISA saving clause because the laws regulate insurance. In
the decision, the Supreme Court held that for a state law to be deemed a law which
regulates insurance, and thus be saved from ERISA preemption, it must satisfy two
requirements: 1) it must be specifically directed toward entities engaged in insurance;
and 2) it must be substantially affect the risk pooling arrangement between the insurer
and the insured.
Mandated Benefits
Mandated benefit laws are state or federal laws that require health plans to arrange for
the financing and delivery of particular benefits, such as coverage for a stay in a hospital
for a specific length of time. In some cases, such as laws that require health plans to
supply chiropractic services, mandated benefit laws also have the effect of requiring
health plans to contract with specific types of providers.
In recent years, the number of state laws mandating coverage has increased
significantly. The types of illnesses or procedures covered, and the degree to which they
are covered, vary from state to state. Even within individual states, mandates vary
according to the type of health plan plan. Figure 3A-1 lists some examples of procedures
or services that fall under at least some mandated benefit laws. In addition to state
mandates, some mandates arise from federal law.
From a financial standpoint, mandated benefits have the potential to influence health
plans in the following ways:
• They increase the cost of a health plan’s health plan to the extent that the
plan must cover mandated benefits that would not have been included in the
plan in the absence of the law or regulation that mandates the benefits.
• Health plans must contract with providers, including specialists, to provide the
required level of mandated benefits. To the extent the mandated benefits
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change the benefit structure of the health plan’s health plan, the health
plans may have to contract with providers with which the health plans
would not have contracted otherwise.
• Health plans must be able to track and process data that demonstrates that
the health plan is complying with the law. The health plan must also gather
and analyze cost data to be able to adequately price the increased benefits.
To the extent that this datatracking and analysis represents an increased load
on the health plan’s information and management systems, costs will
increase.
• Mandated benefit laws may have the effect of causing a higher degree of
uniformity among the health plans of competing health plans in a given
market. Individual health plans that seek to differentiate their products from
those of their competitors in competitive markets will have less flexibility in
benefit design.
• Because self-funded plans typically are exempt from state mandates, in some
markets, large group employers may be motivated to begin self-funding in
order to avoid paying premium increases in other healthcare plans that are
subject to state mandates. In other markets, self-funded plans may be
pressured to add benefit coverage to match the mandated benefits of other
plans. In either case, mandated benefit laws may at least temporarily
influence the structure of the market balance between self-funded and other
types of plans.
A full discussion of all the mandated benefit laws that states have passed is beyond the
scope of this text. The following sections discuss some common and representative
mandates.
Review Question
Mandated benefit laws are state or federal laws that require health plans to arrange for
the financing and delivery of particular benefits. Ways that mandated benefits have the
potential to influence health plans include:
1. Causing a lower degree of uniformity among health plans of competing health

plans in a given market
2. Increasing the cost of the benefit plan to the extent that the plan must cover
mandated benefits that would not have been included in the plan in the absence
of the law or regulation that mandates the benefits
Both 1 and 2
1 only
2 only
Neither 1 nor 2
Incorrect. Mandated benefits increase the degree of uniformity within a particular
market
Incorrect. Mandated benefits increase the degree of uniformity within a particular

market
Correct. Mandated benefits increase the cost of the benefit plan, if the benefit
would not have been included in the absence if law or regulation
Incorrect. Mandated benefits increase the cost of the benefit plan, if the benefit
would not have been included in the absence if law or regulation
Mental Healthcare Coverage 5
Concern that coverage for mental illnesses was not being treated on a par with physical
illnesses motivated lawmakers to enact a mental health parity requirement that
subsequently was incorporated into HIPAA. The federal mental healthcare coverage
requirements bar group health plans from having more restrictive annual and lifetime
limits or caps on mental illness coverage than for physical illness coverage if the health
plan has annual payment limits or aggregate dollar lifetime caps. The federal mental
healthcare coverage law does not mandate coverage for mental illness; it seeks to
ensure that—if a health plan covers mental illness—the caps and limits are comparable
to caps and limits for physical coverage. More than 15 states have enacted their own
mental healthcare coverage laws.
These laws, similar to HIPAA, vary from mandating coverage of treatment for severe
disorders or biologically based illnesses such as schizophrenia, manic-depression, or
bipolar disorder to mandating parity for coverage of mental illnesses comparable to caps
and limits for physical illnesses. Some state laws require that all terms and conditions of
6
coverage (i.e., copayments, deductibles, etc.) be the same for both mental and physical
illnesses
Some state mental health parity laws exclude substance abuse treatment from their
mandates for coverage of mental illnesses. Other state laws provide extensive coverage
for mental illnesses. For example, the Vermont mental health parity law, which includes
in its definition of mental illness any disorder listed in the International Classification of
Diseases Manual (ICDM), requires coverage for the treatment of a wide variety of mental
illnesses, including substance abuse.
In addition, as in several other state laws, the Vermont law prohibits separate
deductibles, copayments, coinsurance, and other similar types of cost-sharing
arrangements for mental and physical illnesses. Generally, health plans must ensure
7
that they comply with the mental health parity requirements of the federal law as well as
any more stringent requirements imposed by the states in which they operate.
Length of Stay Laws 8
Two types of length of stay (LOS) laws enacted by many states are maternity length of
stay and mastectomy length of stay. A federal maternity LOS mandate was enacted by
passage of the Newborns’ and Mothers’ Health Protection Act (NMHPA) of 1996. The
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NMHPA was subsequently incorporated into HIPAA. The NMHPA requires that health
plans provide coverage for hospital stays for childbirth—at least 48 hours for normal
deliveries and 96 hours for Caesarean births. Prior to enactment of the NMHPA, more
than half of the states had enacted maternity LOS mandates. At a minimum, a health
plan must comply with the federal NMHPA law. If the health plan operates in a state with
a similar mandate that has more stringent requirements, it must also comply with those
additional requirements.
Also, most states have considered—and a number have enacted—mastectomy LOS

mandates. Some state mastectomy LOS laws mandate a specific hospital stay. For
example, in New Jersey, health plans and insurers must cover hospital stays for 72
hours for a radical mastectomy and 48 hours for a simple mastectomy. In other states,
such as Florida, health plans and insurers must cover the length of the hospital stay as
determined by the physician. 9
The Texas State Liability Law
In addition to laws that increase health plans’ costs by imposing administrative or

compliance requirements, some laws expose the health plan to financial liability for its
actions or the actions of its providers. Providers and health plans may be liable for
damages if they fail to perform duties imposed upon them by these laws. A tort is a
violation of a legal duty to another person imposed by law, rather than contract, causing
harm to the other person and for which the law provides a remedy.
The business of healthcare is sufficiently complex that health plans face a certain level
of risk from tort actions.
Although it would be impossible to list all laws that could subject a health plan to tort
action, one state law recently passed by Texas has the potential to significantly increase
financial risks faced by health plans through tort actions, and in doing so, increase health
plans’ costs of doing business in Texas. The Texas state liability law (SB 386) states that
any health plan entity is “liable for damages for harm to an insured or enrollee
proximately caused by the health care treatment decisions” made by the health plan’s
employees or agents. In other words, if a physician providing care to a health plan’s plan
member harms the plan member through medical malpractice or other negligence, the
health plan, as well as the provider, is liable. Medical malpractice is a type of negligence
that occurs when a patient is harmed because a provider failed to exercise reasonable
care in providing medical treatment.
Traditionally, health plans have not been liable in cases of physician malpractice,
particularly when the physician was not a full-time employee of the health plan. The
reasoning behind not holding the health plan responsible is that, in the United States,
corporations are not allowed to engage in the practice of medicine; only individuals may
be licensed to practice medicine. Because only individuals have the authority to practice
medicine, malpractice was a tort for which only individual providers were liable. Thus, in
provider contracts with health plans, the risk of malpractice was borne by the providers
(or the insurance companies supplying the physicians with malpractice insurance), and
not the health plans. Under the Texas law, a health plan cannot use the corporate
practice of medicine doctrine as a defense.
Malpractice costs make up 5% to 6% of the total healthcare costs in the United States.
Determining whether or not healthcare providers who contract with health plans are
agents of the health plan and whether or not health plans are liable for the actions of
these agents are significant financial issues for health plans. Currently the Texas law is
being challenged in court, in part on the same basis as any willing provider laws—that is,
that federal laws such as ERISA pre-empt state laws.
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Review Question
Dr. Martin Cassini is an obstetrician who is under contract with the Bellerby Health Plan.
Bellerby compensates Dr. Cassini for each obstetrical patient he sees in the form of a
single amount that covers the costs of prenatal visits, the delivery itself, and post-
delivery care . This information indicates that Dr. Cassini is compensated under the
provider reimbursement method known as a:
global fee
relative value scale
unbundling
discounted fee-for-service
Correct. A global fee is a single fee that the provider is given for all services
associated with an entire course of treatment for a plan member
Incorrect. Under a relative value scale a health plan assigns weighted values to
each medical procedure or service performed by a provider based on the cost and
intensity of that service
Incorrect. Unbundling is the practice of provider's billing for multiple components

of a service that was previously included in a single fee
Incorrect. Discounted fee-for-service reimburses the provider on a per-treatment

basis on a level below the provider's usual charge for that service
Provider Incentive Methods: Withholds, Risk Pools, and Bonuses
Withholds, risk pools, and bonuses are all means of motivating providers to manage
costs by making a portion of their reimbursement dependent on how well the providers
and the health plan manage costs. In all three methods, an assumed or budgeted cost is
developed, and a portion of the providers’ income is subject to enhancement (or loss),
depending on whether costs are held below the budgeted amount during a specific
period.
Withholds
In a withhold arrangement, a percentage of the providers’ reimbursement is not

paid to the providers until the end of a financial period; claims that exceed the
budgeted costs for care during that period are charged against the withheld
funds, and after such claims are paid, the remaining money in the withhold is
distributed to the providers. If providers hold costs below the amount budgeted
for that period, then the entire amount of money in the withhold is usually
distributed to them. If the cost overruns exceed the withhold, then the deficits are
usually the responsibility of the health plan. Withholds usually range from 10% to 20% of
total provider reimbursement for the period.
Risk Pools
A risk pool is an arrangement in which a fund is created at the beginning of a financial

period, any claims approved for payment are paid out of that fund during the period, and
at the end of the period, any remaining risk pool funds are paid to providers. If costs
exceed the funded risk pool, the providers and the health plan pay the deficit according
to percentages agreed upon at the beginning of the contract period.
Review Question
Dr. Jacob Winburne is compensated by the Honor Health Plan under an arrangement in
which Honor establishes at the beginning of a financial period a fund from which claims
approved for payment are paid. At the end of the given period, any funds remaining are
paid out to providers. This information indicates that the arrangement between Dr.
Winburne and Honor includes a provider incentive known as a:
risk pool, and any deficit in the fund at the end of the period would be the sole
responsibility of Honor
risk pool, and any deficit in the fund at the end of the period would be paid by both
Dr. Winburne and Honor according to percentages agreed upon at the beginning
of the contract period
withhold, and any deficit in the fund at the end of the period would be the sole
responsibility of Honor
withhold, and any deficit in the fund at the end of the period would be paid by both
Dr. Winburne and Honor according to percentages agreed upon at the beginning
of the contract period
Incorrect
Yes
Incorrect
Incorrect
Bonus Arrangements
Bonus arrangements, which pay providers over and above their usual reimbursement
at the end of a financial period, are based on the performance of the health plan as a
whole, a group of providers within the plan, or an individual provider. Bonuses provide
financial incentives to providers to minimize unnecessary costs. Bonuses may be based
on a percentage of a provider’s reimbursement or a percentage of the savings
experienced by the health plan. Bonuses based on savings achieved by the plan as a
whole have the advantage of being somewhat easier to administer, but, in such cases,
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the achievement of savings and the bonus for each provider will be based partly on
events outside the provider’s control.
Under a bonus reimbursement arrangement, the providers are not at financial risk to
make up any deficit experienced by the plan. Beyond the possibility of losing their bonus,
providers are not at risk when the plan faces deficits. As we noted previously, providers
in a risk pool arrangement are usually responsible for sharing a plan deficit even if the
deficit is greater than the funded risk pool.
The central motivation for forming risk pools, withholds, and bonus arrangements is to
transfer some of the financial risk associated with overutilization to providers, who at
least partly control utilization rates. In this way, providers are motivated to control
utilization by managing it themselves.
Hospital Reimbursement Methods
Hospitals are an important player in provider reimbursement systems. Often an health

plan will reimburse hospitals using one reimbursement method, and the providers
associated with the hospital will be paid using a different method. Also, a single hospital
may be reimbursed under several different payment systems, which will vary from health
plan to health plan, health plan to health plan1, and from private plans to government
plans such as Medicare and Medicaid. Before continuing our discussion of hospital
reimbursement methods, refer to Figure 3B-2, which provides definitions for some key
terms used in hospital reimbursement.
Straight Charges
The simplest (albeit least desirable) payment mechanism in healthcare is straight

charges, under which a hospital submits its claim in full to a health plan and the plan
pays the bill. It is also obviously the most expensive, after the option of no contract at all.
This is a fallback position to be agreed to only in the event that the health plan is unable
to obtain any form of discount at all, but it is still desirable to have a contract with a no-
balance-billing clause in it for purposes of reserve requirements and licensure.
Straight Discount on Charges
Another possible arrangement with hospitals is a straight discount on charges, under

which a hospital submits its claim to a health plan in full, and the plan discounts it by the
agreed-to percentage and then pays the claim. The hospital accepts this payment as
payment in full. The amount of discount that can be obtained will depend on the factors
discussed above. This type of arrangement is not infrequent in markets with low levels of
health plan penetration but is uncommon in markets with high levels of health plans.
Sliding Scale Discount on Charges
Sliding scale discounts are an option, particularly in markets with low health plan
penetration but some level of competitiveness among hospitals. Under a sliding scale
discount on charges, the percentage discount on a hospital’s bill is reflective of the
hospital’s total volume of admissions and outpatient procedures. Deciding whether to
combine these two categories or deal with them separately is not as important as
making sure that the parties deal with them both. With the rapidly climbing cost of
outpatient procedures, savings from reduction of inpatient utilization could be negated by
an unanticipated overrun in outpatient charges.
An example of a sliding scale is a 20% reduction in charges for 0 to 200 total bed days
per year with incremental increases in the discount up to a maximum percentage. An
interim percentage discount is usually negotiated, and the parties reconcile at the end of
the year based on the final total volume.
How a health plan tracks the discount is also negotiable. A health plan may vary the
discount on a month-to-month basis rather than yearly. Alternatively, the health plan may
track total bed days, number of admissions, or whole dollars spent. Whatever the health
plan finally agrees to should be a clearly defined and measurable objective.
The last issue to look at in a sliding scale is timeliness of payment. It is likely that the
hospital will demand a clause in the contract spelling out the health plan’s requirement to
process claims in a timely manner, usually 30 days or sooner. In some cases a health
plan may negotiate a sliding scale, or a modifier to the main sliding scale, that applies a
further reduction based on the plan’s ability to turn a clean claim around quickly. For
example, the health plan may negotiate an additional 4% discount for paying a clean
claim within 14 days of receipt. Conversely, the hospital may demand a penalty for clean
claims that are not processed within 30 days.
Straight Per-Diem Charges
Unlike straight charges, a negotiated straight per-diem charge is a single charge for a
day in the hospital, regardless of any actual charges or costs incurred. In this most
common type of arrangement, a health plan negotiates a per-diem rate with the hospital
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and pays that rate without adjustments. For example, the plan will pay $800 for each day
regardless of the actual cost of the service.
Hospital administrators are sometimes reluctant to add days in the intensive care unit or
obstetrics to the base per diem unless there is a sufficient volume of regular medical-
surgical cases to make the ultimate cost predictable. In a small health plan, or in one
that is not limiting the number of participating hospitals, the hospital administrator is
concerned that the hospital will be used for expensive cases at a low per diem while
competitors are used for less costly cases. In such cases, a good option is to negotiate
multiple sets of perdiem charges based on service type—for example, medical-surgical,
obstetrics, intensive care, neonatal intensive care, rehabilitation, and so forth—or a
combination of per diems and a flat case rate (explained later) for obstetrics.
Straight Per-Diem Charges
The key to making a per diem work is predictability. If the health plan and the hospital
can accurately predict the number and mix of cases, then they can accurately calculate
a per diem. The per diem is simply an estimate of the charges or costs for an average
day in that hospital, minus the level of discount.
A theoretical disadvantage of the per diem approach, however, is that the per diem must
be paid even if the billed charges are less than the per diem rate. For example, if the
health plan has a per-diem arrangement that pays $800 per day for medical admissions,
and the total allowable charges (billed charges less charges for noncovered items
provided during the admission) for a 5-day admission are $3,300, the hospital is
reimbursed $4,000 for the admission ($800 per day × 5 days).
This is acceptable as long as the average per diem represents an acceptable discount,
but it has been anecdotally reported that some large, self-insured accounts have
demanded the lesser of the charges or the per diems for each case—that is, laying off
the upper end of the risk but harvesting the reward. Such demands are to be avoided
because they corrupt the integrity of the perdiem calculation.
A health plan may also negotiate to reimburse the hospital for expensive surgical
implants provided at the hospital’s actual cost of the implant. Such reimbursement would
be limited to a defined list of implants, such as cochlear implants, where the cost to the
hospital for the implant is far greater than is recoverable under the per diem or outpatient
arrangement.
Review Question
Cascade Hospital has negotiated with the McBee Health Plan a straight per-diem rate of
$1,000 per day for medical admissions. One of McBee’s plan members was admitted to
Cascade for 10 days. Total billed charges equaled $10,000, of which $2,000 were for
noncovered items. This information indicates that, for this admission, the amount that
McBee was obligated to reimburse Cascade was:
$0
$8,000
$10,000
$12,000
Incorrect. The formula is per-diem rate X number of days
Incorrect. A theoretical disadvantage of the per diem approach is that the per diem
must be paid even if the billed charges are less than the per diem rate
Correct. $1,000 X 10 = $10,000
Incorrect. The formula is per-diem rate X number of days.
Sliding Scale Per-Diem Charges
Like the sliding scale discount on charges discussed above, the sliding scale per diem
charge is also based on total volume. Under sliding scale per-diem charges, a health
plan negotiates an interim per diem that it will pay for each day in the hospital;
depending on the total number of bed days in the year, the plan will either pay a lump
sum settlement at the end of the year or withhold an amount from the final payment for
the year to adjust for an additional reduction in the per diem from an increase in total bed
days. It may be preferable to make an arrangement whereby on a quarterly or
semiannual basis the plan will adjust the interim per diem so as to reduce any disparities
caused by unexpected changes in utilization patterns
Differential by Day in Hospital
Charging according to differential by day in hospital refers to the fact that most
hospitalizations are more expensive on the first day. For example, the first day for
surgical cases includes operating suite costs and operating surgical team costs. This
type of reimbursement method is generally combined with a per-diem approach, but the
first day is paid at a higher rate, such as $1,000, and each subsequent day is $600.
Diagnosis-Related Groups
As with Medicare, a common reimbursement methodology is by diagnosis-related group

(DRG), which is a statistical system of classifying inpatient stays into groups for the
purpose of payment. There are publications of DRG categories, criteria, outliers, and
trim points—that is, the cost or length of stay that causes the DRG payment to be
supplemented or supplanted by another payment mechanism—to enable a health plan
to negotiate a payment mechanism for DRGs based on Medicare rates or, in some
cases, state regulated rates. First, though, the plan needs to assess whether it will be to
its benefit.
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If it is the plan’s intention to reduce unnecessary utilization, there will not necessarily be
concomitant savings if it uses straight DRGs. If the payment is fixed on the basis of
diagnosis, any reduction in days will go to the hospital and not to the plan. Furthermore,
unless the health plan is prepared to perform careful audits of the hospital’s DRG
coding, it may experience code creep. On the other hand, DRGs do serve to share risk
with the hospital, thus making the hospital an active partner in controlling utilization and
making plan expenses more manageable. Generally, DRGs are better suited to plans
with loose controls than plans that tightly manage utilization. Insight 3A-2 explains a
Medicare demonostration program, combining DRG payment with incentive, or bonus
payments for quality.
Service-Related Case Rates
Similar to DRGs, service-related case rates are a cruder reimbursement mechanism.

Under service-related case rates, various service types are defined and the hospital
receives a flat per admission reimbursement for whatever type of service to which the
patient is admitted—for example, all surgical admissions cost $6,100. Service types
include medicine, surgery, intensive care, neonatal intensive care, psychiatry, and
obstetrics. If services are mixed, a prorated payment, such as 50% of surgical and 50%
of intensive care, may be made.
Case Rates and Package Pricing
Whatever mechanism a plan uses for hospital reimbursement, it may still need to
address certain categories of procedures and negotiate special rates. Case rates are
rates that are established on a case by case basis. The most common of these is
obstetrics. It is common to negotiate a flat rate for a normal vaginal delivery and a flat
rate for a Caesarean section or a blended rate for both. In the case of blended case
rates, the expected reimbursement for each type of delivery is multiplied by the expected
(or desired) percentage of utilization.
For example, a case rate for vaginal delivery is $2,000, and a case rate for Caesarean
section is $2,600. If expected utilization is 80% for vaginal delivery and 20% for
Caesarean section, then the case rate is $2,120 ($2,000 × 0.8 = $1,600; $2,600 × 0.2 =
$520; $1,600 + $520 = $2,120). With the recent legislative activity regarding minimum
length of stay for obstetrics, flat case rates, regardless of either length of stay or
Caesarean section versus vaginal delivery, are clearly the preferred method of
reimbursement, other than capitation.
Although common, case rates are certainly not necessary if the per diem is all-inclusive,
but a health plan will want to use them if it has negotiated a discount on charges. This is
because the delivery suite or operating room is substantially more costly to operate than
a regular hospital room. For example, a health plan may negotiate a flat rate of $2,100
per delivery. The downside of this arrangement is that the health plan achieves no
added savings from decreased length of stay. The upside is that it makes the hospital a
much more active partner in controlling utilization.
Another area for which a health plan would typically negotiate flat rates is specialty
procedures at tertiary hospitals for medical procedures such as coronary artery bypass
surgery or heart transplants. These procedures, although relatively infrequent, are
tremendously costly.
A broader variation is package pricing or bundled case rates. Package pricing or

bundled case rate refers to an all-inclusive rate paid for both institutional and
professional services. A health plan negotiates a flat rate for a procedure, such as
coronary artery bypass surgery, and that rate is used to pay all parties who provide
services connected with that procedure, including preadmission and post-discharge
care. Bundled case rates are not uncommon in teaching facilities where there is a facility
practice plan that works closely with the hospital
Reimbursement Methods for Ancillary Service Providers
One of the primary means by which health plans have achieved greater financial
efficiency than traditional medicine is through economies of scale. For health plans, this
typically involves developing a network of providers, including individual physicians and
hospitals. health plans seeking to provide comprehensive health plans must also
contract with a variety of providers for ancillary services. Ancillary services is an
umbrella term for a variety of healthcare services outside of surgery, primary care, and
most hospital treatment, and typically these services are provided by non-physicians.
Many ancillary services are diagnostic: laboratory tests, radiology, and magnetic
resonance imaging are all examples of services often considered ancillary by health
plans. Similarly, many kinds of physical and behavior therapy, dialysis, home health
care, and even pharmacy services are considered ancillary services.
One characteristic of most ancillary services that has important contractual and financial
implications for a health plan is that few plan members seek these services without first
being referred to the ancillary provider by a physician. For this reason, the utilization
rates for ancillary services are partly controlled by physician behavior. Consequently,
utilization rates and the costs that a health plan experiences for ancillary providers
depend on the type of network the health plan manages, and the reimbursement
methods it uses for its physicians and hospitals.
An important feature of health plans that have large health plans is that these plans
develop significant data over time concerning quality outcomes by type and intensity of
treatments, including ancillary services. Thus, these health plans are able to provide
physicians with indicators for determining whether a referral to ancillary services should
be made in a given case. The health plans’ case managers may also help control
utilization and maximize quality of care by consulting with physicians and ancillary
providers at the beginning of a case to determine the appropriate frequency and intensity
of use of ancillary services.
Reimbursement methods for ancillary service providers tend to fall into the same general
categories as those we have already discussed for physicians and hospitals: FFS,
discounted FFS, case rates, per diems, and capitation are all used. Within the limits of
the utilization controls mentioned above, these reimbursement systems distribute
utilization risk between the contracting parties much as the same reimbursement
methods distribute risk between physicians and health plans.
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Reimbursement methods for ancillary services may also be influenced by the structure
of the health plan that negotiates the contract with the ancillary service providers. A
closed panel plan, for instance, may operate the ancillary service itself. A closed panel
plan, as well as many open panel plans, may also contract for services with the ancillary
service providers or provider groups.
As we have seen, in choosing methods of provider reimbursement for PCPs, specialists,

hospitals, and ancillary service providers, health plans and the providers themselves
must consider a number of factors, including the
• Type of providers
• Type of service being performed by the providers
• Degree to which transferring utilization risk to the providers is possible and
desirable
Different methods of reimbursement have different implications in terms of who is

responsible for controlling utilization risk and who is responsible for controlling a
significant source of financial costs that a health plan incurs. Capitation, which is already
an important reimbursement method for many physicians and hospitals, is becoming
more common in ancillary service provider contracts. We discuss capitation in the next
lesson.
Chapter 4 A
Capitation in Provider Reimbursement
• Describe percent-of-premium capitation and PMPM capitation

• Explain the differences among and uses of PCP, specialty, full professional,
and global capitation arrangements
• Explain how carve-outs are used in conjunction with some capitation
contracts
• Discuss contact capitation
• Describe some of the key information requirements for developing a
capitation reimbursement system

As we mentioned in a previous lesson, capitation is a provider reimbursement system
that pays prospectively for healthcare services on the basis of the number of plan
members who are covered for specific services over a specified period of time rather
than the cost or the number of services that are actually provided. Under capitation, the
provider is actually compensated per person— often referred to as per capita—rather
than per service delivered. Typically, capitation payments to providers are made at
monthly intervals.
Capitation is per capita, prospective reimbursement, as compared to fee-for-service

(FFS) reimbursement, which is service based and retrospective. As such, capitation
transfers the financial exposure for identified services from the health plan to the
provider.
For the provider, capitation also carries with it some potential advantages. If the provider
manages utilization costs so that those costs are less than capitation payments, the
provider retains the savings. In other words, in exchange for accepting financial risk of
higher-than-expected utilization costs, the provider receives the right to share in any
savings that occur when actual costs are less than expected. Capitation reimbursement
is also paid in advance, without claim delays, which makes the provider’s cash flow more
stable. Stable cash flows reduce business risk for providers, enabling them to pay from a
predictable income any salaries or expense obligations they have.
Capitation is central to health plans and has far-ranging effects on many aspects of
contemporary healthcare delivery. A movement away from FFS and toward capitation
represents a fundamental shift in risk distribution in a health plan. Along with other
aspects of health plans, capitation has been largely responsible for a transformation in
the U.S. healthcare delivery system. In responding to capitation and health plans, nearly
every healthcare organization in the United States has had to change its organizational
strategies and operations.1
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From the health plan’s perspective, capitation motivates providers and provider
organizations to provide services that improve members’ health status and to limit
services that are unnecessary or not cost-effective. Capitation increases physicians’
awareness of the financial costs associated with their treatment decisions and
encourages them to be cost conscious by aligning their financial incentives with their role
in making treatment decisions.
Capitation, like other health plan programs, also usually ties members to specific
providers and provider networks, limiting a member’s choice of providers to the plan’s
provider panel in exchange for cost-effective care. In this lesson we will explore what
capitation is and how it is used. We will also discuss the benefits and drawbacks of using
capitation as a reimbursement method. We begin by providing a broad overview of
capitation.
The next part of the lesson includes a discussion of some of the more complex issues
involved in understanding capitation and creating capitation rates for specific types of
providers, services, and situations. These issues vary according to the size of the plan
and the way in which the risk of higher-than-expected utilization is divided among the
health plan, providers, and stop-loss reinsurers. We will discuss reinsurance in the next
lesson.
Capitation Overview
A capitation rate is an amount paid to a provider or provider organization, typically

monthly, on a per plan member (per capita) basis. This is often referred to as the per
member per month (PMPM) rate. The total reimbursement amount a provider receives is
a function of the number of plan members for whom the provider has responsibility,
rather than the number and type of services actually rendered to those plan members.
The basic elements used in determining a simple capitation rate are
• Services covered by the capitation contract (e.g., primary care provider visits)
• Expected rate of utilization for each of these services
• Average fee for each of these services
A health plan (or a provider organization that wishes to capitate its member providers)
can calculate a simple monthly capitation payment (or PMPM amount) by multiplying the
average number of services used by a member in one year by the average fee-for-
service equivalent payment per service, and then dividing by the number of
reimbursement periods per specified time period (for example, if the reimbursement
period is one month, then the number of reimbursement periods in one year is 12).
Figure 4A-1 shows a sample calculation of a simple monthly capitation rate.
Expected utilization requires a determination of the expected average utilization of each

service by plan members. Determining the expected average utilization requires at least
a year’s worth of experience from a population of credible size. FFS equivalents will also
vary by the type of service.
Determining the Services Covered by Capitation
To develop a capitation rate, a health plan or provider group must define the services
covered by the agreement between the health plan and the providers. This is typically
done by clinical area (for example, primary care services), medical specialty (obstetrics-
gynecology), or service type (outpatient diagnostic testing). Under some circumstances,
some specified services covered by a plan will not be capitated.
Typically, the reason for not capitating specific services is that the plan does not have a
credible block of business with respect to that service. For example, services that are
rendered only in the case of unusual illnesses may be needed so infrequently that it is
impossible to predict accurately the average number of plan members who will use the
service each year, and it is therefore impossible to develop an accurate PMPM rate. In
such cases, the providers will be reimbursed according to another payment system,
such as discounted FFS.
Covered services that are outside the capitation rate are typically defined at the
procedure or service level (using CPT codes), or at the patient diagnosis level (using
codes found in the International Classification of Diseases, tenth edition, which are
known as ICD-9 codes). Additionally, some health plans may reimburse providers on a
discounted FFS basis until a threshold number of plan members designate that provider
as their caregiver. Contractual provisions that allow capitated providers to be paid on a
discounted FFS basis until the provider’s enrollment meets or exceeds a threshold
number are called low-enrollment guarantees.
For example, a health plan may pay a pediatrician under a discounted FFS schedule if
fewer than 100 children covered by the plan use that pediatrician as their PCP. If the
pediatrician serves more than 100 children covered by the plan, then the pediatrician will
be reimbursed according to the capitated rate. Low-enrollment guarantees cause a
capitation contract to transfer less risk to providers than it would otherwise.
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Review Question
The Chamber Health Plan reimburses primary care physicians on a monthly basis by
using a simple capitation method. Chamber assumes an annual utilization rate of three
visits per year. The FFS rate per office visit is $75, and all plan members are required to
make a $10 copayment for each office visit. This information indicates that the capitation
rate that Chamber calculates per member per month (PMPM) is equal to:
$6.25
$16.25
$18.75
$21.25
Incorrect. The formula is (Annual Utilization Rate X FFS equivalent (FFS rate
minus copayment)) / Number of reimbursement periods per year.
Correct (3 X 75-10) / 12 is $16.25
minus copayment) ) / Number of reimbursement periods per year
minus copayment) ) / Number of reimbursement periods per year.
Determining Expected Utilization of Services
In order to develop a capitation rate, an health plan (or provider group) must have data
on (or make assumptions about) the expected utilization of the services covered. This is
the most complex part of the capitation development (or analysis). Typically, health
plans rely on internal or consulting actuaries, who in turn rely on data obtained from
multiple health plans.
The importance of acquiring accurate utilization data has implications for health plan and
provider information systems and data collection. We will discuss some of these issues
later in this lesson.
Other Capitation Issues
Fee-for-service equivalents for each service included in a health plan’s benefit design
are necessary to develop PMPM rates. Typically, FFS equivalents are based on a
benchmark (discounted) fee schedule or by using a relative value scale and relevant
conversion factor. In either case, the FFS equivalents reflect the local or regional market.
The capitation rate for any given provider is also influenced by the presence of
noncapitation contractual elements that apply either to the reimbursement agreement
between the health plan and providers, or to the design of the healthcare plan itself.
These elements, which we will discuss in more detail later in this lesson, include
withholds, risk pools and reconciliations, and member eligibility.

Types of Capitation: PMPM and Percent-of-Premium
The basic capitation described previously and in Figure 4A-1 is a simplified model of the
PMPM type of capitation. In practice, capitated PCPs often work under a PMPM
contract. PMPM capitation is the most common type of capitation.
The second type of capitation uses a percent- of-premium approach to reimbursement

arrangements. Percent-of-premium arrangements are capitation contracts in which
the reimbursement to providers is a percentage of the premium payment the health plan
receives for providing healthcare coverage to plan members. Like PMPM capitation,
percent-of-premium arrangements transfer the risk of overutilization from the health plan
to the provider. Unlike PMPM capitation, which sets reimbursement at a specific dollar
amount per plan member, the dollar amount paid to providers under percent-of-premium
arrangements will vary according to the amount of premiums the health plan receives.
Types of Capitation: PMPM and Percent-of-Premium
Additionally, percent-of-premium arrangements transfer some of the risk associated with

underwriting and rating from the health plan to the provider. In other words, under
percent-of-premium arrangements, the providers share some of the risk that the health
plan has set premiums too low to cover the actual costs of providing covered benefits to
plan members. Of course, in cases where the premiums have a sound actuarial basis
and the plan members’ morbidity experience falls within the predicted range, providers
share in profits generated by the premium rates. The exact amount of underwriting risk
being transferred in any given percent-of-premium arrangement will vary according to
the percentage of the premium that is being paid to the providers as well as according to
the adequacy of the premium rates.
During the period that a percent-of-premium contract is in place, it tightly binds the
provider organization to the health plan. For instance, if the health plan finds it necessary
—for competitive reasons—to decrease premiums, the provider organization will receive
smaller payments because those payments are based on a percentage of the premiums.
In contrast, a PMPM capitation rate will result in the same payment to providers no
matter what premium rate the health plan receives from the plan payor. Because 85% or
more of the premium received by the health plan may be transferred to providers
through a percent-of-premium arrangement (depending upon which clinical and
administrative services are included), the provider organization may bear much of the
risk for the financial and underwriting decisions made by the plan.
For this reason, percent-of-premium arrangements are much more attractive to providers
when these arrangements include provisions that set a limit on the underwriting risk that
the providers accept. One method of limiting this risk that is therefore a critical part of the
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large majority of commercial group health plans’ percent-of- premium contracts is to set
a minimum capitation payment, such as a PMPM “floor.” Such floor rates evolve out of
actuarial considerations and market forces, but their purpose is to limit the underwriting
risk providers accept. Under such contract provisions, the health plan guarantees a
minimum capitation rate will be paid to providers regardless of any premium decreases.
In situations where premium rates are established by an external organization, such as
state or federal governments, a floor rate is not as critical.
Capitation Variations by Medical Service Grouping
Both PMPM capitation and percent-of-premium arrangements pay providers

prospectively rather than on a per-service basis. Both also can be used as the
reimbursement methodology for many different types of providers and provider groups.
Within either type of capitation, variations occur based on what kind of providers and
medical services are covered under the capitation contract. The following list describes
some of the common types of variations:
• PCP capitation
• Specialty capitation
• Full professional capitation
• Global capitation
We discuss each of these capitation variations in turn and how elements within
capitation contracts can be used either to adjust the amount of risk a provider accepts
through the contract, or to adjust the amount of compensation a provider receives to
reflect the provider’s or plan’s performance.
PCP capitation, also called partial capitation, is a capitation payment that reimburses the
provider for primary care services only. Typically, the PCP will refer patients to
specialist providers for services such as radiology, surgery, and laboratory tests.
Specialty capitation uses capitation reimbursement to pay individual specialists or single-

specialty groups to provide a contractually defined set of services to a health plan’s
members.
Full professional capitation, sometimes called full professional services capitation, is a

capitation payment that covers all physician services, including primary care and
specialty services. Typically, this method of reimbursement is used to compensate
provider groups of various types, such as clinics and multispecialty IPAs, and these
groups in turn accept responsibility for the costs of all physician services related to a
patient’s care.
Global capitation, also called full-risk capitation, is a capitation payment that covers all
physician and facility services, including hospital inpatient and outpatient services,
primary and specialty care, and some ancillary services.
Capitation Variations by Medical Service Grouping
PCP Capitation
Primary care provider (PCP) capitation is, by far, the most common type of capitation. In
health plans that capitate their PCPs, new enrollees are required to select a PCP who
will serve as their main connection to the health plan. PCPs include family practitioners,
general practitioners, general internists, and, for children, pediatricians.
Primary care services usually include a range of office-based services as well as

physician visits to hospitalized plan members. Although plan members can receive
emergency care without first seeing a PCP, for other services beyond the scope of
primary care, members must be referred to specific providers by the PCP. Services that
typically require referral include specialist services, lab and X-ray services, and hospital
admissions. Healthcare plans in which PCPs serve in this role are known as gatekeeper
model plans.
Thus, under a gatekeeper model, PCPs, whether they are capitated or not, manage the
risk of overutilization of specialty services and diagnostic tests.
Most primary care capitation arrangements do not make the provider financially
responsible for the cost of major diagnostic tests (such as an MRI) that a PCP might
order. This is because a single expensive test that is rarely required can be much more
expensive than many months of average PMPM payments—and so its inclusion in the
covered services list creates a disproportionately large financial risk for the physician.
In cases where the PCP’s capitation contract does not make the PCP responsible for the
cost of specified expensive tests or procedures, the utilization risk for such costly
services is borne by an entity covering a large volume of members and services. Such
entities are capable of accepting more risk than individual PCPs are able to accept.
Examples of this type of entity include a large group practice, an independent practice
association (IPA), an integrated delivery system (IDS), or the health plan itself. Provider
organizations accepting such risk might act as the health plan would, if responsible for
these services, and screen for the appropriateness of, and require prior approval for,
these services.
Specialists and other providers to whom members are referred by PCPs are usually paid
under a separate capitated or discounted FFS contract with the health plan. If PCPs are
reimbursed on a discounted FFS contract, then the charges for these outside lab and X-
ray services will be paid by the health plan, which in turn typically subtracts that payment
from the monthly capitation disbursement to the PCP.
In addition, most PCP capitation contracts have separate risk pools tracking the PCPs’
members’ use of specialty and hospital services. Methods for reducing the PCPs’
reimbursement when referrals exceed expected levels, and methods of providing PCPs’
bonuses when referral rates are lower than expected, serve as means by which a PCP
can be financially motivated to avoid making unnecessary referrals.
PCP capitation contracts also, however, usually include provisions intended to protect
the PCP against the financial consequences of having a patient (or patients) with a
catastrophic illness, and/or from high member utilization caused by forces beyond the
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PCP’s control. We discuss these provisions, called stop-loss protection, in the next
lesson.
Specialty Capitation
Just as capitation for PCPs typically requires members to select a PCP, capitation for
specialists typically requires that members be tied to specialists in some way so that the
specialist’s PMPM reimbursement can be determined.
In some health plans, women designate an obstetrics-gynecology (OB-GYN) provider, in

much the same way as they would designate a PCP. This designation makes it possible
for the plan to reimburse that OB-GYN provider on a capitated basis. Aside from plans
where a woman designates an OB-GYN provider, tying each member to specialists
when the member enrolls is only possible if the plan design is aligned with the capitation
reimbursement model.
For example, the plan may tie the enrollee’s choice of a PCP to a specific referral
circle, which is a geographically distinct group of physicians, usually those with
privileges at a local hospital, for all specialty referrals. Similarly, the choice of a PCP can
link the member to a multispecialty group practice, an IPA network, or an IDS. This type
of arrangement ties the members to a group of specialists in advance of the members’
need for specialty care, which allows for capitation of those specialists.
Certain highly specialized physician services (such as neurosurgery or organ

transplants) generally would be excluded from the capitation. Capitation of specialized
provider services tends to become more difficult for services that are both very
expensive and very infrequent.
Figure 4A-2 explains in general terms why the high cost and low utilization rates of some
services influence all providers in capitated contracts and why, for some specialty
services, high cost and infrequent utilization are important factors in limiting single
specialist capitation.
For some specialty-specific treatments (e.g., neurosurgery), PMPM rates are extremely
small (less than $0.10 PMPM) because, despite high costs for some cases, utilization
rates are extremely low. Although the population utilization rate may be low, a specialist
who happens to experience even a small number of very expensive cases risks very
high losses under such a contract.
This potential for unexpectedly high costs in some specialty care situations makes
traditional capitation less attractive to specialists than it is to PCPs. Given these risks,
specialty physicians and health plans usually choose some form of discounted FFS (or
other service-specific) payment system. The specialist and health plan can also agree
upon case-specific reimbursements for certain types of cases. For example, a case-
specific reimbursement might cover professional services associated with a coronary
artery bypass graft (CABG) or childbirth.
Given these factors, single-specialty capitation is much less common than PCP
capitation.
Some physicians, particularly internists with specialty board certifications, may provide a
mix of services that health plans consider primary care and specialty care. In most
health plans with PCP capitation, a physician must choose whether to participate as a
PCP or a specialist. A PCP cannot self-refer for specialty services—services beyond
those typically provided by a PCP. Likewise, a specialist cannot receive specialty
capitation and be the member’s primary contact with the plan. These provisions, while
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developed to avoid financial conflicts of interest, can impede continuity of care in some
situations, and point to a limitation of the PCP capitation model.
Full Professional Capitation
Specialists are more commonly capitated as part of a physician’s group that is

reimbursed through full professional capitation. Full professional capitation is a provider
reimbursement method that capitates physician groups that provide both primary and
specialty care. Full professional capitation payments cover all physician services and
associated diagnostic tests and laboratory work. Typically, under full professional
capitation, a health plan capitates an entire physician group such as an IPA (with a
network composed of PCPs and physicians from most specialties) or a multispecialty
group. In turn, the physicians as a group determine how individual physicians will be
remunerated.
In an IPA, individual physicians may be paid on a subcapitation basis, a discounted FFS

basis, an RVS-based fee schedule, an RBRVS-based fee schedule, or some
combination of these methods. Subcapitation is a provider reimbursement method in
which a provider entity (in our example, an IPA) receives either full professional or global
capitation from a health plan and then separately subcontracts with a physician,
physician group, or other provider organization for specific clinical services, using a
capitated payment to reimburse the subcontractor. Only specialties that have high
volume and predictable cost patterns are normally considered for subcapitation.
The capitated entity’s purpose in entering subcapitated arrangements is to minimize the

utilization risk it bears in its capitation contract with the health plan, and to align the
incentives of the subcapitated specialty providers with those of the capitated entity. For
example, if an IPA receives capitation reimbursement from a health plan, the IPA
accepts utilization risk under that capitation contract. By subcapitating providers, the IPA
transfers some of its utilization risk to those providers.
The type of capitation—PMPM or percent-of-premium—received by the provider entity

does not dictate the type of capitation the entity uses to subcapitate its individual
providers. For example, an entity receiving percent-of-premium full professional
capitation can subcapitate individual physicians using either a PMPM or percent-of-
premium capitation methodology. If, however, the subcapitation is PMPM and the full
professional capitation is percent-of-premium, then the capitated entity is incurring the
risk that the percent-of-premium payments it receives from the health plan will be
insufficient to meet the entity’s fixed PMPM obligations to its subcapitated physicians.
If the capitated entity in a full professional capitation arrangement pays any of its
providers using FFS or RVS-based payments, there must be a year-end budget
reconciliation comparing capitation payments received by the entity from the health plan
against fees paid to individual physicians by the entity.
In a multispecialty group practice accepting full professional capitation, individual

compensation may be based on salary plus a bonus; some FFS, RVS, or RBRVS basis;
or an internal subcapitation.
Multispecialty groups—or even PCP groups —may also accept a full professional
capitation and then subcapitate or otherwise externally contract for certain (or, in the
case of a PCP practice, all) specialty care not available internally.
Because capitated reimbursement is structured around spreading risk, provider

organizations have an advantage over individual specialty physicians in capitated
contracting as long as the provider organization has enough volume to prevent any one
physician from shouldering a disproportionate share of risk. This advantage in capitation
contracting is a factor in the growth of many physician groups.
Review Question
Doctors’ Care is an individual practice association (IPA) under contract to the Jasper
Health Plan to provide primary and secondary care to Jasper’s members. Jasper’s
capitation payments compensate Doctors’ Care for all physician services and associated
diagnostic tests and laboratory work. The physicians at Doctors’ Care, as a group,
determine how individual physicians in the group will be remunerated. The type of
capitation used by Jasper to compensate Doctors’ Care is known as:
PCP capitation
partial capitation
full professional capitation
specialty capitation
Incorrect. PCP capitation is a capitation arrangement which reimburses the

provider for primary care services only
Incorrect. Partial capitation, also known as PCP capitation, is a capitation

arrangement which reimburses the provider for primary care services only
Correct. Full professional capitation is an arrangement that covers all physician

services
Incorrect. Specialty capitation uses capitation to pay individual specialists or

single-specialty groups.
Global Capitation
Global capitation, also called full-risk capitation, is a capitation system that pays a
provider organization to provide substantially all of the inpatient and outpatient services
—including clinical, primary, specialty, and ancillary services —that the health plan
offers. As a consequence of accepting a global capitation contract, the provider group
accepts much of the risk that utilization rates will be higher than expected. However, out-
of-network care that is rendered outside the plan’s geographical area is usually excluded
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from the reimbursement and is the responsibility of the health plan. At a minimum, health
plans also retain responsibility for marketing, enrollment, premium billing, actuarial,
underwriting, and member services functions.
Global capitation is usually accepted and administered by an IDS, although other

provider organizations also enter into global capitation contracts. Recall that an IDS is a
provider organization that is fully integrated operationally and clinically to provide a full
range of healthcare services, including physician, hospital, and ancillary services.
Integrated delivery systems are typically built around a hospital or hospital system. The
physicians might be employed directly by the IDS, or they might be affiliated through a
physician-hospital organization (PHO) or a contracted network. Alternatively, a large
multispecialty physician practice or a physician contracting organization called an IPA
might accept global capitation and subcontract with hospitals for inpatient services.
Generally these entities seek to improve operating efficiencies by creating economies of

scale and reducing overhead. They also implement broad policies and procedures that
include system-wide approaches to quality management and improvement. From a
strategic perspective, they create a regional (or “brand”) identity, and they market a
quality-oriented and customerfocused image to consumers.
However, under global capitation direct contracting arrangements, IDSs essentially have
to replicate internally (or externally contract for) many of the functions a health plan
otherwise performs. Again, however, IDSs face significant challenges in securing
sufficient capital to develop operational and informational systems infrastructures and in
developing expertise in plan management. In most markets, health plans have more
experience performing most of these functions.
In some states, providers must obtain a license and meet solvency requirements in order
to participate in global capitation or other arrangements that require the provider
organization to take on substantial risk. Securing a license involves time and financial
investment and can present a significant barrier for provider organizations seeking global
capitation arrangements.
Another implication of global capitation is the need to divide reimbursement among the
hospital(s), physicians, ancillary providers, and primary care and specialist physicians.
Developing this type of agreement among a large number of providers can be a complex
process. In fact, this complexity is often a barrier to provider groups’ developing such
arrangements with health plans. As is the case with health plan provider payment
systems, the system an IDS uses to divide payments among providers must be
understandable to all the participating providers. In addition, those providers must agree
that the system is fair, or in the long run the providers will not wish to renew their
contracts.
Dividing the global capitation payment may be much easier when one entity secures the
global capitation contract and then negotiates subcontracts for specific services—be it a
physician organization contracting with a hospital for inpatient services, or vice versa.
Capitation and Plan Management: Carve-Outs and Disease

Management Programs
Carve-outs are services that are excluded (or carved out) from a capitation payment, a
risk pool, or a health benefit plan. Typically, a health plan will offer these carved-out
services to enrollees, but will manage these services separately. In practice, the term
carve-out has also come to refer to discrete programs covering entire categories of care
—such as mental health, pharmacy benefits, and even specific diseases—that are
usually administered by independent organizations.

Management Programs
Examples of the first type of carve-out are specific services such as childhood
immunizations or expensive lab and radiology services that are excluded from PCPs’
capitated reimbursement payment or from the PCPs’ risk-pool calculations. The specific
services carved out, if any, depend on the contract. The excluded services may be
• Provided by the PCP and reimbursed by the plan on a fee-for-service basis

(e.g., childhood immunizations)
• Handled by another provider (e.g., through a separate lab and X-ray contract)
• Absorbed by the health plan (e.g., expensive services excluded from a risk-
pool calculation)
In the type of carve-out in which entire categories of care are administered by

independent organizations, the organizations are typically reimbursed under a capitated
PMPM contract.
For example, mental health services have often been carved out by health plans, which
contract with a specialty health plan, typically called a managed behavioral health
organization or MBHO. In so doing, the health plans assume that distinct administrative
and clinical expertise is required to effectively manage mental health services. Over
time, however, this trend in managing mental health services has slowed, and many
health plans are integrating mental health care with medical care.
Review Question
The Swann Health Plan excludes mental health coverage from its basic health benefit
plan. Coverage for mental health is provided by a specialty health plan called a
managed behavioral health organization (MBHO). This arrangement recognizes the fact
that distinct administrative and clinical expertise is required to effectively manage mental
health services. This information indicates that Swann manages mental health services
through the use of a:
formulary
risk pod
carve-out
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case rate
Incorrect. A formulary is a listing of drugs that are considered preferred therapy

for a health plan's population and are to be used by the health plan's providers
when prescribing medicine
Incorrect. A risk pod is a small group of physicians practicing independently

within a geographic region who are treated as a group for the purposes of
measuring performance and setting compensation
Correct. Carve outs are services tthat are excluded form a capitation payment or
risk pool, or a health benefit plan
Incorrect. Case rates are rates established on a case by case basis

Management Programs
Pharmaceutical coverage is another area that has frequently been carved out by health
plans. Pharmacy costs have grown at a significantly faster rate than overall healthcare
costs. To manage the growth in these costs, healthcare plans have contracted with
pharmacy benefit managers (PBMs), which are specialty health plan firms that specialize
in managing pharmaceutical costs. These firms develop systems that profile physician
prescribing patterns, check for negative drug interactions, and negotiate significant
discounts from drug manufacturers.
One method commonly used to control utilization and cost is the use of formularies. A
formulary is a listing of drugs, classified by therapeutic category or disease class, that
are considered preferred therapy for a given health plan population and that are to be
used by a health plan’s providers in prescribing medicines. Drugs are placed on the
formulary because of their effectiveness for a given condition and, usually, because the
PBM has been able to negotiate significant volume discounts from the manufacturers of
the drugs. In many cases, PBMs’ expertise and buying power make them costeffective
subcontractors.
The most rapidly growing area related to carve-outs, however, is disease management
(DM). Under DM, carved-out services are often very narrowly defined in terms of specific
diseases, such as diabetes, asthma, AIDS, and cancer. DM programs include data-
driven models for identifying plan members with specific diseases, and structured
programs of interventions designed to manage the disease, improve patients’ functional
status, improve quality of care, and save money otherwise spent on avoidable
emergency room visits and hospitalizations.
In addition to saving plan costs, DM programs can also reduce the risk accepted by
providers who are capitated, because the risk of having to provide high-cost treatments
for these diseases is carved out of the capitation contract. DM carve-outs need not be
transferred to an outside entity. Instead, a health plan or a capitated provider
organization will sometimes develop an internal DM program for patients with a given,
usually chronic, disease.
Contact Capitation
Contact capitation is a form of payment in which specialists receive a flat,

predetermined fee once a referred patient begins to receive treatment from them for a
given condition. This is similar to a case rate—a flat fee paid to the provider in order to
care for a patient with a given condition—which we discussed in the last lesson.
In general, contact capitation works as follows. A plan (or an IPA or IDS that accepts
either capitation for all physician services or global capitation contracts) sets aside a
PMPM amount (actuarially determined and adjusted for members’ age and sex) for each
specialty. Every time a PCP refers a member to a specialist and the specialist sees the
member, the specialist begins to receive a share of those funds on a monthly basis. The
method used to determine the size of the share and the number of months the specialist
receives the contact capitation payment vary by organization. 2, 3
The monthly payment for each specialist is determined by taking the number of active
contact capitation patients for that specialty and dividing it into the total specialty pool for
that month. The specialist collects a proportionate share plus the member copayment. A
contact capitation patient could be active for as little as two months or as long as a year,
depending on the plan and the specific model used.
Some contact capitation contracts make no payment adjustment for different types of
conditions, implicitly making the assumption that physicians in a given specialty in a
given area working within a specific managed care model have a similar case mix on
average. Other contracts may use a simple case mix adjustment that sets an amount of
“extra credit” for each sicker or older patient. Finally, some contracts call for adjusting
relative payments according to each patient’s diagnosis or diagnosis and age and sex. 4
Even under such a system, however, the essential model for contact capitation remains
the same—to divide a pool of accumulated specialty-specific PMPM contributions by
either the total number of active contact capitation patients or the active contact
capitation patients’ total number of relative value units within an RVS or RBRVS system.
Contact capitation rewards the provider for controlling the costs of each case, which
ultimately lowers healthcare costs. Because providers who are reimbursed through
contact capitation are paid for each case they see, however, the risk of overutilization
still exists unless some control is in place to monitor how many cases are presented to
these providers. Often, the control is a gatekeeper PCP whose own reimbursement is
not affected by the number of cases the gatekeeper refers to providers who are
reimbursed through contact capitation.
Using Withholds, Risk Pools, and Year-End Reconciliations in Capitation

Contracts
In health plan markets, most health plans structure provider reimbursement so that, even
in the absence of capitation, providers are sharing some of the financial risk associated
with their treatment decisions. Withholds, risk pools, and periodic tracking and
reconciliation of these accounts are all means of transferring some financial risk to
providers who have some control over utilization costs. Although these methods are
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used in a variety of reimbursement contracts, they are often used in conjunction with
capitation contracts as well.
Withholds and Risk Pools
Recall from a previous lesson that in a withhold arrangement, a percentage of the

providers’ reimbursement is not paid to the providers until the end of a financial period.
Claims that exceed the budgeted costs for care during that period are charged against
the withheld funds, and after such claims are paid, the remaining money in the withhold
is distributed to the providers. Withholds, along with risk pools, serve as a means of
motivating providers and provider groups to be cost- and quality-efficient.
Historically, they have been a common feature of IPA model HMOs, which are HMOs
that contract directly with independent physicians in private practice. In IPA model
HMOs, PCPs are generally capitated, specialists are paid on a discounted FFS basis,
and hospitals are typically reimbursed using per diems. The details that follow are based
on that type of model.
Health plans may create several risk pools—for example, in hospital utilization and
various types of specialty care—within a given healthcare plan. A full professional
capitation arrangement might include a risk pool for hospital utilization, but would not
include a specialty risk pool because the capitation payment incorporates a fixed fee for
specialty care. Similarly, in a global capitation arrangement, all services, outpatient and
inpatient, are reimbursed on a fixed-fee basis. The provider organization assumes the
utilization risk, absorbs any deficits, and keeps any “surplus.”
Again, within a capitation environment, the purpose of withholds and risk pools is the
same as in any other provider reimbursement method: to financially reward providers
who control utilization. For example, if a network’s PCPs are capitated, then they are
financially rewarded for transferring to specialists those patients who generate high
costs. This motivation exists whether or not the patient is best served by seeing a
specialist. But if a withhold or risk pool is incorporated into the PCP’s contract, then
some portion of the expense for the specialists can be deducted from the withhold or risk
pool. This deduction puts the PCP at risk for overutilization of specialists, and therefore
motivates the PCP to avoid making unnecessary referrals.
Withholds are amounts withheld from physicians’ reimbursement pending year-end

analyses of utilization and associated costs for diagnostic testing, specialty care, and/or
inpatient utilization. In capitation contracts, the typical range for withhold amounts is
10%–20% of the capitation payments. Hospitals often share in the risk pool for inpatient
utilization, but they may or may not have a portion of their payments similarly withheld. A
portion or all of the withhold amounts may cover any shortages in the targeted risk pool
funds. If there are surpluses, physicians can receive not only the withhold amounts, but
also bonuses based on a share of the surplus.
The process of designing a withhold provision starts with the health plan and physicians
who negotiate actuarially defined risk pool targets. The targets are typically set as
PMPM amounts for specialty care and days per 1,000 members per year for inpatient
care. The target amounts are age- and gender-specific and are summed to generate the
actual risk pool amounts. At the end of the year, PCPs with specialist costs and/or
inpatient utilization costs that are over budget will lose some of their withhold amounts.
PCPs with lower specialist costs and lower inpatient utilization costs will receive the
withholds, plus a bonus.
Physicians generally share risk with other physicians (for both the specialty and hospital
risk pools), as well as with the local hospital (for the hospital risk pool only). There may
be several levels of pooling of risk—an aggregate level that determines the maximum
payout level per physician and a local (or individual) level that determines a specific
physician’s payout.
At its simplest, the risk pool arrangement may reflect the individual experience of a
physician. Alternatively, the health plan may combine the utilization experience of a
small number of physicians who practice independently into what is called a pool of
doctors, or risk pod. A risk pod is a small group of physicians practicing independently
within a geographic region who are treated as a group for the purposes of measuring
performance or setting compensation. A risk pod will typically contain approximately five
to ten physicians. Physicians within larger groups, such as referral circles or IPAs, may
have their utilization pooled and compared to budgeted amounts.
Generally, PCPs and specialists share the specialty risk pool. The hospital and
physicians typically will share in the risk pool for inpatient services (a "shared risk"
arrangement). In other cases, physicians may share the hospital risk pool (surplus or
deficit) with the health plan.
Just as capitation contracts must clearly define those services that are (and, in some
cases, that are not) covered by the capitation payment, the same applies to risk pools. In
general, only those items that are within a physician’s control should be part of the risk
pool calculation, because the primary purpose of a risk pool is to reward physicians for
avoiding overutilization.
Thus, for a risk pool to achieve its purpose, the physicians in the pool must be able to
manage the utilization rate of the covered services. For example, emergency hospital
services are sometimes excluded from risk pool arrangements for capitated physicians,
because physicians cannot control the number of emergency hospital visits plan
members will make. However, physicians do have some control over the overutilization
of hospital inpatient days for patients who are not receiving emergency care, so
utilization of these inpatient services would be included in the risk pools.
Other important considerations are the numbers and types of risk pools, the risk pool
targets, and how items charged against the risk pool will be priced. For instance, many
services have professional and facility charges associated with them. Generally both
charges will be included.
Risk pools are typically evaluated and "settled" at (or as of) the end of a specified period,
usually one year, though this may vary. In any case, as the year progresses, providers
should receive monthly or quarterly reports showing their performance on a year-to-date
basis. The reporting, at a minimum, will make physicians aware of any high utilization
trends, and will provide a financial motivation for them to change their practice patterns
before the year is complete. 5
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Bonuses and Quality of Care
Health plans have tended to shift away from reimbursement systems that use both
withholds and bonuses based on utilization rates alone and to shift toward
reimbursement methods that consist of a base payment plus a bonus that is based on
both utilization and quality of care measures.
The new bonus is based on a multidimensional model incorporating utilization and

financial factors as well as quality of care targets, data collection targets, and patient
satisfaction measures. 6,7
These evaluations include a variety of quality and customer service related factors
including:
• Member satisfaction survey ratings

• Member transfer rates
• Medical chart reviews
• Available office hours and scheduling ease for members
• Performance on specific Health Plan Employer Data Information (HEDIS)
measures such as immunization rates for children–or other similar measures
(for instance, cholesterol screening, flu vaccination)
• Drug formulary adherence
A health plan or delegated provider organization can design bonus amounts so that they
vary for different levels of performance, and base the bonus paid on a percent of
capitation or on a PMPM rate. In such bonus arrangements, however, it is important that
the bonus amounts generated by quality-of-care measures do not exceed the total level
of surplus available for distribution through the bonus.
Quality-related bonus arrangements such as those described above can be applied to

PCPs, specialists, and hospitals–whether or not the base payments are actually made
on a capitated basis. PCPs paid on a discounted fee-for-service basis, specialists paid
on a discounted FFS or case-rate basis, and hospitals paid on a percentage-of-charges,
per diem or DRG (case rate) basis may gain bonuses based on a similar combination of
related factors. However, as a general rule, providers who accept relatively greater risk
(as in capitation contracts) should receive a larger proportional bonus than the bonus
received by providers who accept less risk through FFS contracts, all other things being
equal.
Year-End Reconciliations
A reconciliation, or a settlement, is the process by which the health plan assesses

providers’ performance relative to contractual terms and reimbursement. Most
agreements call for reconciliations, or settlements, to be performed at year-end.
Consequently, they are often called year-end reconciliations. However, they may be
done quarterly or at any other frequency agreed to by the contractual parties. Typically,
a reconciliation includes a
• Formal measure of utilization and other performance criteria
• Calculation of the risk pool utilization relative to budget
• Reconciliation of any surpluses or losses against monies withheld
• Payment to the providers of any withholds and/or bonuses due
To assure that all the claims for a given period have been reported, utilization
calculations generally require that at least three months and possibly as much as six
months have passed from the closing of the evaluation period. The time required to
receive all (or nearly all) claims for a given period is known as the run out period. From
a business point of view, the health plan must balance the additional accuracy gained
from waiting an extra month for any claims straggling in against the importance to
providers of the health plan’s reporting results as soon as possible. In any case there will
almost always be missing data–for instance, claims incurred but not reported (IBNR)
from out-of-network providers. Therefore, contract provisions should address situations
involving the absence of final data.
Capitation for Different Organizations and Types of Services
Capitation as a form of payment can be applied to services provided by a variety of

different organizations and health care professionals. The two most common types of
providers receiving capitation are physicians and hospitals–sometimes separately,
sometimes together. In this section of the lesson, we discuss the capitation
arrangements made most commonly by physicians, hospitals and integrated delivery
systems (IDSs). Figure 4A-3 summarizes different providers and the types of services
that are often capitated.
Given all these variations and details, it should be no surprise that physicians
increasingly rely on professional administrative expertise in negotiating contracts with
health plans. A group practice may employ (or contract) with an internal practice
administrator. But physicians also rely on IPAs, management service organizations
(MSOs) and PHOs to help them gain access to members covered by a variety of health
plans and to negotiate the best possible contract terms. To enable these organizations
to negotiate the best arrangements, physicians may even give them single signature
authority, which enables the IPA or PHO to sign a binding contract with a health plan.
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Capitation for Hospitals
Hospitals are sometimes paid on a capitation basis for inpatient and/or specific
outpatient services. Because hospitals operate in-house laboratories and radiology
services, and may own satellite locations providing these services, they may be
capitated for outpatient lab and x-ray services, even if they are not capitated for inpatient
care or other outpatient services.
However, as we mentioned earlier in this assignment, the most common reimbursement

methods for hospitals have been per diems (negotiated fees paid per day) and case
rates (for instance, DRG-based payments).
Per diem payments are usually set at a rate that motivates hospitals to provide cost-
effective care to patients who are in the hospital. However, they may also provide
financial motivation for hospitals to keep patients for as many days as possible. In
practice, risk pools are also used to contain inpatient utilization. Inpatient risk pools may
be structured so that physicians and the health plan or physicians and the hospital share
this risk and any savings or overruns.
In the interest of maintaining their autonomy, many hospitals form PHOs, hospital
systems and integrated delivery systems that can accept global capitation payments.
Then the hospital – as a major player in these networks or IDSs – can capture more of
the premium dollar and retain more of the savings generated by reducing both costs per
day and bed days per 1,000 enrolled plan members. Providers and hospitals, however,
face many challenges in seeking to form IDSs. IDSs require significant start-up capital,
as well as expertise in managing a large healthcare entity composed of many different
types of providers. Furthermore, such IDSs still must be able to negotiate a successful
global capitation or global percent-of-premium contract, and once a contract is in place,
these global payments must be equitably divided among participating providers.
Information Requirements for Capitation
Health plans have achieved much of its financial efficiency by developing the means to
gather, analyze and exchange information. With respect to provider reimbursement,
timely, relevant feedback to providers is essential for controlling costs and monitoring
quality—two essential functions in health plans. To perform these functions and set
reimbursement rates on the basis of utilization, a health plan must have a sophisticated
information system.
A simple example of information requirements for health plans is member processing. To

develop capitation rates, health plans must identify and capture demographic information
for every covered member, because, at the most basic level, capitation contracts
reimburse “per member per month” based on a member’s age and gender.
Health plans and provider organizations that subcapitate other providers must have
means of reporting utilization and costs on a per member basis. Without the systems
infrastructure and accompanying data they would be unable to manage their business.
Timely, accurate data supports day-to-day plan management and financial control.
Although health plans generally own operational models and information systems that
can process and analyze the information necessary to operate complex health plan
functions, many providers such as hospitals and physicians still face the challenge of
building information systems that reflect health plan requirements. The fast pace of
change in provider organizations and the level of consolidation that has developed as a
consequence of instituting health plan practices leaves many organizations still
adjusting, trying to figure out how to link incompatible systems.
As providers sign capitated contracts under which they accept more and more of the risk
(e.g., global capitation and percent-of-premium arrangements), they are accepting roles
and financial risk traditionally held by insurance companies and health plans. The
challenge for providers is to merge these new roles and requirements with their
traditional expertise in healthcare delivery.
Key Capitation-Related Information System Components
Ideally, a provider information system within a health plan system will include the
following elements:
• A member information and eligibility module. This module contains basic

demographic information about plan members and includes on-line or
frequent disk or tape updates from health plans. These updates include
demographic information, health plan, plan type, copayment levels,
deductibles, and coordination of benefit (COB) information.
• A patient utilization module allowing for real-time collection of all patient
encounter information including diagnosis, service and procedure codes, and
any relevant billing information (e.g., copayment levels, deductibles).
• An ability to track and reconcile member eligibility (member additions,
changes, and terminations) and capitation payments made by multiple health
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plans, each with multiple product lines (e.g., commercial, Medicare, Medicaid,
POS vs. closed access).
• Import and export capabilities for periodic transfer of data (e.g., eligibility
data, utilization data, referrals, and authorizations) to and from the health
plan.
• Periodic audits using medical charts to verify the accuracy and
completeness of on-line data capture.
Key Capitation-Related Information System Components
In addition, provider organizations at risk for specialist and/or hospital utilization must
have the ability to track incurred but not reported (IBNR) claims, especially if they will
subcontract and reimburse some services on a FFS basis. Generally these systems
involve matching referrals to claims paid and the systems must be able to accrue an
estimated amount due for those referrals at a given point in time without accompanying
claims.
In percent-of-premium capitation systems, health plans must be able to information on

plan members. In the large majority of cases, the health plan will be charging different
premium rates to different groups, which means that the information system must track
which members from which groups sign up with a given provider. Then the health plan
and provider must use this data to determine how the percent-of-premium payment can
be divided as fairly as possible among the various capitated providers.
Accuracy and timely data capture enables effective reporting, which in turn facilitates
better management and improved planning. Reports showing utilization per member per
month (and, if applicable, IBNR claims), gives provider organizations information on
actual utilization relative to budgeted amounts. 8
Accuracy and timeliness are important elements in data management because they help
both providers and health plans avoid significant losses. Data should be reportable by
health plan, by product line (for example, commercial, Medicare, Medicaid)–and possibly
by the same age and sex categories used for capitation payments.
In the case of percent-of-premium capitation contracts, both the health plan and the
capitated providers will be motivated to analyze costs by employer group to make sure
that the health plan is properly rating and underwriting each group. In cases where a
group’s premiums do not adequately reflect the actual risk the group represents, then
both the health plan and the providers are unintentionally accepting greater-than-
expected risk through the percent-of-premium reimbursement contract.
Other internal reports might examine the cost side: physician time/cost per visit, non-
physician clinician time/costs per visit, visits per member per year, and overhead.
Together such data would enable the organization to monitor clinical productivity and to
provide timely feedback to physicians on variations in practice patterns.
Utilization Benchmarks and Historical Data

To develop capitation rates, health plans must gather utilization data and then use it to
make assumptions about future utilization. The more accurate the utilization
assumptions, the more realistic the capitation rate. More realistic capitation rates benefit
both the health plan and the providers, since it reduces the financial risk faced by each.
In addition, health plans typically have either in-house or external consulting actuaries
available to support their efforts. Providers, provider organizations, and IDSs also
contract with actuaries who provide the expertise that the providers need to negotiate
knowledgeably.
Actuaries are experts in studying and modeling utilization and the effects of variations in
cost sharing (copayment levels and deductibles), benefits (inclusions and exclusions),
and plan design variations (gatekeeper versus open access, in-network only versus in-
network and out-of-network benefits, etc.). Actuaries are also responsible for generating
the standard age- and sex-specific PMPM cells in capitation reimbursement tables. We
discuss underwriting and rating in more detail in lesson 7, 8, and 9.
FFS Equivalents and Pricing Per Expected Service
In developing or analyzing a capitation rate, obtaining fees for each expected type of
service rendered by providers is important. Information used to determine these fees can
come from many different sources. But, in general, there are two main issues with fees:
(1) their levels, and (2) the relative pricing of services (within and between specialties).
Physicians analyzing a contract are very interested in the effective fees they will receive
for each unit of service, and frequently want to adjust individual fee assumptions. After
year-end settlements, physicians who are analyzing their contracts will want to know the
fee-for-service equivalent fees they received for each unit of service.
The issue of relative fees for different services becomes more complex when the
capitation contract covers physicians from different specialties–physicians in a
multispecialty practice or those who are part of an IPA or an IDS with a full professional
or global capitation contract. Use of a relative value unit (RVU) scale, such as the
resource-based relative value scale (RBRVS) used by Medicare, or other scales
available commercially, can help with this challenge.
With a relative value scale each service is assigned a relative weighting, then a factor
(the “conversion factor”) is applied to convert the relative fees to actual (or theoretical)
amounts for specific services. Thus providers or a health plan can use an RVU scale to
develop a capitation rate, analyze a rate or allocate a capitation payment among
physicians within a single-specialty group or among physicians in a multispecialty group. 9
Once FFS equivalents have been chosen, they should be adjusted for the expected
member copayment levels.
Member Tracking and Eligibility Issues
In plans with capitated payment arrangements, tracking eligibility is an important issue

for providers and health plans. Because of their dealings with employer groups, health
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plans are accustomed to retroactive member additions and deletions. Providers,

however, may be less accustomed to additions and deletions, and can be more exposed
(financially) under capitation.
Two situations are particularly problematic in provider reimbursement. One is when a

member is added to a PCP’s panel because he or she needed to see a PCP, and visits
the office the same month that the PCP receives the first capitation payment for that
member. If the member had been on the plan but had not previously selected a PCP, the
provider typically can collect retroactive capitation payments from the health plan.
The second problematic situation occurs when a member is retroactively terminated

after the provider has been paid one or more monthly capitation payments for the
member, possibly after the member has received services from the provider. Although
some health plans absorb the capitation expenses instead of passing them to the
provider, many do not. Those health plans that do not absorb the expenses pass the
expenses to the provider by retroactively adjusting the provider’s capitation payment–
and then, if any services have been rendered, the physician must pursue payment from
the (former) member.
The Challenge of Capturing Capitated Encounters
Unlike fee-for-service reimbursement, where a claim has to be filed for the provider to
receive a payment, in a simple capitated environment there is no direct financial
incentive for providers to accurately document the specific services received by patients
on each visit (typically referred to as an “encounter”). Data collection in a capitated
environment is thus sometimes inaccurate.
However, any systematic underreporting of utilization leads to an overestimation of the

effective reimbursement received per unit of care (the “fee for service equivalency”
calculated by dividing total capitated payments by the number of services delivered).
Underreporting therefore makes the provider organization appear to be achieving better
financial results than it actually is under a given contractual capitation arrangement. Data
that fails to capture all utilizaion will erroneously indicate that the capitation rate is
excessively high. This in turn may cause the health plan to seek lower capitation rates.
Providers will have no data to demonstrate that these lower rates would be inadequate.
While underreporting of encounters may at first appear to be in the health plan’s financial
interest, no one is well served for long if decisions are being made on the basis of flawed
data. Furthermore, most health plans retain claims payment responsibilities rather than
delegating those responsibilities to other parties. Health plan’s that retain claims
payment responsibilities also retain the responsibility to gather information from and
share results with providers.
To correct information-reporting problems, an effective information system must be in

place at the provider location. The system must capture data and regularly transmit it to
the health plan so that utilization and financial analyses are based on the most accurate
data available. In fact, some health plans make an incentive payment (e.g., an extra 1%
bonus on capitation payments) to providers who submit complete and timely encounter
data.
Variations and New Directions for Provider Reimbursement
Health plans are an evolving form of healthcare delivery and financing. Capitation, as a
financial reimbursement model that exerts a powerful influence on care delivery,
continues to evolve as well. Some examples of capitation variations and provider
reimbursement concepts are listed below. Most are still at the conceptual stage, while
some have been put into practice in at least a limited way.
These provider reimbursement concepts can be organized in the following categories:
• Payment arrangements affecting PCPs (PCP capitation with FFS for

preventive care, and reimbursement for the gatekeeper role)
• Payment arrangements affecting both PCPs and specialists (specialists
receive primary care capitation, capitation for specialists and FFS for PCPs,
and “Open Access” plans and reimbursement)
• Payment arrangements affecting specialists
We discuss each of these concepts in the following sections.
PCP Capitation with FFS for Preventive Care
To create a special incentive for PCPs to provide immunizations and other preventive
services, health plans may choose to pay physicians for these services on a discounted
fee-for-service basis, even if the PCPs are capitated for other services.
For example, the HEDIS reporting formats show plan performance on providing eye
exams for people with diabetes, flu shots for older adults, and childhood immunizations,
among other measures. Paying PCPs for providing these services on a discounted fee-
for-service basis encourages physicians to perform these services, which, in turn,
improves the quality of patient care. The claim generated enables the plan’s information
system to capture each service provided.
Reimbursement for the Gatekeeper Role
Primary care physician capitation payments theoretically cover the expected utilization of
members with the PCP receiving a discounted FFS-equivalent for each service.
However, there is an additional category of work involved in the PCP role—patient care
management. In response to physicians’ concerns that they were not being paid for this
role, some plans have designated part of the capitation payment to PCPs as a PMPM
payment for administrative tasks related to the gatekeeper role.
Specialists Receiving Primary Care Capitation
Individuals with chronic conditions are often treated predominantly by specialist

physicians who are experts in treating these conditions. In some of these situations,
quality of care is significantly improved by having specialists closely involved, monitoring
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these members and treating their conditions, even when the members require services
otherwise considered “primary care.”
However, a capitated health plan using a gatekeeper model typically requires these
individuals to see their PCP first for a referral to the specialist. A relatively large
percentage of complaints received by health plans that use gatekeeper models grow out
of these situations because these members are regular users of healthcare services,
and frequently both they and their doctors feel frustrated by the constraints of the
gatekeeper system. (These situations are less frequent for health plans that do not
capitate PCPs, and in “open access” plans that allow self-referral to specialists.)
One possibility is to make the specialist the PCP of record. In some cases, the
specialists managing these patients are, in fact, internists with a subspecialty–for
instance, endocrinology or cardiology. However, patients with chronic illnesses use
healthcare services more than the average member and so the typical capitation
payment would be far too low.
Another possibility is to allow the specialists acting as PCPs to self-refer for specialty
care. But this is almost always impossible in a gatekeeper model because most plans
make physicians choose at the outset whether to be listed as either a PCP or a
specialist, and nearly all plans prohibit self-referrals as a means of controlling
overutilization.
Some health plans have devised special arrangements by modifying health plan
contractual policies to accommodate these members and their special requirements.
These modifications include reimbursing providers who treat them through a discounted
fee-for-service arrangement, or using a capitation rate that reflects the physicians’ level
of contact and interaction with plan members who have chronic conditions.
Typically, PCPs are capitated in gatekeeper models, but the majority of specialists are
not. Some plans, however, are experimenting with reimbursement systems that pay
PCPs on a FFS basis and specialists through capitation contracts. 10
The reasoning behind the creation of this payment system is that specialty care is very
expensive relative to primary care, and therefore plans should encourage PCPs to
provide as many of the covered services as they can. By paying them on a FFS basis,
and capitating specialists, health plans can minimize their costs. Once capitated,
specialists need not get prior authorization to provide a given treatment. Thus they gain
a level of autonomy by assuming the risk for high utilization.
Open Access Plans and Capitation
Open access health plans are plans where members can self-refer to any network
specialist. This plan design makes it harder to accurately capitate PCPs because
members will self-refer to specialists for services otherwise included in PCP capitation
payments. PCPs will also be reluctant to accept a specialty care risk pool arrangement if
they do not control referrals.
This plan design lends itself to discounted fee-for-service reimbursement for PCPs, who
then have an incentive to treat conditions rather than encouraging members to see a
specialist. Specialists can be paid on a discounted FFS basis, or through capitation
arrangements.
Chapter 4B
Risk Transfer in Health Plans
Capitation and Plan Risk discussed capitation as a system that distributes risk among
the parties to a health plan provider reimbursement contract. This lesson explores the
management strategy of transferring risk. Health plans, employers with self-funded
plans, and providers with capitation or other risk-sharing reimbursement contracts all
face a number of risks in the course of playing their roles in managed healthcare. As we
mentioned in Risk Management in health plan1s, health plans and provider
organizations use various types of liability insurance to transfer a number of risks that
are not unique to health plans. For example, a health plan may purchase fire insurance
to protect its home office building. Our focus in this lesson, however, is on stop-loss
coverage, which is a widely used means of transferring risks specifically surrounding the
liabilities generated in health plan by utilization rates.
Transfer Approaches
Health plans use two basic means of transferring utilization risk and the risk of higher-
than-expected medical expense outcomes. The first, as we have discussed in previous
assignments, involves reimbursement arrangements with providers, including capitation
contracts and other payment systems that place providers “at risk” for utilization rates.
These payment systems
• require providers to share the risk of overutilization

• use financial rewards to motivate providers to manage the portion of that risk
over which they have control
The focus of this lesson is a second means of transferring risk: the use of insurance to
transfer the risk of higher-than-anticipated medical expenses. The insurance typically
used in this type of risk transfer includes various forms of stop-loss insurance and stop-
loss reinsurance. In the healthcare industry, the terms stop-loss reinsurance and stop-
loss insurance are often used interchangeably, and with respect to risk transfer, in many
ways they function the same. Traditionally, however, the insurance industry has
distinguished between reinsurance and insurance according to what type of entity is
purchasing the policy. According to this distinction, stop-loss reinsurance is a type of
insurance that an insurer purchases to transfer the risk of loss on medical expenses
above a certain amount, either for individual catastrophic cases, or for the total medical
expense liability incurred by a healthcare plan. Stop-loss insurance provides protection
on the same kind of losses, but to entities that are not licensed insurers, such as
physicians and hospitals with at-risk contracts, employers with self-funded healthcare
plans, and health plans that are not regulated by state insurance departments.
Under a stop-loss reinsurance contract, a health plan that is regulated as an insurer is

transferring risk from itself to a reinsurer. The reinsurer accepts this risk in exchange for
a premium that the health plan pays. An entity that is not licensed as an insurer, but that
is at risk for medical expense losses— for example, a physician group under capitation
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or an employer offering a self-funded healthcare plan to its employees—buys stop-loss

insurance, but not reinsurance. In a few jurisdictions, however, courts have held that the
stop-loss protection purchased by employers offering self-funded plans is reinsurance
rather than insurance, even though such employers are not licensed insurers. Because
the core function of both stop-loss reinsurance and stop-loss insurance is the same—the
transfer of risk in exchange for a payment—we will use the term stop-loss coverage in
cases that apply equally to insurance and reinsurance. In other words, stop-loss
coverage can be either in the form of insurance or reinsurance and can be purchased by
any of the parties who accept utilization risk in a health plan contract, including health
plans, providers, provider groups, hospitals, and employers or other groups with self-
funded plans. The entity that provides the stop-loss coverage is called the carrier.
Carriers include health plans, other insurers, and reinsurers.
Types of Stop-Loss Coverage
There are two general types of stop-loss coverage: specific stop-loss coverage and
aggregate stop-loss coverage. After describing these two types, we will examine some
important features of each.
Specific Stop-Loss Coverage
Specific stop-loss coverage is insurance or reinsurance that provides protection

against losses arising from individual cases in which medical expenses are
disproportionately large or catastrophic. This stop-loss coverage is the more commonly
written of the two stop-loss types. Specific stop-loss insurance can be used, for example,
to assure that the costs of treating the acute illnesses of one or two plan enrollees do not
wipe out all or a significant percentage of a provider’s capitation reimbursement or risk
pool allocation. Specific stop-loss coverage normally applies to each and every member
for whom the provider (or employer or health plan, as the case may be) is at risk. Thus,
specific stop-loss coverage is triggered on a case-by-case basis when an individual
member experiences serious illness or injury that requires expensive medical treatment.
If, on the other hand, higher-than-expected medical costs occur exclusively because the
plan experiences a large number of small claims, specific stop-loss coverage will not be
triggered.
Aggregate Stop-Loss Coverage
Aggregate stop-loss coverage is insurance or reinsurance that protects against losses

that occur when utilization rates among a covered population as a whole are significantly
higher than anticipated at the time that either the reimbursement rates or the premium
rates were established. For example, an employer offering a self-funded healthcare plan
would be protected under aggregate stop-loss insurance against losses associated with
an unexpectedly large number of its covered employees seeking medical treatment
during the same coverage period. In contrast to specific stop-loss coverage, aggregate
stop-loss is triggered when the total covered medical expenses generated by the plan
reach an agreed-upon level, rather than by individual high-cost cases.
Review Question
The Longview Hospital contracted with the Carlyle Health Plan to provide inpatient
services to Carlyle’s enrolled members. Carlyle provides Longview with a type of stop-
loss coverage that protects, on a claims incurred and paid basis, against losses arising
from significantly higher than anticipated utilization rates among Carlyle’s covered
population. The stop-loss coverage specifies an attachment point of 130% of Longview’s
projected $2,000,000 costs of treating Carlyle plan members and requires Longview to
pay 15% of any costs above the attachment point. In a given plan year, Longview
incurred covered costs totaling $3,000,000.
With regard to the type of stop-loss coverage provided to Longview by Carlyle and to
whether this coverage is classified as insurance or reinsurance, the risk transfer
approach used in this situation can be described as:
aggregate stop-loss reinsurance

aggregate stop-loss insurance
specific stop-loss reinsurance
specific stop-loss insurance
Incorrect. Stop-loss reinsurance is a type of insurance that insurers purchase.
Correct. Aggregate stop-loss insurance protects non insurance entities, like

physicians or hospitals from the losses that occur when utilization rates for a
covered population as a whole are significantly higher than expected
Incorrect. Specific stop-loss reinsurance protects the insurer from individual

cases where medical expenses are catastrophic
Incorrect. Specific stop-loss reinsurance protects the hospital or physician from

individual cases where medical expenses are catastrophic
Stop-Loss Attachment Points
An important feature of any stop-loss coverage is that coverage’s attachment point. The
attachment point is the loss amount that must occur before the stop-loss coverage
begins to cover any expenses. The higher the attachment point, the greater the risk
retained by the entity purchasing the stop-loss coverage, and the lower the cost of that
coverage, all other things being equal. In other words, the attachment point of a stop-
loss insurance or reinsurance agreement functions like a deductible.
The purchaser of the stop-loss coverage pays all expenses up to the attachment point.
For expenses in excess of the attachment point, the carrier of the stop-loss coverage is
at risk. However, a stop-loss agreement usually does not call for the carrier to reimburse
the purchaser for 100% of the costs above the attachment point. Instead, there is usually
a corridor of expense amounts for which the stop-loss coverage pays the purchaser a
certain percentage of the expenses.
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The exact percentage is negotiated by the carrier and the entity purchasing the stop-loss
coverage, based on the purchaser’s risk tolerance in relation to the cost of the stop-loss
coverage, the size of the corridor, the amount of the attachment point, and other
coverage variables. Beyond this corridor, the stop-loss coverage may reimburse the
purchaser at 100% of all additional expenses as a way of setting a maximum limit on the
exposure to loss for the purchaser.
Figure 4B-1 provides an example of stop-loss coverage structured in this way.
To understand why the stop-loss coverage in Figure 4B-1 contains a corridor for
amounts greater than the attachment point, notice that both the hospital and the health
plan benefit from the structure of this stop-loss coverage.
Stop-Loss Attachment Points
First, the hospital receives protection against the risk that one or two large-amount
claims will wipe out the hospital’s entire withhold pool.
Second, because the hospital and the health plan share the exposure to risk for the first
$75,000 of a patient’s treatment costs, the health plan is assured that the hospital is
motivated to expend some effort in delivering cost-efficient care for the first $75,000 of
the cost of any case, even though the hospital’s total exposure to loss is only $35,000.
Third, the hospital is motivated to notify the health plan of serious cases relatively early
and to work with the health plan in developing the best treatment option for the patient,
which enables the health plan to initiate case management techniques as quickly as
possible.
Fourth, the possibility of stop-loss coverage facilitates the use of contracts that place the
hospital at risk for overutilization. Placing the provider at risk is a key cost-control
element in many health plan strategies. The availability of stop-loss coverage allows the
hospital (or other providers) to share risk and utilization management without placing the
hospital in the position of assuming so much risk that its own solvency is in danger.
health plans purchase specific stop-loss coverage much more frequently than they
purchase aggregate stop-loss coverage because most stop-loss carriers require high
attachment points in aggregate stop-loss. Aggregate stop-loss essentially transfers
underwriting risk from the purchaser to the carrier.
As we noted in Risk Management in Health Plans, underwriting risk is the largest risk
health plans face. Providing aggregate stop-loss with a low attachment point to a health
plan would require that the stop-loss carrier accept most of the risk for the health plan’s
core business. This degree of risk would therefore require the carrier to charge a
premium that would be nearly as large as the premium the health plan charges to
provide the group healthcare coverage. Thus, in most cases, aggregate stop-loss for
health plans is either too expensive or has such a high attachment point that purchasing
such stop-loss is not practical.
Review Question
For the year in which Longview’s incurred covered costs were $3,000,000, the amount
for which Longview will be responsible is:
$2,000,000
$2,600,000
$2,660,000
$3,900,000
Incorrect. The formula is (Attachment Point + 15% of the amount over attachment.)
Incorrect. The formula is (Attachment Point + 15% of the amount over attachment
Correct. 130% of 200,000 is $260,000, and 15% of 40,000 (the amount over
attachment) is $6,000. 260,000 + 6000 + $266,000
Incorrect. The formula is (Attachment Point + 15% of the amount over attachment.)
Incurred Claims and Paid Claims in Stop-Loss Settlement
In addition to the specific and aggregate categories of stop-loss coverage, another

important distinction between stop-loss coverages is the manner in which claims are
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settled. The stop-loss contract may provide that claims are settled using a paid claims
method, or on an incurred claims method. Under the paid claims method, the stop-loss
carrier is obligated to make stop-loss payments based on when the stop-loss
policyholder—for example, a group employer—pays the claim for the enrolled member’s
medical expenses. Until the policyholder pays the claim, the stop-loss carrier is not liable
to the policyholder for that claim.
Under the incurred claims method, the stop-loss carrier is obligated to make payments
on the applicable claims as of the date the medical expense was incurred. Figure 4B-2
provides examples of both the paid claims and incurred claims methods of settlement.
The difference between paid claims and incurred claims administration is an important
issue for risk managers involved in stop-loss coverage to consider before the stop-loss
contract is signed. This issue is important because stop-loss contracts are written for
specific periods of time. At both the beginning and end of stop-loss contracts, some
claims will have been incurred but not paid. In the example described in Figure 4B-2, for
instance, if the term of the stop-loss contract ends on September 1, then in the absence
of any other agreement, the stop-loss carrier will be obligated to pay its share of the
expenses under the incurred claims method, but would not be obligated to pay under the
paid claims method. The reverse would be true if the stop-loss coverage begins to take
effect on September 1.
As much as 90% of all medical expenses are not paid in the same month in which they
occur, however. The process of the treatment itself, the time it takes the provider to bill
the plan and for the plan to process the provider’s bill combine to cause most payment
dates to follow treatments by more than 30 days.
For this reason, some expenses will be incurred before the stop-loss contract year
begins but paid after the contract year begins, and some expenses will be incurred
before the contract year ends but not paid until after the contract year ends. Thus, the
parties involved in stop-loss coverage must make certain that the coverage matches not
only the level of risk that the entity seeking the coverage can tolerate, but also that the
timing of the coverage is appropriate to the needs of the parties.
A stop-loss contract can be written to cover any number of variables having to do with
the contract period, when claims are incurred, and when claims are paid. Variation in
contracts can include the following types of clauses (the "claims" listed below are
assumed to have met the appropriate aggregate or specific attachment points):
• Claims paid
• Claims will be covered if paid during the contract year, no matter when the
expenses were incurred.
• Claims incurred and paid
• Claims that are both incurred and paid during the contract year will be covered.
• Claims incurred and paid with run-in
• Claims that are paid within the contract year are covered, as long as they were
incurred either in the contract year or within the run-in period. A run-in period is a
set number of months or days before the contract year of a stop-loss contract
begins. For example, suppose the contract year begins October 1, 1999, and has
a 60-day run-in period. A claim that was incurred on August 10, 1999, and was
paid on October 10 would be covered, because August 10 falls within the 60-day
run-in period.
• Claims incurred in contract year and paid within contract year plus X days
Claims are paid if they both (1) occur within the contract year and (2) are paid
within a specific number of days after the contract year ends. This form of
agreement allows the purchaser of the stop-loss coverage time to process claims
incurred in the last few months of the contract year.
In stop-loss agreements, the carrier is seldom responsible for paying the purchaser
before the purchaser pays the medical expenses. One reason stop-loss contracts are
structured this way is that not all of the medical expenses are necessarily covered by the
health plan; therefore the carrier’s liability is based on the medical expense payments
the stop-loss purchaser actually makes.
Review Question
Carlyle most likely is responsible for paying Longview for the claims incurred before
Longview has actually paid the medical expenses.
True
False
Incorrect. In stop-loss agreements the carrier is seldom responsible for paying the
purchaser before the purchaser pays the medical expenses
Correct!
Health Plans as Suppliers of Stop-Loss Coverage
Health plans are both suppliers and purchasers of stop-loss coverage. A health plan
may purchase stop-loss coverage to limit its own exposure to large losses, but it may
also supply stop-loss coverage to at-risk providers with whom it has reimbursement
agreements or to groups with self-funded healthcare plans. For example, a health plan
that capitates a provider group almost always provides or offers to provide stop-loss
coverage to that provider group.
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The reason that such protection is attractive to both health plans and providers has to do
with the law of large numbers. Recall that the larger the number of enrollees a health
plan has, the closer the average medical expense of those enrollees will be to the
average experience of the general population, assuming that the plan has attracted
enrollees of average health.
This means, for example, that actuaries can predict with reasonable accuracy
approximately how many enrollees in a large group plan will experience illnesses or
injuries that result in extremely large medical expense costs. Even if actuaries accurately
predict the number of large cases that will occur over a period of time, however, it is
impossible to tell in advance which specific enrollees will become ill, and therefore
impossible to tell which of the capitated providers will have to bear the expense of
treating these seriously ill enrollees.
Suppose, for example, the expected experience of the employer group includes two
cases of high-cost treatments. The premiums for that group can be designed so that the
health plan is compensated for the risk of assuming these expensive cases. If the plan
signs full professional capitation contracts with 10 provider organizations, these
capitation rates reflect the average degree of risk assumed by the provider organization
for each enrolled member who signs up with that organization. However, neither the
providers nor the health plan knows which of the 10 provider organizations will have to
treat the two enrollees who will become seriously ill.
This element of chance is obviously a problem for the providers, because the treatment
costs of these patients could be higher than the reimbursement any one individual
provider group receives under the capitation contract. Assuming two provider groups
treat these two high-cost patients, the contract would be financially disastrous for 2 out
of the 10 provider groups unless these groups are able to secure some form of
protection.
In the absence of stop-loss protection, such a capitation contract is much less desirable
for the providers, because none of the 10 provider groups can tell ahead of time whether
it will be responsible for a very expensive medical treatment.
If stop-loss coverage were not available to at-risk providers, health plans would also face
disadvantages. First, as we have just seen, convincing providers to sign a capitation
contract would be difficult. Second, if the risk for the large cases is factored into the
capitation rate for all the provider groups, then two of the groups are disastrously
undercompensated, while eight are slightly overcompensated. In other words, the
reimbursement for the risk is spread out, but the risk itself is concentrated, resulting in an
inefficient reimbursement system.
Health plans use two means of providing stop-loss protection to at-risk providers. One
method is to offer, in exchange for a premium, stop-loss coverage in the form of a
separate insurance contract along the lines we have already discussed.
The second method of supplying at-risk providers with protection against large losses is
to structure capitation and other risk agreements in such a way that providers share only
a small amount of the risk of catastrophically large losses. This second method, which is
quite commonly used, is not an insurance contract. With this type of stop-loss protection,
each provider is at risk according to the capitation contract, but once a case or course of
treatment reaches a specified level of expense, the reimbursement method limits the
provider’s risk. For example, on a case that reaches the specified expense level, the
provider may be reimbursed for further treatment according to a discounted FFS
schedule. The discounted FFS payments cover the provider’s expenses in treating the
case, and thus eliminate much of the risk to the provider of large losses on individual
catastrophic cases.
Technically, this type of contractual arrangement is neither insurance nor reinsurance,

although its practical effect is to supply the providers with stop-loss protection. This
protection is not technically insurance because the health plan is retaining the risk of
catastrophic cases. In other words, because the capitation contract does not transfer the
catastrophic risk to the providers in the first place, they do not have to seek insurance to
transfer that risk back to the health plan or an insurer.
Typically, the provider remains responsible for some share of the loss on large-amount
cases. This share of the risk remains within the limit that the provider is willing and able
to accept, but just as coinsurance motivates an enrollee to avoid seeking unnecessary
care, a share of the risk in large-amount cases motivates the provider to control costs in
those cases.
In our discussion of provider reimbursement methods, we stressed the importance of

capitation as a means of transferring some of the risk of overutilization from the health
plan to the provider in order to motivate the provider to supply cost-effective care. If a
capitation contract transfers risk from a health plan to the provider, you may wonder why
the health plan is willing to retain the risk of very expensive cases, or offer to transfer
some of that risk back from the provider to the health plan.
The answer is that the risks being transferred by capitation and those being transferred
by stop-loss coverage are different types of risk. The main goal for a health plan in
seeking a capitation agreement from a provider is to motivate the provider to supply the
most cost-effective care by managing the utilization variables over which the provider
exercises at least some control.
Stop-loss insurance, however, transfers the risk that a given provider will have to treat
an enrollee who suffers a serious illness or injury and whose treatment costs under the
most efficient care are still too high for that provider to absorb. The provider has no
control over whether or not an enrollee contracts such an illness, no matter what
reimbursement system the health plan uses. Thus, a provider without stop-loss coverage
may provide excellent treatment while efficiently controlling costs and still suffer ruinous
losses if one or two patients develop catastrophic illnesses.
As we mentioned earlier in this lesson, stop-loss agreements also can be structured to

motivate providers to inform the health plan soon after a serious illness is diagnosed,
which allows the health plan to engage in large-case management as soon as possible.
Providers with capitation contracts do not always purchase stop-loss coverage from the
health plan offering the contract. Provider groups and hospitals in particular may shop
for the least expensive stop-loss coverage. Large groups with self-funded healthcare
plans also explore the stop-loss market, often with the help of a broker or agent. In doing
- 127 -
so, both the providers and self-funded groups must have an accurate assessment of the
liability that the healthcare plan exposes them to, and their own ability to retain risk.
A health plan that retains a large-amount risk through stop-loss provisions in a provider
reimbursement contract can expect to incur larger costs in the long run, either because
the health plan will have to pay large-amount claims itself or because the health plan will
have to purchase stop-loss coverage to protect itself against the risk of those costs.
Typically, capitation contracts in which the health plan offers a provider stop-loss
coverage or non-insurance stop-loss protection will offer capitation rates that are lower
than those offered by contracts in which the health plan transfers to the provider the risk
of large losses.
Health plans purchase stop-loss coverage as a means of adjusting the amount of risk
the organization retains. For a health plan, decisions concerning how to deal with risks
associated with its core business involve an assessment of opportunity costs. Risk
retention and risk transfer both have benefits and drawbacks. The health plan must
assess the benefits and drawbacks of these choices given the specifics of the risk
involved.
The central benefit of retaining utilization risk for a health plan is the possibility that the
payments, such as premiums, that the health plan receives for assuming the risk will be
greater than the actual cost of the risk.
However, as we pointed out in our solvency discussion in Risk Management in Health

Plans, by assuming risk a health plan assumes potential liabilities. The decision to retain
risks carries with it the cost of making assets available to cover losses. As long as these
assets are held in liquid investments, they cannot be used for long-term investments in
many kinds of business opportunities, such as expanding into new markets or
developing new products; nor, in the case of for-profit health plans, can they be
distributed to stockholders as earnings.
Transferring risk through stop-loss insurance or reinsurance reduces the health plan’s
risk, particularly pricing or underwriting risk, and thereby reduces the health plan’s need
for liquid assets in support of these risks. Typically, solvency requirements set by the
RBC formula are higher than those set by the HMO Model Act. Consequently, for health
plans that find themselves subject to new RBC requirements as a result of a state’s
adoption of RBC solvency requirements, purchasing stop-loss coverage can reduce the
need to raise money in order to increase the health plan’s net worth. The influence of
stop-loss coverage on a health plan’s underwriting risk is limited compared to the
influence of the health plan’s provider reimbursement contracts. Nevertheless, stop-loss
does marginally reduce the health plan’s underwriting risk.
An added benefit of stop-loss coverage as a means of reducing risk is that stop-loss

contracts can offer the health plan a more flexible means of dealing with risk than many
alternatives. The stop-loss contract can adjust for the amount of risk transferred, the
period of time that the risk is transferred, as well as the conditions under which it is
transferred.
Stop-loss coverage itself carries costs, however. Like any insurer or reinsurer, a stop-
loss carrier must not only set premiums at a rate high enough to cover the insured
losses, but must also include in the premium an amount sufficient to administer the
insurance and provide a return on investment. The health plan will also experience its
own administrative costs in securing stop-loss coverage and making claims under that
coverage. Furthermore, because stop-loss carriers are at risk based on the health plan’s
underwriting and actuarial practices, the carrier may wish to review those practices
before issuing stop-loss protection.
The cost of a stop-loss contract varies depending on a number of factors. Costs will vary
according to the type of stop-loss (specific or aggregate), the number of persons
covered by the stop-loss contract, the types of losses that are covered, the predicted
rate at which the plan’s population of enrollees will experience catastrophic illnesses or
injuries, and the stop-loss coverage’s attachment point, among other elements.
Finally, although purchasing stop-loss coverage reduces a health plan’s underwriting

risk, the same stop-loss coverage will increase the health plan’s affiliate risk. Recall that
affiliate risk is the risk that the financial condition of an affiliated entity (in this case, the
stop-loss carrier) will cause an adverse change in capital (in this case, the health plan1’s
capital). Although the decrease in underwriting risk is always greater than the increase in
affiliate risk, the increasing affiliate risk is part of the cost of securing stop-loss coverage.
The greater the financial strength of the stop-loss carrier, the lower the health plan’s
affiliate risk.
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Chapter 5 A
Health Plan Funding
• Distinguish between fully funded and self funded health plans

• Identify and describe the two main types of self funded health plans
In the context of this course, health plan funding refers to the process of determining
the source of payment for services rendered by a health plan to its plan members.
Typically, the entity that is financially responsible, in part or in full, for funding the cost of
healthcare benefits is (1) an employer or another group plan sponsor such as a
government agency or (2) an insurance company or health plan.
Often the group plan sponsor is referred to as the primary payor and the insurer or HMO,
for example, is referred to as a third party payor. Three typical options for health plan
funding are fully funded plans, self-funded plans, and alternative funding arrangements,
also called modified self-funded plans or partially self-funded plans.
Fully Funded Plans
A fully funded plan, also called a fully insured plan, is a form of group insurance in
which an insurer or a specific type of health plan, rather than an employer or other group
plan sponsor, is licensed to assume the financial responsibility for healthcare services
rendered to or for health plan members. In other words, in a fully funded plan, a group
2
plan sponsor pays a premium to a health plan and the health plan assumes the risk that
the premiums will not be enough to cover the costs of services rendered to health plan
members.
Recall from Healthcare Management: An Introduction that a premium is a payment or

series of payments made to a health plan or insurance company by purchasers, and
often plan members, for healthcare benefits. Premiums are required by a health plan to
establish and maintain the plan in force. Typically, fully funded health plans require group
plan sponsors to prepay monthly premiums for healthcare services. In Pricing and Rating
lesson, it discusses how an insurer or health plan establishes premiums for its products
Fast Definition
A plam sponsor is an entity that establishes and maintains a healthcare benefit plan. The
plan sponsor is often an employer, but it may be a union, a trade or professional
association, or a committee composed of representatives of a number of employers or
associations.1
Indemnity plans, Blue Cross and Blue Shield plans, HMOs, PPOs, and POS options may
be fully funded health plans. Health plans either (1) bear all plan risks or (2) share these
risks with employers or other group plan sponsors. Figure 5A-1 provides a brief review of
traditional indemnity plans and Blue Cross and Blue Shield plans.
Under a fully funded health plan, upon acceptance of a premium, a commercial

insurance company, Blue Cross or Blue Shield organization, or HMO, for example, bears
the entire financial risk of paying for all claims for services provided as well as the
administrative expenses associated with health plan operations. Therefore, if the dollar
amount of services rendered to group plan members exceeds the dollar amount of
premiums collected, the insurer must make up the difference. On the other hand, if
group plan members incur a lower dollar amount of healthcare services than the dollar
amount of premiums collected, then the insurer may earn a larger profit on the health
plan.
Most health plans, including indemnity plans, incorporate the use of some health plan
techniques in the financing and delivery of healthcare services. Indemnity carriers have
offered various alternate funding arrangements for a long time, although, in many states,
HMOs are prohibited from offering alternate funding arrangements. Even in those states
that allow HMOs to offer alternate funding, most HMOs still enter into fully funded
arrangements.
A fully funded plan is the traditional funding arrangement for a group health insurance
plan. The insurer usually issues the group health policy on a 12-month, renewable basis.
The monthly premium is typically guaranteed for 12 months and provides coverage for
that period. With proper notification to the group plan sponsor, the insurer may increase
the premium for the next 12-month period. In recent years, multiyear premium rate
guarantees have become more common.
To prevent insurers from setting inadequate premium rates, some states require that the
state insurance department approve all first-year premiums charged by insurers.
States that have this requirement attempt to protect the insurer from insolvency and plan
members from losing coverage because of insurer insolvency.
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Fast Definition
Insolvency is the inability of a health plan or insurer to meet its financial obligations on
time. 6
Depending on the size of the group and the state laws that apply to the group, the
insurer may establish new premium rates for the group at the end of the initial 12-month
period. New premium rates may be determined in part by the sex and attained ages of
group plan members, the location of the group, and the group’s industry classification,
for example. For large groups, the rates may also be determined on the basis of the
group’s experience.
Insurers and employers have developed a variety of alternatives to this traditional

arrangement of paying premiums in advance to fund a group health plan. These
alternative funding arrangements modify the manner in which premiums are paid, thus
enabling employers to reduce the total cost of providing a health plan to their employees. 8
We discuss these alternative funding methods in Alternative Funding Methods
Fast Definition
Attained age is the current age of a plan member. 7
Self-Funded Plans 9
A self funded plan, also called a self insured plan, is a form of group health coverage in
which a group plan sponsor—typically a large employer—rather than a health plan or
insurer, is financially responsible for the costs of healthcare services rendered to or for
plan members. A self funded plan may be completely or partially self funded. For
10
example, in a partially self funded plan, an employer may purchase stop loss insurance
to transfer part of the financial risks that the employer has assumed.
Many employers take an active role in providing healthcare benefits by choosing to self
fund, either partially or completely, the medical expense coverage they provide for their
employees. As a result, these employers bear some or all of the risk of paying for the
costs of healthcare services, including the risk that these costs may exceed
expectations.
Self funding may help employers and other group plan sponsors to manage increasing
healthcare costs. In a typical fully funded plan, the health plan or insurer sets premiums
that are adequate to:
• Pay the costs associated with healthcare services rendered to plan members
• Cover administrative and selling expenses, including administrator fees and
broker or agent commissions
• Provide some profit for the health plan or insurer
Under a self funded plan with separate stop loss insurance coverage or a partially self
funded health plan, the employer typically is financially responsible for paying a certain
level of healthcare services. The risk for incurring costs above a specified level can be
transferred to a traditional health insurance provider. For example, an employer could
self fund the health plan’s first $50,000 of a plan member’s healthcare expenses and
purchase supplemental medical insurance coverage from an insurer to cover healthcare
expenses that exceed $50,000.
By self funding, an employer may avoid some of these costs, such as broker or agent
commissions, that are included in the premiums for fully funded plans. Another
advantage to self funding is improved cash flow for the employer, because the employer
initially retains the money it would have paid in premiums. Instead, the employer pays for
healthcare expenses as they occur. As a result, the employer can earn interest on that
money. However, a potential disadvantage is that the employer may experience severe
cash flow problems resulting from unexpectedly high costs for healthcare services
rendered to plan members.
Self funded plans are exempt from state laws and regulations that apply to health
insurance policies. Therefore, employers that establish a self funded health plan may
have more freedom with respect to state-mandated coverage requirements and may
avoid premium taxes.
However, most self funded plans are subject to the federal Employee Retirement Income
Security Act (ERISA), because employee benefits that are subject to ERISA include
medical, surgical, and hospital care benefits. Funding requirements under ERISA
mandate that health plans develop written policies regarding the plan’s funding sources,
procedures for carrying out these policies, and specified funding methods used to
support the plan’s goals. Further, self funded health plans must comply with ERISA
requirements concerning the limits on benefit discrimination for classes of employees.
When an employer self funds a health plan, the money that the employer and employees
normally would have paid in premiums to a health plan or insurer is deposited into an
account until the money is used to pay healthcare expenses. The account into which the
employer deposits the money is called the funding vehicle. The type of funding vehicle
determines the type of self funded health plan. Two common types of self funded plans
are general asset plans and trusteed plans.
Review Question
The following statements are about the option for health plan funding known as a self-
funded plan. Select the answer choice containing the correct response:
In a self-funded plan, an employer is relieved of all risk associated with paying for
the healthcare costs of its employees.
Self-funded plans are subject to the same state laws and regulations that apply to
health insurance policies.
Employers electing to self-fund a health plan are required to pay claims from a
separate trust established for that purpose.
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An employer electing to self-fund a health plan has the option of purchasing stop-
loss insurance to transfer part of the financial risk to an insurer.
Incorrect. The employer bears some or all of the risk.
Incorrect. Self-funded plans are expempt form state laws and regulations that
apply to health insurance plan policies
Incorrect. There are two types of funding vehicles for self-funded plans, a trusteed
plan (separate trust) or a general asset plan, paying for healthcare expenses from
the employers current operating funds.
Correct. An employer electing to self-fund a health plan does have the option of
purchasing stop-loss insurance to transfer part of the financial risk to an insurer -
becoming partially self-funded.
General Asset Plan
A general asset plan, also called a non-trusteed plan, is a type of self funded health
plan under which the employer pays covered healthcare expenses from its current
operating funds, rather than from a trust fund established for this specific purpose. In a
11
general asset plan, the employer usually deposits money into a commercial checking
account or similar account.
The premiums and other funds set aside for the health plan are not considered separate
from the employer’s current assets or operating funds, from which the employer pays all
healthcare expenses. Therefore, in the meantime, the employer has the use of this
money until it is needed to pay for healthcare services. One disadvantage of a general
asset plan is that these funds are subject to the claims of the employer’s creditors, so
the funds may not be available when needed.
Trusteed Plans
Trusteed plans are another type of self funded group health plan. A trusteed plan is a
type of self funded plan under which covered healthcare expenses are paid from a trust
established by the employer or other group sponsor. Under a trusteed plan, the
12
employer deposits into a trust funds set aside for the health plan. The trustee, not the
employer, has the duty of managing the trust property for the benefit of employees and
their dependents who are covered by the health plan. Unlike funds deposited in a
general asset plan, funds placed in a trusteed plan are not subject to the claims of the
employer’s creditors. Other advantages of establishing a trusteed plan include the
preferred tax treatment available to trusteed plans.
Figure 5A-2 lists three common trusts that an employer may establish to fund a health
plan. We discuss the 501(c)(9) (VEBA) trust in detail in Alternative Funding Methods.
- 135 -
Chapter 5 B
Alternative Funding Methods
• Distinguish between a contributory plan and a noncontributory plan

• Describe the individual components of a premium, including the interest
charge, the risk charge, and the retention charge
• List the key characteristics of premium delay arrangements, reserve-
reduction arrangements, minimum-premium plans, retrospective-rating
arrangements, and administrative-services-only arrangements
Alternative Funding Methods

This lesson consists of excerpts from a chapter on alternative funding methods, which
are also referred to as alternate funding arrangements. Note that this excerpt looks at
alternate funding arrangements from the perspective of the employer. For example, the
discussion of cost savings and improved cash flow is from an employer’s perspective,
rather than that of a health plan. However, the underlying definitions and concepts
remain valid for health plans.
Generally, whenever this lesson discusses an insurance company or insurer, the

statement also applies to health plans, which are sometimes referred to as medical
expense plans. Also, keep in mind that the term claims in the context of health plans
refers to medical expenses or expenses for healthcare services provided to or for plan
members. Figure 5B-1 is a list of the definitions of several key terms that are not defined
in the lesson itself.
The methods of alternative funding can be divided into two general categories: those
that primarily modify traditional fully insured group insurance contracts and those that
have some self funding (either partial or total). The first category includes:
• Premium-delay arrangements
• Reserve-reduction arrangements
• Minimum-premium plans
• Retrospective-rating arrangements
These alternative funding methods are regarded as modifications of traditional fully

insured plans because the insurance company has the ultimate responsibility for paying
all benefits promised under the contract. Most insurance companies will allow only large
employers to use these modifications. Although practices differ among insurance
companies, generally a group insurance plan must generate between $150,000 and
$250,000 in claims before these funding methods will be available to the employer.
The second category of alternative funding methods includes
• Total self-funding from current revenue and self-administration
- 137 -
• Self-funding with administrative-services-only arrangements

• Funding through a 501(c)(9) trust
In contrast to the first category of alternative funding methods, some of these

alternatives can be used by small employers.
Review Question
With regard to alternative funding arrangements, the part of a health plan premium that
is intended to contribute to the claims reserve that a health plan maintains to pay for
unusually high utilization is known as the:
interest charge
retention charge
risk charge
surplus
Incorrect. An interest charge is, in a premium-delay arrangement, the part of the

premium that affects the amount of interest lost to the health plan.
Incorrect. Retention charge is the part of a premium that is intended to cover

expenses (other than medical) and allow the health plan to make a profit
Correct!
Incorrect. A surplus is the amount which a health plan’s assets exceed its
liabilities and capital.
Premium-Delay Arrangements
Premium-delay arrangements allow the employer to defer payment of monthly

premiums for some time beyond the usual 30-day grace period. In fact, these
arrangements lengthen the grace period, most commonly to 60 or 90 days. The practical
effect of premium-delay arrangements is that they enable the employer to have
continuous use of the portion of the annual premium for other purposes.
For example, a 90-day premium delay allows the employer to use three months (or 25%)
of the annual premium for other purposes. This amount roughly corresponds to what is
usually in the claims reserve for medical expense coverage. Generally the larger this
reserve is on a percentage basis, the longer the premium payment can be delayed.
Because the insurance company still has a statutory obligation to maintain the claims
reserve, it must use other assets besides the employer’s premiums for this purpose. In
most cases, these assets come from the insurance company’s surplus.
Premium-Delay Arrangements
A premium-delay arrangement has a financial advantage to the extent that an employer

can earn a higher return by investing the delayed premiums than by accruing interest on
the claims reserve. In actual practice, interest is still credited to the reserve, but this
credit is offset by either an interest charge on the delayed premiums or an increase in
the insurance company’s retention charge.
Upon termination of an insurance contract with a premium delay arrangement, the

employer is responsible for paying any deferred premiums. However, the insurance
company is legally responsible for paying all claims incurred prior to termination, even if
the employer fails to pay the deferred premiums. Consequently, most insurance
companies are concerned about the employer’s financial position and credit rating.
For many insurance companies, the final decision of whether to enter into a premium-
delay arrangement, or any other alternative funding arrangement that leaves funds in the
hands of the employer, is made by the insurer’s financial experts after a thorough
analysis of the employer. In some cases, this may mean that the employer will be
required to submit a letter of credit or some other form of security.
Reserve-Reduction Arrangements
A reserve-reduction arrangement is similar to a premium-delay arrangement. Under the

usual reserve-reduction arrangement, the employer is allowed (at any given time) to
retain an amount of the annual premium that is equal to the claims reserve. Generally
such an arrangement is allowed only after the contract’s first year, when the pattern of
claims and the appropriate amount of the claims reserve can be more accurately
estimated.
In succeeding years, if the contract is renewed, the amount retained will be adjusted
according to changes in the size of the reserve. As with a premium-delay arrangement,
the monies retained by the employer must be paid to the insurance company upon
termination of the contract. Again, the advantage of this approach lies in the employer’s
ability to earn more on these funds than it would earn under the traditional insurance
arrangement.
Minimum-Premium Plans
Minimum-premium plans were designed primarily to reduce state premium taxes.

However, many minimum-premium plans also improve the employer’s cash flow. Under
the typical minimum-premium plan, the employer assumes the financial responsibility
for paying claims up to a specified level, usually from 80% to 95% of estimated claims.
The specified level may be determined on either a monthly or an annual basis. The
funds necessary to pay these claims are deposited into a bank account that belongs to
the employer.
However, the actual payment of claims is made from this account by the insurance
company, which acts as an agent of the employer. When claims exceed the specified
level, the balance is paid from the insurance company’s own funds. No premium tax is
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levied by the states on the amounts the employer deposits into such an account, as it
would have been if these deposits had been paid directly to the insurance company. In
effect, for premium-tax purposes, the insurance company is only considered to be the
administrator of these funds and not a provider of insurance.
Under a minimum-premium plan, the employer pays a substantially reduced premium,

subject to premium taxation, to the insurance company for administering the entire plan
and for bearing the cost of claims above the specified level. Because such a plan may
be slightly more burdensome for an insurance company to administer than would a
traditional group arrangement, the retention charge may also be slightly higher. Under a
minimum-premium arrangement, the insurance company is ultimately responsible for
seeing that all claims are paid, and it must maintain the same reserves that would have
been required if the plan had been funded under a traditional group insurance
arrangement. Consequently, the premium will include a charge for the establishment of
these reserves, unless some type of reserve-reduction arrangement has also been
negotiated.
Some insurance regulatory officials view the minimum-premium plan primarily as a

loophole used by employers to avoid paying premium taxes. In several states, there
have been attempts to seek court rulings or legislation that would require premium taxes
to be paid either on the funds deposited in the bank account or on claims paid from
these funds. Most of these attempts have been unsuccessful, but court rulings in
California require the employer to pay premium taxes on the funds deposited into the
bank account. If similar attempts are successful in the future, the main advantage of
minimum-premium plans will be lost.
Review Question
The Rathbone Company has contracted with the Jarvin Insurance Company to provide
healthcare benefits to its employees. Under this contract, Rathbone assumes financial
responsibility for paying 80% of its estimated annual claims and for depositing the funds
necessary to pay these claims into a bank account. Although Rathbone owns the bank
account, Jarvin, acting as Rathbone’s agent, makes the actual claims payments from
this account. Claims in excess of Rathbone’s contracted percentage are paid by Jarvin.
Rathbone pays to Jarvin a premium for administering the entire plan and bearing the
costs of claims in excess of Rathbone’s obligation. This premium is substantially lower
than would be charged if Jarvin were providing healthcare coverage under a traditional
fully insured group plan. Jarvin is required to pay premium taxes only on the premiums it
receives from Rathbone. This information indicates that the type of alternative funding
method used by Rathbone is known as a:
premium-delay arrangement
reserve-reduction arrangement
minimum-premium plan
retrospective-rating arrangement
Incorrect. A premium-delay arrangement allows the employer to defer payment of
monthly premiums for some time beyond the typical 30-day grace period
Incorrect. Under the usual reserve reduction agreement the employer is allowed to
retain the amount of annual premium that is equal to the claims reserve
Correct. Under a typical minimum-premium plan the employer assumes the

financial responsibility for paying claims up to a specified level.
Incorrect. Under retrospective-rating arrangements the insurance company

charges the employer an initial premium that is less than what would be justified
by the expected claim for the year.
Retrospective-Rating Arrangements
Under retrospective-rating arrangements, the insurance company charges the

employer an initial premium that is less than what would be justified by the expected
claims for the year. In general, this reduction will be between 5% and 10% of the
premium for a traditional group insurance arrangement. However, if claims plus the
insurance company’s retention charge exceed the initial premium, the employer will be
called upon to pay an additional amount at the end of the policy year. Because an
employer will usually have to pay this additional premium, one advantage of a
retrospective-rating arrangement is the employer’s ability to use these funds during the
year.
This potential additional premium is subject to a maximum amount based on some

percentage of expected claims. For example, assume that a retrospective-rating
arrangement bases the initial premium on the presumption that claims will be 93% of
those actually expected for the year. If claims in fact are below this level, the employer
will receive an experience refund (discussed in Rating and Underwriting). If they exceed
93%, the retrospective-rating arrangement will be “triggered,” and the employer will have
to reimburse the insurance company for any additional claims paid, up to some
percentage of those expected, such as 112%. The insurance company bears claims in
excess of 112%, so some of the risk associated with claims fluctuations is passed on to
the employer
This will reduce both the insurance company’s risk charge and any reserve for claims
fluctuations. The amount of these reductions will depend on the actual percentage
specified in the contract, above which the insurance company will be responsible for
claims. This percentage and the one that triggers the retrospective-rating arrangement
are subject to negotiations between the insurance company and the employer. In
general, the lower the percentage that triggers the retrospective arrangement is, the
higher will be the percentage above which the insurance company is fully responsible for
claims. In addition, the better the cash-flow advantage the employer has, the greater will
be the risk of claims fluctuations. In all other respects, a retrospective-rating
arrangement is identical to the traditional group insurance contract.
Total Self-Funding and Self-Administration
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The purest form of a self funded benefit plan is one in which the employer pays benefits
from current revenue (rather than from a trust), administers all aspects of the plan, and
bears the risk that actual benefit payments will exceed expected benefit payments. In
addition to eliminating state premium taxes, avoiding state-mandated benefits, and
improving cash flow, the employer has the potential to reduce its operating expenses to
the extent that the plan can be administered at a lower cost than the insurance
company’s retention charge (other than premium taxes). A decision to use this kind of
self-funding is generally considered most desirable when all the following conditions are
present:
• Predictable claims.
• A noncontributory plan.
• A nonunion situation.
• The ability to effectively and efficiently handle claims.
• The ability to provide other administrative services.
• The ability to obtain discounts from medical care providers if medical
expense benefits are self-funded.
Predictable claims.
Budgeting is an integral part of the operation of any organization, and it is necessary to

budget for benefit payments that will have to be paid in the future. This can best be done
when a specific type of benefit plan has a claim pattern that is either stable or shows a
steady trend. Such a pattern is most likely to occur in those types of benefit plans that
have a relatively high frequency of low severity claims. Although a self-funded plan may
still be appropriate when the level of future benefit payments is difficult to predict, the
plan will generally be designed to include stop loss coverage (discussed in Capitation and
Plan Risk).
A noncontributory plan.
Several difficulties arise if a self-funded benefit plan is contributory. Some employees

may resent paying “their” money to the employer for benefits that are contingent on the
firm’s future financial ability to pay claims. If claims are denied, employees under a
contributory plan are more likely to be bitter toward the employer than they would be if
the benefit plan were noncontributory. Finally, the Employee Retirement Income Security
Act (ERISA), which is discussed in Rating and Underwriting, requires that a trust must
be established to hold the employees’ contributions until the plan uses the funds. Both the
establishment and maintenance of the trust will result in increased administrative costs to
the employer.
A nonunion situation.
Self-funding of benefits for union employees may not be feasible if a firm is subject to
collective bargaining. Self-funding (at least by the employer) clearly cannot be used if
benefits are provided through a negotiated trusteeship. Even when collective bargaining
results in benefits being provided through an individual employer plan, unions often
insist that benefits be insured in order to guarantee that union members will actually
receive them. An employer’s decision about whether to use self-funding is most likely
motivated by the potential to save money. When unions approve of self-funding, they
also frequently insist that some of these savings be passed on to union members through
additional or increased benefits.
The ability to effectively and efficiently handle claims.
One reason that many employers do not use totally self-funded and self-administered
benefit plans is the difficulty in handling claims as efficiently and effectively as an
insurance company or other benefit-plan administrator would handle them. Unless an
employer is extremely large, only one person or a few persons will be needed to handle
claims. Who in the organization can properly train and supervise these people? Can they
be replaced if they should leave? Will anyone have the expertise to properly handle the
unusual or complex claims that might occur? Many employers want some insulation from
their employees in the handling of claims. If employees are unhappy with claim payments
under a self-administered plan, dissatisfaction (and possibly legal actions) will be
directed toward the employer rather than toward the insurance company. The employer’s
inability to handle claims, or its lack of interest in wanting to handle them, does not
completely rule out the use of self-funding. As will be discussed later, employers can
have claims handled by another party through an administrative-services-only contract.
The ability to provide other administrative services.
In addition to claims, the employer must determine whether the other administrative
services normally included in an insured arrangement can be provided in a cost-effective
manner. These services are associated with plan design, actuarial calculations, statistical
reports, communication with employees, compliance with government regulations, and
the preparation of government reports. Many of these costs are relatively fixed, regardless
of the size of the employer; unless the employer can spread them out over a large number
of employees, self-administration will not be economically feasible. As with claims
administration, an employer can purchase needed services from other sources.
The ability to obtain discounts from medical care providers if medical expense
benefits are self-funded.
In order to obtain much of the cost savings associated with health plans, the employer
must be able to secure discounts from the providers of medical care. Large employers
whose employees live in a relatively concentrated geographic region may be able to enter
into contracts with local providers. Other employers may use the services of third party
administrators who have either established or entered into contracts with preferred
provider networks. Recall from Healthcare Management: An Introduction that a third
party administrator (TPA) is a company that provides administrative services to health
plans or self-funded health plans.
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Total Self-funding and Self-administration
The extent of total self-funding and self-administration differs significantly among the
different types of group benefit plans. The larger the employer is, the more likely that its
medical expense plan will be self funded. The major problem with a self funded medical
expanse plan is not the prediction of claims frequency but rather the prediction of the
average severity of claims. Although infrequent, claims of $300,000 to $500,000 or more
do occasionally occur. Most small and medium-size employers are unwilling to assume
the risk that they might have to pay such a large claim.
Only employers with several thousand employees are large enough to anticipate that
such claims will regularly occur and to have the resources that will be necessary to pay
any unexpectedly large claims. This does not mean that smaller employers cannot self
fund medical benefits. To avoid the uncertainty of catastrophic claims, these employers
often self fund basic medical expense benefits and insure major medical expense
benefits or self fund their entire coverage but purchase stop-loss protection.
It is not unusual to use self-funding and self-administration in other types of benefit

plans, such as those providing coverage for dental care, vision care, prescription drugs,
or legal expenses. Initially, it may be difficult to predict the extent to which these plans
will be utilized. However, once the plans have “matured,” the level of claims tends to be
fairly stable. Furthermore, these plans are commonly subject to maximums so that the
employer has little or no risk of catastrophic claims. Although larger employers may be
able to economically administer the plans themselves, smaller employers commonly
purchase administrative services.
Review Question
Advantages to a company that elects to self-fund and to administer all aspects of its
healthcare benefit plan include:
eliminating state premium taxes

avoiding state-mandated benefit requirements
improving its cash flow position
all of the above
• Incorrect. While an advantage of self-funding is the elimination of state

premium taxes, other answers are also correct.
• Incorrect. While avoiding state-mandated benefit requirements are an
advantage of an employer's decision to self-fund, other responses are also
correct.
• Incorrect. While companies who self-fund can improve their cash flow
position, other responses are also correct
• Correct. All of the above are advantages of self-funding.
Self-funding with Administrative-Services-Only Arrangements
Two of the problems associated with self-funding and self-administration are the risk of
catastrophic claims and the employer’s inability to provide administrative services in a
cost-effective manner. For each of these problems, however, solutions have evolved—
namely stop-loss coverage and administrative-services-only (ASO) contracts—that still
allow an employer to use elements of self-funding. Although an ASO contract and stop-
loss coverage can be provided separately, they are commonly written together. In fact,
most insurance companies require an employer with stop-loss coverage to have a self
funded plan administered under an ASO arrangement, either by the insurance company
or by a third party administrator.
Until recently, stop-loss coverage and ASO contracts were generally provided by
insurance companies and were available only to employers with at least several hundred
employees. However, these arrangements are increasingly becoming available to small
employers, and in many cases, the administrative services are now being purchased
from third party administrators who operate independently from insurance companies.
We discussed stop-loss coverage in Capitation and Plan Risk. Following is a brief
description of ASO arrangements.
Under an administrative-services-only (ASO) contract, the employer purchases

specific administrative services from an insurance company or from an independent third
party administrator. These services will usually include the administration of claims, but
they may also include a broad array of other services. In effect, the employer has the
option to purchase services for those administrative functions that can be handled more
cost effectively by another party. Under ASO contracts, the administration of claims is
performed in much the same way as it is under a minimum-premium plan; that is, the
administrator has the authority to pay claims from a bank account that belongs to the
employer or from segregated funds in the administrator’s hands. However, the
administrator is not responsible for paying claims from its own assets if the employer’s
account is insufficient.
In addition to listing the services that will be provided, an ASO contract also stipulates
the administrator’s authority and responsibility, the length of the contract, the provisions
for terminating and amending the contract, and the manner in which disputes between
the employer and the administrator will be settled. The charges for the services provided
under the contract may be stated in one or some combination of the following ways:
• Percentage of the amount of claims paid

• Flat amount per processed claim
• Flat charge per employee
• Flat charge for the employer
Payments for ASO contracts are regarded as fees for services performed, and they are
therefore not subject to state premium taxes. However, one similarity to a traditional
insurance arrangement may be present: The administrator may agree to continue paying
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any unsettled claims after the contract’s termination but only with funds provided by the
employer.
Funding through a 501(c)(9) Trust
Section 501(c)(9) of the Internal Revenue Code provides for the establishment of 501(c)
(9) trusts, commonly referred to as voluntary employees’ beneficiary associations or
VEBAs. Recall from Health Plan Funding that 501(c)(9) trusts are funding vehicles for
the employee benefits that are offered to members. The trusts have been allowed for
many years, but until the passage of the 1969 Tax Reform Act, they were primarily used
by negotiated trusteeships and association groups. The liberalized tax treatment of the
funds accumulated by these trusts resulted in their increased use by employers as a
method of self-funding employee benefit plans. However, the Tax Reform Act of 1984
imposed more restrictive provisions on 501(c)(9) trusts, and their use has diminished
somewhat, particularly by smaller employers who previously had overfunded their trusts
primarily as a method to shelter income from taxation.
Advantages
The use of a 501(c)(9) trust offers the employer some advantages over a benefit plan
that is self-funded from current revenue. Contributions can be made to the trust and can
be deducted for federal income tax purposes, just as if the trust were an insurance
company. Appreciation in the value of the trust assets or investment income earned on
the trust assets is also free or taxation. The trust is best suited for an employer who
wishes to establish either a fund for claims that have been incurred but not paid or a
fund for possible claims fluctuations. If the employer does not use a 501(c)(9) trust in
establishing these funds, contributions cannot be deducted until they are paid in the form
of benefits to employees. In addition, earnings on the funds will be subject to taxation.
Although the Internal Revenue Code requires that certain fiduciary standards be
maintained regarding the investment of the trust assets, the employer does have some
latitude and does have the potential for earning a return on the trust assets that is higher
than what is earned on the reserves held by insurance companies. A 501(c)(9) trust also
lends itself to use by a contributory self-funded plan, since ERISA requires that, under a
self-funded benefit plan, a trust must be established to hold the contributions of
employees until they are used to pay benefits.
There is also flexibility regarding contributions to the trust. Although the Internal
Revenue Service will not permit a tax deduction for “overfunding” a trust, there is no
requirement that the trust must maintain enough assets to pay claims that have been
incurred but not yet paid. Consequently, an employer can “underfund” the trust in bad
times and make up for this underfunding in good times with larger-than-normal
contributions. However, any underfunding must be shown as contingent liability on the
employer’s balance sheet.
Disadvantages
The use of a 501(c)(9) trust is not without its drawbacks. The cost of establishing and
maintaining the trust may be prohibitive, especially for small employers. In addition, the
employer must be concerned about the administrative aspects of the plan and the fact
that claims might deplete the trust’s assets. However, as long as the trust is properly
funded, ASO contracts and stop-loss coverage can be purchased.
Requirements for Establishment
In order to qualify under Section 501(c)(9) of the Internal Revenue Code, a trust must
meet certain requirements, some of which may hinder its establishment. These
requirements include the following conditions:
• Membership in the trust must be objectively restricted to those persons who share
a common employment-related bond. Internal Revenue Service (IRS) regulations
interpret this broadly to include active employees and their dependents, surviving
dependents, and employees who are retired, laid off, or disabled. Except for plans
maintained pursuant to collective-bargaining agreements, benefits must be
provided under a classification of employees that the IRS does not find to be
discriminatory in favor of highly compensated individuals.
It is permissible for life insurance, disability, severance pay, and supplemental

unemployment compensation benefits to be based on a uniform percentage of
compensation. In addition, the following persons may be excluded in determining
whether the discrimination rule has been satisfied: (1) employees who have not
completed three years of service, (2) employees under age 21, (3) seasonal or
less-than-half-time employees, and (4) employees covered by a collective-
bargaining agreement if the class of benefits was subject to good-faith bargaining.
• With two exceptions, membership in the trust must be voluntary on the part of
employees. Members can be required to participate (1) as a result of collective
bargaining or (2) when participation is not detrimental to them. In general,
participation is not regarded as detrimental if the employee is not required to
make any contributions.
• The trust must provide only eligible benefits. The list of eligible coverages is
broad enough that a trust can provide benefits because of death, medical expenses,
disability, and unemployment. Retirement benefits, deferred compensation, and
group property and liability insurance cannot be provided.
• The sole purpose of the trust must be to provide benefits to its members or their
beneficiaries. Trust assets can be used to pay the administrative expenses of the
trust, but they cannot revert to the employer. If the trust is terminated, any assets
that remain after all existing liabilities have been satisfied must either be used to
provide other benefits or be distributed to members of the trust.
• The trust must be controlled by (1) its membership, (2) independent trustees (such
as a bank), or (3) trustees or other fiduciaries, at least some of whom are
designated by or on behalf of the members. Most 501(c)(9) trusts are controlled
by independent trustees selected by the employer.
Limitation on Contributions
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The contributions to a 501(c)(9) trust (except collectively bargained plans, for which U.S.
Treasury regulations prescribe separate rules) are limited to the sum of (1) the qualified
direct cost of the benefits provided for the taxable year and (2) any permissible additions
to a reserve (called a qualified asset account). The qualified direct cost of benefits is the
amount that would have been deductible for the year if the employer had paid benefits
from current revenue.
The permissible additions may be made only for disability, medical supplemental
unemployment, severance pay, and life insurance benefits. In general, the amount of the
permissible additions includes (1) any sums that are reasonably and actuarially
necessary to pay claims that have been incurred but remain unpaid at the close of the
tax year and (2) any administration costs with respect to these claims.
There are several potential adverse tax consequences if a 501(c)(9) trust does not meet
prescribed standards. If reserves are above permitted levels, additional contributions to
the reserves are not deductible and earnings on the excess reserves are subject to tax
as unrelated business income. (This effectively negates any possible advantage of using
a 501(c)(9) trust to prefund postretirement medical benefits.) In addition, an excise tax is
imposed on employers maintaining a trust that provides disqualified benefits. The tax is
equal to 100% of the disqualified benefits, which include (1) medical and life insurance
benefits provided to key employees outside the separate accounts that must be
established, (2) discriminatory medical or life insurance benefits for retirees, and (3) any
portion of the trust’s assets that revert to the employer.
Review Question
The following statements are about 501(c)(9) trusts. Select the answer choice containing
the correct statement:
In the event a 501(c)(9) trust is terminated, any funds remaining in the trust revert
back to the employer.
In order to satisfy Internal Revenue Code (IRC) requirements, membership in a
501(c)(9) trust is mandatory for all employees.
Contributions made by an employer to a 501(c)(9) trust are deductible for federal
income tax purposes.
Typically, a 501(c)(9) trust is controlled solely by the employer that established the
trust.
Incorrect. If the trust is terminated the assets that remain must be used for other
benefits or distributed to members of the trust.
Incorrect. Membership in the trust must be voluntary, with two exceptions.
Correct. Contributions, with the exception of 'overfunding' a trust, are deductible

for federal income tax purposes.
Incorrect. The trust must be controlled by its membership, independent trustees
or by trustees or other fiduciaries.
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Chapter 6 A
Financial Aspects of Medicare and Medicaid for Health
Plans
• Describe the new payment methodology for Medicare

• Define the Medicare adjusted community rate (Medicare ACR) and its
relationship to the Medicare average payment rate (Medicare APR)
• List the two federal Medicaid law directives to states concerning payment
methodology for health plans and describe some methods used by states to
comply with these directives
• Describe some of the financial risks for a health plan that provides healthcare
services to the Medicare or Medicaid populations versus the commercial
population
• List the key features of a state Medicaid program that will determine a
Medicaid managed care plan's level of risk
• Describe some of the aspects of a health plan’s regulatory environment that
impose additional costs on health plans
• Discuss provider reimbursement in Medicare and Medicaid markets

Plans
The Balanced Budget Act of 1997 (BBA), a federal law, contained provisions designed to
further increase enrollment in and availability of Medicare and Medicaid contracting
health plans. The BBA amended Medicaid law to facilitate states’ ability to mandate the
enrollment of most Medicaid beneficiaries into health plans.
In addition, the BBA expanded the range of health plan choices available to Medicare
beneficiaries and significantly revised the program under which health plans enter into
risk-based contracts to provide services to Medicare beneficiaries. The revised Medicare
risk-contracting program, known as Medicare+Choice, began on January 1, 1999.
In December, 2003, the Medicare Modernization Act of 2003 was signed into law. This
Act changed the name of the Medicare+Choice program to Medicare Advantage, and
provided a number of short term and long term reforms to the program to enhance
benefits for enrollees and encourage access and shoice within the system. The final
regulations are expected in spring 2005, and at that time the courses will be updated
accordingly. See Insight 6A-1.
Insight 6A-1
The Medicare Modernization Act of 2003

On December 8, 2003, President George W. Bush signed into law the Medicare
Modernization Act of 2003 (MMA), taking steps to expand private sector health care
choices for current and future generations of Medicare beneficiaries. The MMA proposes
short-term and long-term reforms that build upon more than 30 years of private sector
participation in Medicare.
The centerpiece of the legislation is the new voluntary prescription drug benefit that will
be made available to all Medicare beneficiaries in 2006. Additional changes to the M+C
program include:
• M+C program’s name is changed to Medicare Advantage (MA);

• Increased funding is provided for MA plans in 2004 and 2005;
• MA regional plans are established effective 2006.
On January 16, 2004 CMS announced new county base payment rates for the MA
program. Beginning March 1, 2004, all county MA base rates received an increase which
plans are required to use for enhanced benefits. Plans may use the extra money in one of
four ways:
• Reduce enrollee cost sharing;

• Enhance benefits for enrollees;
• Increase access to providers;
• Utilize the stabilization fund.
The short-term reforms have already improved benefits and reduced out-of-pocket costs
for millions of Medicare beneficiaries who are covered by health plans in the Medicare
Advantage program, previously known as the Medicare+Choice program. These
coverage improvements became effective on March 1, 2004.
On June 1, 2004, beneficiaries saw additional improvements in Medicare under another

important MMA initiative, the Medicare-Endorsed Prescription Drug Discount Card
Program, which will remain in effect through the end of 2005. This program gives
beneficiaries the option of purchasing prescription drug discount cards—sponsored by
private sector entities and endorsed by Medicare—which offer discounted prices on
prescription drugs. Furthermore, the discount card program is providing low-income
Medicare beneficiaries with up to $600 annually in assistance, in both 2004 and 2005, to
help cover their prescription drug costs.
Beginning in 2006, the MMA will provide beneficiaries with a broader range of private
health plan choices similar to those that are available to working-age Americans and
federal employees. In addition to the locally-based health plans that currently cover more
than 4.6 million Medicare beneficiaries, regional PPO-style plans will be available as a
permanent option under the Medicare Advantage program.
Beginning in 2006, all beneficiaries will have the option of choosing prescription drug
coverage delivered through private sector entities. This coverage will be available as a
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stand-alone drug benefit or, in other cases, as part of a comprehensive benefits package
offered by Medicare Advantage health plans.
Other important provisions of the MMA address Medigap choices and specialized
Medicare Advantage plans for beneficiaries with special needs.
Public comments on the regulations are currently in review, and changes to the draft
regulations are anticipated. Final regulations are expected in the spring of 2005, and
content updates will be made after the release of the final regulations.

Plans
Contracting to provide services to Medicare and/or Medicaid beneficiaries presents a
range of financial issues for health plans. In this lesson, we discuss Medicare and
Medicaid payment to health plans, the distinct financial risks and costs associated with
providing services to Medicare and/or Medicaid beneficiaries, and issues related to
paying providers for services rendered to a health plan’s Medicare and/or Medicaid
enrollees.
This discussion focuses on health plans that have Medicare and/or Medicaid
beneficiaries enrolled pursuant to a risk-based contract with the Centers for Medicare
and Medicaid Services (CMS), the federal government agency responsible for
administering the Medicare and Medicaid programs. However, an important issue to
keep in mind is that almost every health plan has participating Medicare beneficiaries
who are not enrolled under a Medicare contract but are enrolled under the health plan’s
commercial lines of business.
Background: Medicare and Medicaid Payment to Health Plans
In the following sections, we discuss federal and state laws and regulations that set forth
the methods for paying health plans for providing healthcare services to the Medicare
and Medicaid populations.
Medicare
Prior to 1998, Medicare contracting plans were paid 95% of the estimated cost of
providing the services to a beneficiary under Medicare fee-for-service, known as the
adjusted average per capita cost (AAPCC). The payment amounts were calculated on a
county-by-county basis and were beneficiary specific in that they adjusted for
demographic factors including age, sex, and institutional status, as well as factors
reflecting whether the beneficiary was Medicaid-eligible, had other insurance that was
primary to Medicare, and was eligible for both Medicare Parts A and B.
Under AAPCC payment methodology, the payment rate for plans tended to vary
significantly by geographic region. In many areas, particularly rural areas, the rates of
payment were so low that Medicare risk-based contracts were not feasible. The payment
rates for plans also tended to vary significantly from year to year, making the program
unreliable for many contractors.
In 1998, CMS implemented a new payment methodology authorized under the BBA.
Under the new methodology, Medicare-contracting health plans are paid the highest of
the following three amounts:
• A rate reflecting a blend between national and local fee-for-service cost

(unlike the old methodology which was based entirely on local costs) and
subject to other adjustments such as a phased-in carve-out of graduate
medical education payments and a budget neutrality factor
• The health plan’s payment rate for the previous year, increased by 2 percent
• A "floor" payment amount per enrollee covered, which was $367 per enrollee
per month in 1998 and is increased annually by a rate that reflects the
national rate of growth in per capita Medicare expenditures
Payments are adjusted by the same demographic and other factors applied under the
previous payment methodology.
The new payment methodology has significantly decreased the rate of growth in
payments to health plans. As a result of basing payments on the new methodology, the
payment rate in rural and other low-payment counties was raised to the payment floor.
The increased payment rate in these counties, however, was financed by reducing the
rate of increase in payments in other counties where most Medicare contractors are
located. Because of the constraint that these Medicare changes be budget neutral, the
blended rate methods was not used in payments for 1998 or 1999. During 1998 and
1999, the vast majority of plans were paid an amount equal to their previous year’s
payment increased by 2%. This trend is expected to continue for several years. Before
the new methodology was implemented, growth in payment rates was typically greater
than 5%.
Citing the decreasing growth in Medicare payments to health plans in conjunction with
increasing growth in medical costs, in 1998 some plans with risk-based Medicare
contracts announced their intention to terminate their Medicare contracts or significantly
decrease their service areas in 1999.
Beginning in the year 2000, CMS will further revise the payment methodology by
implementing a risk adjustment methodology known as the Principal Inpatient
Diagnostic Cost Group (PIP-DCG) to account for variations in per capita costs based
on health status. This risk adjustment methodology will be integrated with recalculated
adjustment factors for age, gender, Medicaid eligibility, and institutional status to adjust
payments to health plans.
Because CMS currently only has inpatient data on which to base such a risk adjustment
methodology, the agency is constrained initially to using a model that requires only
inpatient data.1
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The application of the risk adjustment methodology could make payments to health
plans vary significantly from current payment levels and over time, therefore making
participation in the Medicare program less attractive to health plans that have a
healthier-than-average enrollment by substantially reducing their overall payments.
Under both the old and new payment methodologies, health plans with risk-based
Medicare contracts are required to calculate and submit to CMS a Medicare adjusted
community rate (ACR). The Medicare adjusted community rate (Medicare ACR) is
the plan’s estimate of the premium it would charge Medicare enrollees in the absence of
Medicare payments to the health plan. To determine this estimated premium, the health
plan uses the same rates it charges enrollees in non-Medicare plans for a benefit
package limited to covered Medicare services. 2
The Medicare ACR includes amounts for administrative costs and profit. Each health
plan compares its Medicare average payment rate (APR), which is the average
amount the health plan receives or expects to receive from CMS per beneficiary
covered, to its Medicare ACR. If the average rate of Medicare payment exceeds the
health plan’s Medicare ACR, the plan is required to use the “excess” amount either to
provide additional benefits or to reduce enrollee cost-sharing obligations.
Medicare-contracting health plans compete on premium amounts and benefits with other
Medicare-contracting health plans, Medigap insurers, and the Medicare fee-for-service
program for beneficiaries. The more benefits a health plan can provide and the lower the
premium, the better the health plan will be able to compete by attracting beneficiaries to
enroll in their health plan. In the past, one of the key benefits health plans used to
differentiate themselves from competitors was pharmacy benefits, particularly in markets
with relatively high Medicare payments to health plans.
Pharmacy benefits have extremely limited coverage under the fee-for-service program
and are an expensive benefit for health plans to provide. Given that the beneficiaries
have benefit choices, a health plan that offers pharmacy benefits attracts beneficiaries
who need pharmaceuticals to treat chronic or long-term conditions or diseases. These
same beneficiaries tend to have higher-than-average needs for other healthcare
services as well. One effect of the application of the new payment methodology has
been to cause a number of Medicare-contracting health plans to reduce their costs
through discontinuing or scaling back their pharmacy benefits.
Review Question
Health plans with risk-based Medicare contracts are required to calculate and submit to
CMS a Medicare adjusted community rate (Medicare ACR). Medicare ACR can be
defined as the:
estimated cost of providing services to a beneficiary under Medicare FFS,

adjusted for factors such as age and gender
health plan’s estimate of the premium it would charge Medicare enrollees in the
absence of Medicare payments to the health plan
average amount the health plan expects to receive from CMS per beneficiary
covered
health plan’s actual costs of providing benefits to Medicare enrollees in a given
year
Incorrect. To determine this estimated premium a health plan uses the same rates
it would charge enrollees in non-Medicare plans for a health benefit package
limited to covered Medicare services
Correct. The ACR is the plan's estimate of the premium it would charge Medicare
enrollees absent the Medicare payment
Incorrect. While the plan does consider the CMS Medicare payument in its
calculations, the givernment payment alone does not determine the ACR.
Incorrect. The ACR is based on estimated premiums, not actuals.
Medicaid
Recall from Figure 6A-1 that Medicaid is a joint federal-state program. States administer
their own Medicaid programs after obtaining federal government approval of their
programs. The federal government provides some funding for state Medicaid programs.
While Medicare law explicitly sets forth the methodology for payment of contracting
plans, federal Medicaid law is relatively quiet on the question of payment to contracting
plans. Federal Medicaid law does not contain any provisions regarding payment
methodology but sets forth two directives for states. First, a state’s payment to health
plans for providing Medicaid services can not be more than it would have cost the state
to provide the services under Medicaid fee-for-service (FFS), known as the upper
payment limit.3
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Second, states must pay Medicaid-contracting health plans that accept risk for
comprehensive services on an "actuarially sound basis." 4
One way that states comply with the requirement that payments not exceed FFS cost is
to base their payment rates on the actuarial FFS equivalent, and then apply a factor of
95% or less to determine the amount health plans will receive on a per member per
month basis.5
These states then may apply any number of adjustments to the rates. Not all states base
their payments on FFS equivalents. States use a variety of methodologies to determine
payments to health plans, including competitive bidding. In states that base payments on
competitive bids, plans providing services in the same geographic locations may receive
different rates of payment because the bid from one plan may differ from bids made by
the other plans.
States vary not only in the methodology they use to pay health plans but also on the
services for which health plans are paid and the mechanisms through which health plans
are paid.
For example, states commonly carve out specific services from the capitation rate paid
to health plans. Such services may be provided through a separate health plan that is
paid to provide only those carved-out services (mental health and substance abuse
services are frequently provided in this manner) or the state may reimburse the health
plan separately for the carved-out services. Some states carve out the costs related to
childbirth delivery from the health plan capitation payment and make a separate, one-
time payment to the health plan when an enrollee gives birth. States commonly carve
out support services such as case management or transportation to provider facilities
and provide reimbursement for the services on a fee-for-service basis to the health plan
and/or other providers eligible to deliver such services.
As illustrated in the preceding paragraph, there are many variations in the methods that
each state uses to pay its Medicaid-contracting health plans. However, across states
there has been a general trend toward tightening payments to health plans while
increasing contracting requirements and oversight. As we mentioned earlier, Medicaid is
a joint federal-state program, which means that some of the funds for the Medicaid
program are provided by the federal government and some by the states. The trend
toward tightening payments is likely to become more pronounced as federal Medicaid
cuts (or decreases in the rate of growth of payments to health plans with Medicaid
contracts) are implemented over the next five years. Moreover, the federal Medicaid cuts
are likely to cause more states to manage costs by implementing mandatory health plan
programs.
In addition to more stringent federal and state payment policies, several other factors
have led to Medicaid health plan contracts becoming less attractive to health plans in
some states. Medicaid programs in some areas are unstable as states struggle with
implementing and financing the programs. A few states have solicited health plans to
participate in proposed Medicaid managed care programs that were never implemented.
Other states have missed target dates, which had been proposed to and approved by
CMS, to move from voluntary to mandatory health plan programs, thereby delaying the
potential benefits of health plans for this population.
Financial Risks of Providing Services to Medicare and/or Medicaid

Benefits
Providing services under Medicare and/or Medicaid can impose financial risks and costs
on health plans that are distinct from those related to providing services to the
commercial population. Differences in financial risks and costs include
• Disenrollment provisions
• Intensive initial services, such as enrollee for education and outreach
programs
• Utilization rates of the Medicare and Medicaid populations
• Marketing
Fast Definition
Lock-in provisions require that plan enrollees stay enrolled in a plan of their choice for a
certain period of time, such as a year.
Commercial enrollees are typically locked in to a plan for a twelve-month period. In

contrast, currently all Medicare beneficiaries and most Medicaid beneficiaries can
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disenroll from a health plan on a monthly basis. Therefore, Medicare- and Medicaid-
contracting health plans are less assured of recovering their initial enrollment and
service provision costs through monthly payments for ongoing enrollment.
However, the BBA may provide some relief to both Medicare- and Medicaid-contracting
plans through its provisions. The BBA contains provisions that allow states greater
flexibility in locking in Medicaid beneficiaries. Medicare provisions allow for modified
lock-in periods beginning in the year 2002. Modified lock-in periods allow an enrollee to
disenroll during a period of time—in the case of Medicare after the year 2002, that period
of time is three months--after making an initial election to a plan. After the time period,
the enrollee is locked in until the annual election period.
Medicare and Medicaid enrollees tend to have a high level of costs in the first few
months of enrollment as the health plan educates them about the system and performs
initial health screenings to evaluate their health. Health plans also tend to have high
costs for providing healthcare services during the initial months of enrollment as they
address any healthcare issues identified in the initial screenings and initiate members
into appropriate routines of care. A significant issue in Medicare contracting health plans,
and one that differentiates the Medicare market from the commercial market, is the
amount of time that it takes to recover these initial costs.
In addition, the costs involved in providing care to the Medicare and Medicaid
populations are significantly different than those involved in providing care to the
commercial population.
For example, health plans are likely to incur greater expenses related to enrollee
education for Medicare and Medicaid beneficiaries in order to ensure that the
beneficiaries understand their enrollment in a health plan system and the appropriate
protocols and sites for accessing covered care. State and federal laws require that
health plans follow certain procedures to ensure that Medicaid enrollees understand
their coverage. States with mandatory health plan programs assign Medicaid
beneficiaries to a health plan in cases where the beneficiaries have not selected a health
plan themselves. These Medicaid managed care plans may incur significant costs in
providing outreach to inform the beneficiary that they have been enrolled in the health
plan’s plan and to educate the beneficiary about the implications of their enrollment.
Furthermore, Medicare and Medicaid plans have higher costs than the costs
experienced by health plans that contract for commercial business. These higher costs
relate to coordinating care and case management due to the higher incidences of
chronic illness in both the Medicare and Medicaid populations.
An important area of difference between Medicare and Medicaid and commercial

populations is how each group utilizes medical services. The Medicare population tends
to utilize a higher proportion of specialty care than do enrollees in commercial group
plans do. In contrast, the Medicaid population tends to utilize a higher proportion of
primary care services than do either the Medicare or commercial populations.
A final area in which Medicare and Medicaid plans are likely to incur additional expense
is associated with individual marketing. With commercial products, health plans typically
enroll members by groups. For example, when a health plan provides health plan
options to a large employer, the employees sign up individually but all the individuals
that sign up for each option can be treated as a group. Within an employer group, health
plans may compete with other healthcare options offered by the employer, but in
general, the need to inform commercial members about product options requires less
time and money per enrollee than that required to present the same types of information
to Medicare- and Medicaid-eligible beneficiaries.
Review Question
The types of financial risks and costs to which a health plan is subject depends on
whether the health plan provides services to the Medicare and/or Medicaid populations
or to the commercial population. One distinction between providing services to the
Medicare and Medicaid populations and to the commercial population is that Medicare
and Medicaid enrollees typically:
are locked into a plan for a 12-month period, whereas enrollees from the
commercial population may disenroll from a plan on a monthly basis
require less enrollee education than do enrollees from the commercial population
have higher incidences of chronic illness than do enrollees from the commercial
population
are enrolled in a health plan through a group situation, whereas the commercial
population typically enrolls in a health plan on an individual basis
Incorrect. Most medicaid enrollees can disenroll from a health plan on a monthly
basis.
Incorrect. Health plans are likely to incur greater expenses related to enrollee
reducation to ensure that beneficiaries understand the appropriate sites and
protocols for receiving care.
Correct. Medicare and Medicaid enrollees typically have higher incidences of

chronic illness than do enrollees from the commercial population.
Incorrect. Medicare and Medicaid enrollees are enrolled on an individual basis.
Typically, under Medicare, a large portion of a plan’s enrollees will be enrolled

individually rather than through groups, despite an increasing willingness by employers
to contract with Medicare health plans to provide coverage to their Medicare-eligible
employees and retirees.
Medicare-contracting health plans must market and appeal to individual beneficiaries by

communicating the advantages of enrolling in a health plan to receive Medicare benefits.
Medicaid-contracting health plans must also appeal to individual enrollees. However,
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under Medicaid, the ability of a health plan to market and the extent to which they need
to market will depend upon state law regulating Medicaid health plan marketing and
whether the relevant state uses a third-party enrollment broker to educate beneficiaries
about their health plan choices.
Despite the increased costs of providing services to Medicare and Medicaid populations,
Medicare- and Medicaid-contracting health plans with well-managed programs can still
be successful because health plan techniques have the potential to significantly
decrease the cost of providing services to beneficiaries from the amount it would have
cost to provide the services under FFS programs.
For Medicaid populations, the central challenge that health plans face is influencing the
behavior of enrollees. Medicaid-contracting health plans can decrease costs by ensuring
that Medicaid beneficiaries (1) access care at appropriate sites (and that they avoid
inappropriate utilization of expensive emergency room services) and (2) receive
appropriate care for chronic illnesses. Medicare-contracting health plans can decrease
costs by influencing physician behavior to ensure appropriate utilization of specialty and
inpatient services, to better coordinate care, and to manage chronic illnesses.
Risk Related to the Structure of State Medicaid Programs
The risk involved in providing care to the Medicaid population depends largely on the
structure of the relevant state’s Medicaid program. Key features of state programs that
determine the level of risk a Medicaid contractor will assume. These features include:
• Which Medicaid groups are eligible to enroll in health plans

• Whether the state has a guaranteed eligibility provision
• Whether the state has a lock-in provision that mandates that each person
who enrolls in a health plan’s plan remain in that plan for a certain period of
time
• Whether the state mandates participation in the health plan program.
Medicaid Eligibility Groups Eligible to Enroll in Health Plans
The Welfare Reform Act replaced a federal welfare program called Aid to Families with
Dependent Children (AFDC) with Temporary Assistance to Needy Families, but
Medicaid eligibility for women and children remains tied to state AFDC eligibility levels as
they existed in 1996 (although states have the flexibility to provide for more liberal
eligibility standards).
The majority of persons receiving Medicaid are women and children who meet AFDC
eligibility standards. Most of the remaining recipients are persons who are aged and
disabled. Although the AFDC population comprises 70% of recipients, it accounts for
only 30% of costs. Aged and disabled Medicaid beneficiaries account for the majority of
Medicaid costs.
Historically, state Medicaid managed care programs have focused on enrollment of the
AFDC population. However, states are beginning to enroll their disabled populations into
health plans as well. Financial risk is particularly high with disabled enrollees, partly
because states have struggled to find an accurate payment methodology to account for
their higher costs.
Aged Medicaid beneficiaries are both Medicare and Medicaid. This dual eligibility means
that technically, they could participate in an Medicaid managed care program. Few
states, however, have chosen to incorporate this population into their Medicaid health
plan programs because of the difficulty in coordinating Medicare and Medicaid payments
and services. Medicare requirements allow Medicare beneficiaries to receive Medicare
benefits from the Medicare participating provider of their choice, whether or not the
provider is part of a health plan network. Therefore, a state could require that an aged
beneficiary obtain Medicaid-covered services from a Medicaid-contracting health plan,
but would not be able to require the same beneficiary to obtain Medicare-covered
services from a health plan.
Review Question
Geena Falk is eligible for both Medicare and Medicaid coverage. If Ms. Falk incurs a
covered expense, then:
Medicaid will be Ms. Falk’s primary insurer

Medicare will be Ms. Falk’s primary insurer
Correct. Medicare is the primary insurer.
either Medicare or Medicaid will be Ms. Falk’s primary insurer depending on her
election
Medicare and Medicaid will each be responsible for one-half of Ms. Falk’s covered
expense
Medicaid Eligibility Groups Eligible to Enroll in Health Plans
In addition, if a beneficiary is eligible for coverage under both Medicare and Medicaid,
Medicare is the primary insurer. In effect, many of the Medicaid benefits would simply be
coverage of copayments and deductibles for Medicare-covered services, and these
Medicare services would be delivered in a non-health plan environment.
Because Medicaid managed care enrollees are likely to be women and children, the
Medicaid population has a different spectrum of healthcare needs than do typical
enrollees in commercial group plans. Medicaid-contracting health plans focus their
resources on providing prenatal and obstetrical care and well child services. However,
as previously noted, health plans must be prepared to manage the chronic care needs of
this population. As government policy expands Medicaid eligibility for children, chronic
care issues, such as management of pediatric asthma, will become increasingly
important to health plans.
Guaranteed Eligibility Provision
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One of the determining factors in a person’s eligibility for Medicaid is the amount of
financial resources and income that person has. Thus, changes in financial status can
cause a person to gain or lose eligibility. The temporary nature of Medicaid eligibility
poses significant problems for Medicaid-contracting health plans.
Medicaid beneficiaries change eligibility status so frequently that it is often difficult to

average costs over time or provide any continuity of care. Fluctuations in enrollee
eligibility may make it difficult for a health plan to recover its costs of providing initial
services such as education, any initial outreach, or physical examinations. Moreover,
fluctuations in eligibility decrease the incentive for health plans to provide additional non-
Medicaid-covered preventive services as a cost savings mechanism because a
beneficiary’s enrollment may be of short duration.
Prior to the BBA, states had a limited ability to guarantee eligibility of Medicaid
beneficiaries for periods of longer than a month. The BBA amended Medicaid law to
allow states to guarantee eligibility for 6 months for any individual enrolled in a health
plan entity and to allow states to guarantee eligibility to all beneficiaries under the age of
19 for up to 12 months. 6
It is unclear whether states will take advantage of the ability to guarantee eligibility to all
enrollees of health plan entities because of the potential cost of such a measure.
However, a few states have already adopted and implemented guaranteed eligibility
provisions for beneficiaries under the age of 19 in connection with implementation of
their State Children’s Health Insurance Programs, which are federally funded and are
designed to allow states to create programs to ensure that needy children have
healthcare coverage.
Lock-In Provisions
As noted earlier, lock-in provisions require that enrollees stay enrolled in the plan of their
choice for a certain period of time, such as a year. Lock-in provisions increase the
financial stability of the Medicaid market for health plans because typically an enrollee
must stay with a given plan for some period of time before the health plan recovers the
initial costs attributable to signing up that enrollee. In the absence of a lock-in provision
under state law, Medicaid beneficiaries can disenroll from a health plan on a monthly
basis.
Prior to the BBA, states could only lock-in beneficiaries to a few limited categories of
Medicaid-contracting health plans. Because it was unlikely that all Medicaid-contracting
health plans in a state fit into these categories, this provision was of limited use. States
were more likely to seek a waiver of the monthly disenrollment requirement, which was a
requirement that Medicaid beneficiaries be allowed to disenroll from a health plan on a
monthly basis.
In 1997, the BBA amended Medicaid law to facilitate states’ ability to lock-in a
beneficiary’s health plan enrollment for up to a year. However, the provision requires that
beneficiaries be allowed to disenroll without cause for 90 days after enrollment.
Therefore, the law may not address health plan concerns regarding the ability to recover
initial costs.
Cost of Compliance with Medicare and Medicaid Regulatory Requirements
A significant cost for Medicare and Medicaid contracting plans is the cost of compliance
with federal and/or state regulatory requirements. At the same time the rate of increase
in Medicare and Medicaid payments to health plans is slowing, the regulatory
requirements imposed on participating health plans are increasing.
Both Medicare- and Medicaid-contracting plans are required to comply with federal and
state requirements relating to the submission of data in order for the regulating entity to
oversee the quality of care provided in the plan. Under Medicare, plans are required to
report on the Health Plan Employer Data and Information Set (HEDIS).
Many state Medicaid programs are also requiring reporting on HEDIS measures or on
similar quality of care measures. Beginning in 1998, CMS required that all Medicare-
contracting health plans’ HEDIS data be audited. Although CMS covered the cost of the
audit in 1998, it is likely that Medicare-contracting health plans will be required to pay for
the audits in subsequent years.
In 1997, the BBA made amendments that imposed additional costly requirements on
Medicare-contracting plans that began in the 1998 contracting year. The BBA amended
Medicare law to authorize an assessment on Medicare-contracting health plans to fund
CMS’ efforts to educate Medicare beneficiaries about their Medicare health plan choices.
For 1998, the assessment equaled 0.428% of health plans’ capitation payments. For
many health plans, this was a significant cost, because the majority of health plans only
received a 2% increase in their previous year’s rate for 1998.
Although the law sets forth guidelines regarding the amount of the annual assessment,
the specific amount of the assessment will be set each year through the legislative
appropriation process. In addition, Medicare-contracting health plans were required to
begin submitting inpatient encounter data to CMS to serve as a basis for CMS’ risk
adjustment of health plan payments. The cost of collecting and submitting such data
must be borne by the health plan.
Beginning in 1999, Medicare-contracting health plans will be required to comply with a

number of additional regulatory provisions that will impose additional costs on the health
plans. Most of the requirements came from the provisions of the BBA that authorized the
Medicare+Choice program (see Figure 6A-1). The requirements include, but are not
limited to, shorter timeframes for making routine coverage determinations and new
requirements regarding physician participation in the Medicare health plan.
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One of the most significant new requirements for Medicare-contracting health plans is
compliance with the Quality Assessment Performance Improvement (QAPI). The
Medicare+Choice regulations require that Medicare contracting plans comply with the
quality standards and requirements beginning January 1, 1999. In addition, CMS will
issue the QAPI standards to states as guidance for the development of quality
assurance and improvement strategies in their Medicaid programs.
Although adoption of QAPI is voluntary for states, it is likely that states will adopt the
QAPI standards as a mechanism for compliance with new Medicaid requirements
regarding quality assurance standards. The BBA amended Medicaid law to require that
states contracting with health plans develop and implement quality assessment and
improvement strategies consistent with the requirements set forth in QAPI. One of the
requirements is that the state’s strategy be consistent with standards established by the
Secretary of Health and Human Services. The Secretary will use QAPI as those
standards.
Another new requirement that may result in additional health plan costs and are
applicable to both Medicare- and Medicaid-contracting health plans are requirements to
cover emergency room services under a “prudent layperson” standard. This standard
holds that if a prudent layperson would reasonably believe that an emergency medical
condition existed, the health plan must pay for the cost of the emergency care,
regardless of whether such an urgent medical condition actually existed.
Finally, further new requirements regarding coverage of services provided in an

emergency room after an enrollee is stabilized may also increase costs.
In early 1998, the President issued an executive order to all federal agencies
responsible for administering healthcare programs. The order required the agencies, to
the extent possible through administrative measures, to implement the provisions of the
“Consumer Bill of Rights and Responsibilities,” developed by the President’s Advisory
Commission on Consumer Protection and Quality in the Health Care Industry.
Many of the requirements of the Consumer Bill of Rights and Responsibilities were
incorporated in the Medicare+Choice implementing regulations. Those requirements
include, but are not limited to, allowing women direct access to a woman’s health
specialist for routine and preventive services, providing direct access to specialists for
enrollees with complex or serious medical conditions, and taking specified actions to
provide for continuity of care. It is likely that CMS will require state Medicaid agencies to
impose similar requirements on their Medicaid-contracting health plans.
Paying Providers to Provide Medicare and/or Medicaid Services
To remain financial viable, a health plan’s Medicare or Medicaid product must accurately
calculate payments to providers and develop arrangements that encourage providers to
appropriately control utilization. In this section, we discuss issues involved in developing
effective payment arrangements for the provision of services to Medicare and Medicaid
enrollees.
Federal Law Regulating Health Plan Payments to Providers under Medicare

and Medicaid
One of the most significant factors affecting payment of providers by Medicare- or

Medicaid-contracting health plans is compliance with federal law regarding such
payments. There are a number of provisions under Medicare and Medicaid law that
affect the structure of provider payment arrangements and the relative amounts that
certain providers must be paid or that the providers must accept as payment.
The Physician Incentive Law 7
Under federal law, Medicare and Medicaid contracting health plans are prohibited from
making specific payments to physicians or physician groups as an inducement to limit or
reduce medically necessary services to specific individuals. The law further requires that
if a Medicare or Medicaid contract places a provider at “substantial financial risk” for
services that the provider does not directly provide (i.e. referrals), then the health plan
must provide stop-loss protection to the provider and must conduct beneficiary
satisfaction surveys.
Under the regulations, a provider is at "substantial financial risk" if incentive

arrangements place the provider at risk for amounts in excess of 25% of the provider’s
total potential reimbursement, where the risk is based on the use or cost of referral
services and the size of the patient panel is not greater than 25,000 patients. The patient
panel may be determined by "pooling" physician group enrollees from different product
lines and even different Medicare- or Medicaid-contracting health plans if specified
conditions are met.
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The Physician Incentive Law
Finally, the law requires that the health plans provide the HHS Secretary or state
Medicaid agency with sufficient descriptive information to determine whether the health
plan is in compliance with the law.8
The regulations also define the requirement that the health plan provide adequate stop-
loss protection where physicians or physician groups are at substantial financial risk.
Under the regulation, health plans must meet this requirement by ensuring that the
physicians or physician groups have adequate stop-loss coverage. The health plan may
either pay for stop-loss insurance itself or ensure that another organization pays for it.
Either aggregate or individual stop-loss protection may be used to meet the stop-loss
requirement. If aggregate stop-loss protection is used, it must cover 90% of the cost of
referrals that exceed 25% of total potential payments. If individual stop-loss protection is
used, the limit per individual must be decided based on the number of patients assigned
to the patient panel, and the stop-loss protection must cover 90% of the cost of referral
services that exceed the per-patient limit.
Finally, the regulations specify the information that health plans must disclose to CMS or
the state Medicaid agency regarding physician incentive arrangements.
Non-Discrimination in Provider Payments
The BBA amended Medicare and Medicaid law to provide that a contracting health plan
may not discriminate with respect to participation, reimbursement, or indemnification
against any provider who is acting within the scope of the provider's license or
certification under applicable state law, solely on the basis of such licensure or
certification.
This provision would prohibit health plans from paying different amounts to providers for
the same service incases where the reimbursement differences are based solely on
differences in how the providers are licensed or certified. For example, a Medicare or
Medicaid contracting health plan would be obligated to pay a social worker and a
psychiatrist the same amounts for providing the same type of counseling. Similarly, a
Medicare or Medicaid contracting health plan would be required to pay an
anesthesiologist and a nurse anesthetist the same amounts for providing the same
services.
Review Question
Juan Ramirez, a licensed social worker, and Dr. Laura Lui, a licensed psychiatrist, are
under contract to the Peninsula Health Plan. Peninsula has contracted with CMS to
provide services to Medicare and Medicaid beneficiaries. Both Mr. Ramirez and Dr. Lui
provide the same type of counseling services to Peninsula's enrollees. With respect to
amendments made to the Balanced Budget Act (BBA) of 1997 that impact provider
reimbursement, the amount by which Peninsula will reimburse Mr. Ramirez will be equal
to:
50% of Dr. Lui's reimbursement
D is correct
“Non-Discrimination in Provider Reimbursement Law”
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Paying Providers to Provide Medicare and/or Medicaid Services

Anti-Kickback Law
In general, the federal anti-kickback law prohibits any individual from offering or
accepting anything of value in exchange for making a referral for, or ordering, an item or
service for which payment may be made in whole or part under a federal health
program, including Medicare or Medicaid. For example, a primary care physician cannot
accept a payment from a specialist for referring a patient to the specialist.
9
The anti-kickback law contains several exceptions for practices that are not considered
to be in violation of the law. These exceptions include
• Discounts that are properly disclosed and reflected in the costs claimed or
charges made by the provider;
• Payments by an employer to an employee for bona fide employment in the
provision of covered items and services;
• Remuneration between an organization and an individual or entity providing
items and services pursuant to a written agreement where the organization
has a Medicare contract or the organization places the individual or entity at
significant financial risk for the services to be provided
• Activities protected by the safe harbor regulations promulgated by the
secretary of HHS.
The safe harbor regulations are regulations developed by the Secretary of HHS that
make other exceptions to the anti-kickback law for some types of arrangements that are
unlikely to lead to fraud or abuse. In other words, the Secretary of HHS has identified
activities that do not violate to the anti-kickback law. There are two sets of final safe
harbor regulations. The first set identifies safe harbors in several broad areas. The
second set of regulations offers three safe harbors designed specifically to address
health plan arrangements. Of the three health plan safe harbors, the one most relevant
to Medicare and Medicaid provider payment arrangements allows providers to negotiate
price reductions or discounts with “health plans” in anticipation of increased business.
An activity does not have to meet one of the statutory or regulatory safe harbors to avoid
anti-kickback prosecution. An arrangement that does not meet the requirements for safe
harbor protection is not necessarily illegal. The safe harbors were provided to give health
plans assurance that those arrangements are generally immune from potential criminal
and civil sanctions.
An anti-kickback analysis of a provider payment arrangement may have three possible

outcomes. First, the arrangement may not be implicated under the anti-kickback statute,
in which case there is no potential for anti-kickback liability. Second, the arrangement
may be implicated by the statute but fall under one of the anti-kickback safe harbors. In
such a case, unless the arrangement is a sham transaction, there is no potential for anti-
kickback liability. Finally, the arrangement may be implicated by the statute and not fit
within one of the anti-kickback safe harbors.
It is important to note that the anti-kickback law applies not only to services provided
under a health plan’s Medicare and Medicaid contracts, but also to any services for
which federal health program payment may be made. This would include services to
employer group enrollees who have Medicare as primary or secondary payor because in
some instances payment may be made under the Medicare program.
The Physician Self-Referral Law
The physician self-referral law prohibits physicians from making a referral to another
provider entity for designated health services if the physician, or an immediate family
member of the physician, has a financial relationship with the entity.10
A "financial relationship" includes a direct or indirect relationship between a physician

and an entity with which the physician has an ownership or investment interest or
compensation arrangement. Therefore, if a physician has a payment arrangement with a
health plan and makes referrals to an entity owned by the health plan or in which the
health plan has an investment interest, the self-referral law may be implicated.
To bill for a service that falls under the physician self-referral ban, any financial
relationships that a physician has with an entity must meet one of the exceptions
provided in the law. A general exception for prepaid plans exempts from the self-referral
ban services furnished by
• Medicare-contracting HMOs
• Organizations with prepaid Medicare demonstrations
• Federally qualified HMOs to their enrollees
Medicaid-contracting health plans were more recently added by regulation to this list of
exceptions to the self-referral ban.
Structuring Provider Payment Arrangements
In addition to the Medicare and Medicaid laws set forth above, payment arrangements
between Medicare- and Medicaid-contracting health plans and providers are subject to
the same legal requirements as those for providing services to the commercial
population. In addition, Medicare and Medicaid physician payment arrangements are
subject to the same informal influences as commercial arrangements.
As under commercial contracts, geographic location and experience with health plans
play a role in the structure of physician payment arrangements. For example, if the
health plan is located in a geographic region in which physicians are reluctant to take
financial risk in connection with the commercial population, the same or greater
reluctance will apply to the Medicare and Medicaid population.
Consequently, health plans with commercial lines of business are likely to use similar
structures in their provider payment arrangements under Medicare and Medicaid and
their commercial population. The payment amounts will be different, however, reflecting
the different utilization patterns of these populations.
Typically, health plans enter into one contract with a provider that covers all the health
plan’s lines of business.
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The mechanisms for payment (FFS, capitation, withholds, bonuses, and the formulas for
calculating withholds and bonuses) are typically the same across the health plan’s lines
of business, unless the providers refuse to accept risk for a specific population, or state
law prevents certain types of providers, such as PPOs, from accepting capitation.
However, the amount of payment will vary based on the line of business and, for
Medicare and/or Medicaid, the health plan will either provide for stop-loss protection or
limit any risk for referral to avoid delegation of “substantial financial risk” under the
physician incentive law.
Most health plans also refine their provider reimbursement methodologies for their
Medicare or Medicaid products to focus on areas of specific concern, such as specialty
referrals for Medicare beneficiaries, including ophthalmology (cataract treatment, etc.),
cancer treatment, and cardiac services.
In some instances, a health plan’s Medicare or Medicaid payment arrangements may

also be affected by its partnership with another healthcare organization that specializes
in Medicare or Medicaid managed care. Such organizations focus on Medicare or
Medicaid health plans and frequently collaborate with an existing commercial health plan
or develop a new health plan product with a provider organization. Often these specialty
Medicare/Medicaid health plans use their own proven Medicare or Medicaid provider
payment methodologies.
Review Question
One way that the Medicare and Medicaid programs differ is that under Medicare, a
smaller proportion of provider reimbursement goes to the primary care providers and a
greater proportion of the reimbursement goes to hospitals and specialists.
True
False
Correct
Incorrect. In Medicare, a larger proportion of the provider reimbursement goes to

hospitals.
Payment Amounts
In determining the amount to pay providers to supply services to individuals enrolled

under their Medicare or Medicaid contracts, health plans need to balance two objectives
that may be conflicting. First, the health plan needs to pay providers at levels that ensure
the health plan will have an economically viable Medicare or Medicaid program. Second,
the health plan needs to pay providers enough to make participation in their Medicare or
Medicaid products attractive to the provider.
In many markets, health plans pay providers an amount similar to the amount the
provider would have received under fee-for-service Medicare or Medicaid. This is true
whether the provider is paid on a fee-for-service basis or on a capitation basis where the
capitation amount is calculated by determining the actuarial equivalent of the value of
services under the relevant FFS system.
However, this general rule does not apply in all geographic regions. Recall that Medicare
payments to health plans have been based on a percentage of the AAPCC, which often
means that the health plans are paid less than the market FFS rate. To pay providers an
amount similar to that they would receive under FFS, the health plan must achieve
savings through utilization management. But in competitive markets where services such
as inpatient days have already been reduced, such savings are difficult.
Moreover, in Medicare, in some areas of the country there has been a trend in FFS
provider payments toward paying providers less than the Medicare fee schedule
amount. This is particularly true in urban settings that have a relative oversupply of
competing specialists, hospitals or labs and where the beneficiaries in the area are
willing to switch providers.
Payment Amounts
Figure 6A-2 discusses how payment is determined for providers who do not have
contracts with Medicare health plans.
The way in which provider reimbursement is distributed differs under Medicare and
Medicaid. Under Medicare, a smaller proportion of the total payment for services goes to
primary care providers and a greater proportion of the payment goes to hospitals and
specialists.
This difference in utilization rates for PCPs and specialists must be reflected in any
capitation arrangements made with providers rendering services to the Medicare and
Medicaid plan members. Therefore, if provider capitation payments for services provided
to Medicare beneficiaries are calculated by applying a multiplier to the commercial
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provider rates to account for higher utilization, the multiplier is smaller for primary care
services than other services.
Under Medicaid, a greater proportion of the provider payments goes to primary care
providers. For example, the multiplier for primary care physicians in a Medicaid
capitation contract might be 3 to 4 times the multiplier used in a commercial capitation
contract. For other services such as those provided by skilled nursing facilities, the
difference in multipliers will be even greater.
Providers and Financial Risk in Medicare and Medicaid
For health plans, the central financial risks in Medicare and Medicaid markets stem from
two conditions. First, the government sets the payments received by health plans, and
therefore the health plans cannot easily seek an increase these payments even in the
face of rising costs. Second, regulations determine which services must be provided,
and which persons are eligible to enroll in a plan.
Therefore, a health plan’s most important tool for achieving profit is the control of
utilization rates. A key method of controlling overutilization in health plan environments
is, as we have seen, provider reimbursement contracts that put providers at financial risk
in cases of overutilization.
It is important to remember that there are two basic categories of services for which
providers may accept risk–services they provide directly and referral services. For
physicians, referral services include inpatient services and specialty physician services.
A provider payment arrangement may delegate risk for none, one, or both of these
categories of services.
As noted earlier in this lesson, geographic region and experience with health plan play a
similar role in determining whether a provider will accept risk under Medicare or
Medicaid as it does with the commercial population.
In addition, physicians and providers who have experience with the commercial
population, but not the Medicare or Medicaid population, may be reluctant to assume
risk in connection with the Medicare or Medicaid population or may request significant
utilization data from the health plan before entering into a risk arrangement. There is
typically more provider reluctance to accept risk in connection with providing services to
the Medicaid population than with providing services to the Medicare population.
For physicians or physician groups, the size of the patient panel is a key factor in
whether the physician or physician group will be willing to accept risk. Other factors
being equal, the more patients a physician or physician group has, the more attractive
risk arrangements will be because, as we have seen in our discussion of the law of large
numbers, the more patients a provider has, the more likely it is that the health utilization
rate for that group of patients will fall within a predictable range.
Providers who are already accustomed to accepting capitation payments are most
ideally suited to provide services to a Medicare-contracting health plan, particularly if
those providers have had experience treating large number of older patients, or have
had experience with Medicare populations. These providers understand the need to
manage the overall care of the member and establish an ongoing relationship with
members rather than providing episodic treatment for disparate illness or injuries. 11
As a practical matter, a key influence on the structure of payment arrangements

between Medicare- and Medicaid-contracting health plans and their physicians is the
federal physician incentive law discussed earlier. Recall from our earlier discussion that
the physician incentive law regulates payment arrangements with physician and
physician groups and only regulates financial risk for services the physician or physician
group does not directly provide. A health plan typically designs its risk-sharing
arrangements to serve its business purposes, and then performs an analysis of the
arrangement’s compliance with the physician incentive law.
In some cases, the risk imposed by an arrangement meets the definition of substantial
financial risk. If the health plan can make small adjustments to the arrangement to bring
it under the substantial financial risk threshold without changing the basic structure of the
arrangement, the health plan will do so rather than comply with the additional regulatory
requirements that are imposed when a health plan places a physician or physician group
at substantial financial risk.
If bringing the compensation arrangement under the substantial financial risk threshold
undermines the basic structure of the arrangement, the health plan can choose instead
to buy (or require providers to buy) stop-loss insurance. The health plan can also provide
stop-loss insurance to providers as a means of complying with the physician incentive
regulations for its Medicare or Medicaid products.
Review Question
Correct statements about the financial risks associated with benefits that health plans
provide to the Medicare and Medicaid markets include:
that, because the government sets the payments received by health plans, the
health plans cannot easily obtain an increase in those payments even in the face
of rising costs
that regulators determine which services must be provided under Medicare and
Medicaid and which persons are eligible to enroll in a plan
that there is typically more provider reluctance to accept risk in connection with
providing services to the Medicaid population than with providing services to the
Medicare population
all of the above
Incorrect. While this statement is correct, other statements are true as well.
Correct. All the answers above are correct.
Providers' Financial Risk and Medicaid
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Under Medicaid, some providers that have traditionally provided services to low-income
persons and served as a safety net have relatively little experience with accepting
financial risk. However, it is important to include such providers in the health plan’s
network, and health plans may be required under state law or contracting conditions to
include such providers in their networks.
Prior to implementation of Medicaid amendments made under the BBA, health plans
were required to pay FQHCs 100% of reasonable costs unless the FQHC negotiated
another arrangement with the health plan. As discussed earlier in this lesson, the BBA
amended Medicaid law to require states to make supplemental payments to FQHCs and
RHCs to guarantee that the level of payment from the health plan equals the guaranteed
payment level set forth in federal law.
Provider Reimbursement and Risk and Medicare
Effective use of hospital utilization is the single most likely factor to contribute to the
success of a Medicare-contracting health plan. 12
Therefore, it is useful for Medicare contracting health plans to structure their physician
payment arrangements in a manner to provide incentive to avoid the risk of
overutilization of hospital services. Such incentives can be provided through withholds,
capitation contracts, or bonuses. The mechanism used by a particular health plan is
likely to depend on the mechanisms used for that health plan’s commercial population.
Managing the use of specialty services is also an important consideration for Medicare-
contracting health plans. Because of the higher use of specialists required to provide
care to the Medicare population, health plans should implement an incentive that
addresses effective referrals from PCPs to appropriate specialists and from one
specialist to another.
Special Risk Sharing Rules for Medicare-Contracting PSOs
If a Medicare-contracting health plan is a provider sponsored organization (PSO), it is

subject to requirements to share risk with its providers. As defined under Medicare law, a
PSO is a public or private entity that is established or organized and operated by a
provider or group of affiliated healthcare providers and that provides a substantial portion
of healthcare items and services under its Medicare contract directly through the
provider or group of affiliated providers.
If the PSO is established or operated by a group of affiliated providers, the affiliated

providers must share financial risk with respect to the provision of items and services
under the Medicare contract and must have a majority financial interest in the PSO.
The implementing regulations to the law specify that each affiliated provider must share,
directly or indirectly, in substantial financial risk. The regulations indicate that the
following mechanisms may constitute risk-sharing arrangements and may have to be
used in combination to demonstrate substantial financial risk in the PSO:
• Capitation payment for each Medicare enrollee

• Payment of a predetermined percentage of the PSO premium or the PSO’s
revenue
• The PSO’s use of significant financial incentives for its affiliated providers,
with the aim of achieving utilization management and cost containment goals.
For example, the use of significant withholds or bonus arrangements would
fall under this category
• Other mechanisms that demonstrate significant shared financial risk. 13
It is likely that a PSO would not have commercial lines of business and therefore would
not have agreements to provide services to commercial enrollees on which to base its
Medicare provider payment arrangements.
Key Health Plan Issues in Medicare and Medicaid Markets
As we have seen, in deciding whether to enter into a Medicare or Medicaid contract or

evaluating the Medicare or Medicaid markets, health plans should be mindful of the
payment amounts the organization will receive, the regulatory environment, and the
special needs of the populations to be served.
Finally, a health plan’s relationships with providers are an important factor in its success.
To make a Medicare or Medicaid product financially viable, a health plan must
• Structure its payment arrangements to attract providers who will work well in
a health plan environment
• Provide incentives to appropriately control utilization and manage care, and
to be consistent with the health plan’s financial goals given the payment rate
that the health plan receives from the state or federal government.
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Chapter 7A
The Relationship between Rating and Underwriting
Health plans use underwriting and rating to achieve some of the central goals of their
core business: pricing health plan benefits and other products in such a way that the
rates for the health plan’s products, including health plans, are adequate, reasonable,
equitable, and competitive. Each of these is described in Figure 7A-1.
The process by which a health plan achieves these goals is complex. A health plan
regularly monitors how well its assumptions about expenses and risk match the costs
that the health plan incurs. Demographic factors, medical treatments, technology, and
health plan techniques change over time. As a result, a health plan’s expenses change,
so the health plan analyzes and incorporates the effect of these and other changes into
its underwriting and rating assumptions
Rating and Underwriting
Rating, also called pricing, is the process of calculating the appropriate premium to
charge purchasers, given the degree of risk represented by an individual or group, the
expected costs to deliver healthcare services, and the expected marketability and
competitiveness of the healthcare services. Underwriting is the process used to assess
1
the risks associated with providing healthcare services for an individual or group and to
determine the conditions under which those risks are acceptable. 2
The process of rating is usually accomplished by using a mathematical formula that
considers the specific costs that affect the delivery and financing of healthcare services
to a particular group or individual. The rating formula represents each cost by a specific,
measurable, cost-generating variable. This formula is sometimes called the book rate
formula or the manual rating structure. We discuss manual rating later in this lesson.
health plan’s underwriting process may modify the book rates and/or establish certain
conditions that must be satisfied by the group or individual before the health plan
accepts the risks associated with providing healthcare services. The rating structure that
a health plan uses must
• Consider the costs of providing healthcare services

• Calculate premium rates for those services
• Anticipate future increases in utilization and claims costs
• Comply with applicable laws and regulations that govern premium rates
The results of the rating formula are typically expressed on the basis of per member per
month (PMPM) cost. The PMPM cost must in turn be transformed into premium rates for
each employee category through the use of an appropriate tier rating structure, which we
discuss later in this lesson and in Pricing and Rating lesson.
The rating formula and its components have other important applications to a health
plan. These applications include establishing budgets or cost objectives by medical
service category or department; establishing funding for provider-based risk pools; and
identifying, quantifying, and ranking opportunities for healthcare services within the
health plan. A health plan can use these data to establish provider-based education and
incentives necessary to realize business opportunities. A health plan’s actuarial and
underwriting functions are involved in the development of premium rates and risk
selection.
The Actuarial Function
Generally, the actuarial function is the work group and/or processes that a health plan
establishes to be responsible to see that the health plan’s operations are conducted on a
mathematically sound basis. Recall from the Health Plan Financial Information lesson
3
that an actuary develops premium rates and evaluates claims experience with respect to
the risk associated with healthcare benefits for product pricing, provider contracting, and
other purposes. Ultimately, the determination of the appropriate rate (price) to charge for
a given level of healthcare benefits and administrative services (cost) in a particular
market (competition) is a critical component of managing the profitability of a health plan.
Employees in a health plan’s actuarial function typically
• Calculate premium rates

• Identify the type and amount of the health plan’s liabilities
• Conduct research to establish underwriting guidelines
• Determine the health plan’s overall profitability
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• Play a key role in managing the health plan’s risk-based capital (RBC)
requirements, if applicable
• Design and revise healthcare products and services (with employees in the
health plan’s marketing function)
The Underwriting Function
Recall from the Health Plan Financial Information lesson that an underwriter assesses
and classifies the degree of risk represented by a proposed group or individual. The
underwriting function is the work group and/or set of processes that a health plan
establishes to assess the risks associated with a group or individual and which
determines the conditions under which those risks are acceptable to the health plan. 4
Through a process of risk assessment, risk classification, and risk selection, the
underwriting function seeks to ensure that the actual costs of providing healthcare
benefits for each purchaser do not exceed the costs that were assumed when the price
of those benefits was calculated.
A health plan’s underwriters and other employees who perform the underwriting function
use purchaser-specific quantitative or qualitative considerations to modify the results
obtained from the rating formula to reflect accurately the health plan’s risks in
underwriting the purchaser or group. For large employer groups, underwriters may
include minimum penetration requirements, which we discuss in the next lesson. For
small employer groups, underwriters also may consider the result of medical
underwriting, which we discuss in the Small Group Underwriting and Individual
Underwriting lesson.
Either the actuarial function or the underwriting function in a health plan also negotiates
and manages stop-loss insurance contracts and reinsurance contracts that the health
plan uses to transfer some or all of its risk. Underwriters and other employees who
perform the underwriting function in a health plan rely on the premium rate structure
developed by the actuarial function and consider which assumptions should be accepted
as is or modified through additional general or specific procedures.
Review Question
The following paragraph contains two pair of terms enclosed in parentheses. Determine
which term in each pair correctly completes the statements. Then select the answer
choice containing the two terms you have chosen.
In a typical health plan, an (actuary / underwriter) is ultimately responsible for the

determination of the appropriate rate to charge for a given level of healthcare benefits
and administrative services in a particular market. The (actuary / underwriter) assesses
and classifies the degree of risk represented by a proposed group or individual.
actuary / actuary
actuary / underwriter
underwriter / actuary
underwriter / underwriter
Incorrect. An actuary is responsible for the determination of appropriate rates, but
not the assessment and classification of the degree of risk
Correct. An actuary is responsible for the determination of appropriate rates, and

an underwriter the assessment and classification of the degree of risk
Incorrect. An underwriter assesses and classifies the degree of risk, while an

actuary is responsible for the determination of appropriate rates.
Incorrect. While an underwriter assesses and classifies the degree of risk, an

underwriter is not responsible for the determination of appropriate rates.
Underwriting, Rating, and Risk Management
In Risk Management in Health Plans, we discussed how a health plan uses risk
management techniques to avoid, assume, share, or transfer the risks associated with
the financing and delivery of healthcare services. In the following sections, we review
risk assessment, risk classification, and risk selection in the context of underwriting and
rating.
Risk Assessment
As part of its decision process to provide healthcare benefits to a group or individual, a

health plan reviews the risk assessment factors associated with that group or individual.
Risk assessment factors associated with group healthcare benefits may include the size,
stability, experience, geographic area, industry, level of participation, and demographics
associated with a group and the type of health plan and the level of healthcare benefits
being sought by the group.
Risk assessment factors associated with individual healthcare benefits may include the
individual’s age, gender, health status, occupation, hobbies, and the existence of other
healthcare benefits. Although some of the same factors apply to both group and
individual underwriting, an analysis of these factors is typically less detailed for large
groups because group members with high utilization rates are expected to offset those
with low utilization rates. We discuss key risk assessment factors in group underwriting
in the next lesson. Key risk assessment factors in small group and individual
underwriting are discussed in the Small Group Underwriting and Individual Underwriting
lesson.
Risk Classification
To assist in the development of appropriate premium rates, a health plan classifies the
risks associated with groups and individuals. In the context of establishing premium
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rates, risk classification involves sorting group members into classes or tiers. The
actuarial function develops premium rates for each class or tier.
Typically, the amount of risk associated with each tier determines the premium rate for
that tier. Two-tier, three-tier, or four-tier classes are typically used for employer groups.
In some cases, up to seven tiers may be used. Premium rates vary among tiers.
For example, in a two-tier structure, an employer is billed one amount for each employee
who enrolls for employee-only coverage (Tier 1), and another amount for each employee
who enrolls for family coverage (Tier 2). In other words, the premium is determined by
multiplying the Tier 1 rate by the number of employees who enroll for employee-only
coverage and the Tier 2 rate by the number of employees who enroll for family
coverage, then combining these two amounts.
Figure 7A-2 depicts common tiers used in rating methods. We continues our discussion
of the development of premium rates by tier in the Pricing and Rating lesson.
A health plan usually develops premium rates on the basis of a group’s risk profile. The
degree to which a group’s rates are based on its own risk profile depends on the size of
the group and applicable state regulations regarding rating practices. For example, some
states do not allow health plans to use a rating differential based on the health status of
small groups. Risk classifications for group underwriting include those based on
utilization patterns and/or average claims costs. Risk classifications for individual
underwriting include preferred risk, standard risk, substandard risk, and uninsurable risk.
A health plan may have one risk classification that consists of groups whose members
have the lowest utilization patterns and/or average claims costs, compared to those of
other similar groups. Similarly, the health plan may have another risk classification for
those groups whose members have the highest utilization patterns and/or average
claims costs.
Between these two ranges are groups whose members exhibit less extreme levels of
utilization patterns and/or average claims costs. As you may have expected, health
plans usually charge groups or individuals with lower utilization patterns and/or average
claims costs a lower premium rate for a given level of healthcare coverage.
Risk Selection
After classifying the risk, a health plan decides to accept or to decline the risk, based
largely on the health plan’s tolerance for risk and the cost of providing a given level of
healthcare benefits. Note that federal law and some state laws may limit a health plan’s
ability to decline coverage for some individuals and groups.
Suppose an employer group offers its employees a double option: an HMO and a
traditional indemnity plan. Assume that the premiums are lower for the HMO than for the
indemnity plan. In this case, individual low utilizers are more likely to enroll in the HMO
because they are less likely to be concerned about the limits imposed by the HMO.
In this context, individual low utilizers of healthcare services are those group members
who, because they tend to be healthier, have lower levels of utilization and lower
average claims costs. Similarly, given a triple option (an HMO, an HMO with a POS
option, and an indemnity plan), individual low utilizers are most likely to enroll in the
HMO and least likely to enroll in the indemnity plan, for the same reason. In contrast,
individual high utilizers of healthcare services are more likely to enroll in a health plan
with a POS option or an indemnity plan because they want broad access to healthcare
services in anticipation of using such services.5
Note that the premium and the presumed level of quality for each product also influence
choice in a double-option or triple-option environment. For example, if the employer
offers several HMOs as options, employees will select an HMO on the basis of premium
and access. Most likely, the HMO that charges the lowest premium would be selected by
both high and low utilizers of healthcare services, if access is similar across the HMO
options.
Underwriting Guidelines 6
Underwriting guidelines are general rules that the underwriting function uses in
assessing, classifying, and selecting risks that an insurer or health plan assumes. An
health plan’s underwriting guidelines address the level of overall risk and the risk
classifications that the health plan is willing to accept when offering a given level of
healthcare benefits to individual or group plan members.
The underwriting function determines what degree of risk is so high that a health plan
cannot underwrite the business at all, thereby declining the risk. These determinations
are established according to the health plan’s strategic goals, its attitude (conservative
or aggressive) toward risk, and its pricing decisions.
Underwriting guidelines influence a health plan’s cash flows—money coming into the
plan in the form of premiums and money going out of the health plan in the form of
healthcare expenses.
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Managing the underwriting cycle effectively is a means of influencing the health plan’s
cash flows positively. The underwriting cycle is the historical occurrence of a period
during which health insurers generated underwriting profits on their business, followed
by a period during which the health insurers generated underwriting losses on their
business. For the past three decades, the underwriting cycle has followed a pattern of
three years of underwriting profits, followed by three years of underwriting losses.
Review Question
The Northwest Company offers its employees the option of choosing to receive their
healthcare benefits from an HMO or from a traditional indemnity plan. The premiums for
the HMO are lower than for the traditional indemnity plan. In this situation, it is correct to
assume that:
1. Individual low utilizers are more likely to enroll in the traditional indemnity plan
2. Individual high utilizers are more likely to enroll in the HMO
Both 1 and 2
1 only
2 only
Neither 1 nor 2
Incorrect. Low utilizers will traditionally select the lowest cost plan. High utilizers
will select a plan with broad access to healthcare services.
Incorrect. Low utilizers will traditionally select the lowest cost plan.
Incorrect. High utilizers will select a plan with the broad access to healthcare
services an indemnity plan affords
Correct. Low utilizers will choose a low cost option, and high utilizers will select a
plan with the broad access to healthcare services an indemnity plan affords.
Underwriting Guidelines
Historically, the underwriting cycle occurred when health insurers and health plans
adopted more strict underwriting guidelines after three unprofitable years of underwriting
healthcare coverage. Strict underwriting guidelines typically result in premium rate
increases for a health plan. As a result of higher premiums, the health insurers and
health plans experienced three highly profitable years, which provided them a financial
cushion from which they could relax their underwriting guidelines.
The establishment of lenient underwriting guidelines usually resulted in lower premium
rates for the health plan. Charging lower premium rates improved the health insurer’s or
health plan’s ability to respond to market competition. However, lower premium rates
could result in several unprofitable years for the health plan, the health insurer, or the
health plan. During years in which health insurers and health plans experienced
underwriting losses on specific products, investment income and revenues from other
sources were critical for the health insurers and health plans to generate company-wide
net income (profit).
Following several years of losses, the health insurer or health plan was likely to tighten
its underwriting guidelines once again. Strict underwriting guidelines usually resulted in
higher premium rates, thereby improving the plan’s profitability for the next few years.
Finding the appropriate balance between competitive premium rates and actuarially
sound premium rates is therefore critical to managing the underwriting cycle and
predicting healthcare cash flows. By the late 1990s, conventional wisdom is that the
effect of the underwriting cycle has been alleviated by the evolution of health plan
techniques, which have improved a health plan’s ability to predict costs.
Rating Components 7
To develop an effective rate formula, health plans pay close attention to two major
components in setting premium rates: (1)the cost of incurred claims and (2) the retention
charge. The cost of incurred claims, also called incurred claims expense, is the portion
of the premium that a health plan determines will be needed to pay claims. For large
group plans, a health plan projects the cost of incurred claims by collecting claims
experience data.
The period of time during which a health plan collects this data is called the experience
period. Typically, the experience period ends three or more months before the rating
period (contract renewal date) to give the health plan enough time to review the data,
develop the new rate, and give the purchaser advance notice of a rate change, if any.
The new rate then becomes applicable at renewal; in other words, during the next
contract (or rating) period.
Recall from the Fully Funded and Self-Funded Health Plans lesson that, in the context of
healthcare benefits, the retention charge is the portion of the premium that is not paid
out to cover the cost of incurred claims. In other words, it is the portion of premium that a
health plan retains to cover administrative expenses such as processing claims, staff
salaries, taxes, conversion charges, and to allow a margin for profit. Retention charges
also include risk charges and other charges.
A health plan’s retention charge differs on the basis of the health plan’s structure. For
example, a capitated health plan includes most of the costs incurred by the plan’s
medical management function—including utilization management and quality
management—in its cost of incurred claims rather than its retention charge. On the other
hand, costs incurred by the medical management function in health plans that are not
capitated typically are included in the retention charge component of the plan’s premium.
Figure 7A-3 presents an example of how a health plan computes the cost of incurred
claims, using various retention rates.
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Underwriting, Market Competition, and Group Size
Generally, the amount of underwriting that a health plan performs varies according to
market competition and group size. For example, health plans that operate in very
competitive markets may choose to accept greater risks than they would be willing to
take on otherwise in order to obtain market share. They then use risk management
techniques to transfer some or all of these additional risks.
Government mandates influence the degree of underwriting that a health plan

undertakes in order to obtain group business. Legal and regulatory requirements often
mandate that all members of a group, particularly small groups of 2 to 50 members, be
accepted regardless of the risk posed by any individual group member.
In assessing, classifying, and selecting the risks for a group, a health plan may use
medical underwriting. Medical underwriting is the use of health questionnaires, medical
histories, paramedical examinations, or physical examinations to assess, classify, and
select or decline the risk.
There is an inverse relationship between the degree of medical underwriting a health

plan undertakes and group size. In other words, health plans use medical underwriting
regularly in underwriting individuals and small groups, unless prohibited by law or
regulation, but seldom use it in the case of large groups. We discuss medical
underwriting in more detail in Small Group Underwriting and Individual Underwriting. The
following sections discuss common rating methods used by health plans to price their
products.
Rating Methods 8
As noted in the preceding section, the actual premium rate charged by a health plan is a
direct result of the actuarial function (calculating the appropriate premium rate for a given
level of healthcare benefits) and the underwriting function (assessing, classifying, and
selecting the risks to be assumed). Also, as we have seen, the financial success of a
health plan depends a great deal upon its ability to appropriately price its products.
Recall from Risk Management in Health Plans that antiselection is the tendency of
people who have a greater-than-average likelihood of loss to seek healthcare coverage
to a greater extent than people who have an average or lower-than-average likelihood of
loss. Antiselection, also called adverse selection, can also occur when the highest
utilizing groups or individuals enroll in a particular health plan, rather than choose no
option or another healthcare benefit option. This type of antiselection typically occurs
within groups that have a dual option or triple option available to them or within highly
competitive markets.
Although health plans that attract the healthiest (lowest utilizing) groups experience
favorable selection, competition for these groups’ business is so keen that a health plan
may be tempted to undercharge a group in order to obtain or retain the group’s
business. In this case, the group would most likely retain their current health plan
because the group would not be able to obtain the same level of healthcare benefits at a
lower cost in the marketplace. We discuss the issue of pricing in a multiple-choice
environment in more detail in Pricing a New Health Plan.
Recall from Risk Management in Health Plans that antiselection is the tendency of
people who have a greater-than-average likelihood of loss to seek healthcare coverage
to a greater extent than people who have an average or lower-than-average likelihood of
loss. Antiselection, also called adverse selection, can also occur when the highest
utilizing groups or individuals enroll in a particular health plan, rather than choose no
option or another healthcare benefit option. This type of antiselection typically occurs
within groups that have a dual option or triple option available to them or within highly
competitive markets.
Although health plans that attract the healthiest (lowest utilizing) groups experience
favorable selection, competition for these groups’ business is so keen that a health plan
may be tempted to undercharge a group in order to obtain or retain the group’s
business. In this case, the group would most likely retain their current health plan
because the group would not be able to obtain the same level of healthcare benefits at a
lower cost in the marketplace. We discuss the issue of pricing in a multiple-choice
environment in more detail in Pricing a New Health Plan.
Undercharging may be an appropriate short-term solution in certain circumstances—for

example, to enter a new market or to increase market share in an existing market.
However, undercharging a group is not a viable long-term strategy because a health
plan must charge premium rates that are adequate to cover at least the health plan’s
costs.
Further, competing on the basis of price alone may encourage employer groups to view
healthcare benefits as a commodity to be purchased from the health plan that charges
the lowest price with no consideration of service levels and other important healthcare
delivery factors. Health plans differentiate themselves in the marketplace by the benefits
they provide, and they must set premium rates that are adequate to cover their
expenses and generate a fair profit. A variety of rating methods is available to health
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plans to achieve their strategic business goals. Below is a review of several common
rating methods.
Community Rating
Community rating is a rating method that sets premiums for financing healthcare
benefits according to the expected costs for healthcare in a market or segment, known
as a block of business, rather than to a subgroup within that block of business. In other
words, a health plan calculates the premium rate according to the costs for the block as
a whole, rather than as a function of each risk class within the block of business.
Because both low-risk and high-risk classes are factored into community rating, the
expected costs are spread across the entire community.
Community rates may vary by type of health plan or group size, although all groups pay
similar premiums for the same level of benefits. If actual costs exceed expected costs,
then the health plan is financially responsible for the difference. Community rating is
seldom used for large groups, except where specified by state law, because other rating
methods are more specific, and, therefore, more competitive. However, health plans
often first calculate a large group’s premium using community rating as a point of
reference for calculating the premium rate under another rating method.
Community Rating
The use of modified community rating methods has increased for small groups, spurred
by several federal and state initiatives that have mandated such community rating
methods for small groups. Some small groups benefit from modified community rating
methods because these groups incur less fluctuation in premium rates and have more
stable contract relationships with health plans than they are likely to have under other
rating methods. However, typically 70% to 80% of small groups have actual healthcare
costs that are below the average, or community, rate, so these groups pay higher
premiums to achieve that stability.
From the perspective of both the health plan and the group, premium rates established
using community rating are generally more stable than those established under other
rating methods. Consequently, the group can more accurately estimate its total premium
costs and the health plan can receive a steady flow of premium income. Community
rating is also compatible with health plan provider reimbursement techniques such as
capitation.
The use of community rating enables a health plan to spread the risks it assumes for
both high-risk and low-risk groups throughout the market or segment it serves.
Community rating is a relatively straightforward process—typically only a few factors are
considered in determining premium rates—so a complex information system is not
required in most circumstances.
Although community rating tends toward stable premium rates, the advantages of such
stability may be undercut by a competitor that uses another rating method or is willing to
charge a lower premium. In the latter case, a competing health plan may be willing to
assume greater underwriting risk in order to obtain or retain market share. Artificially low
premium rates may attract a group initially, but a health plan most likely would have to
increase premiums significantly after it determines the community’s actual utilization
rates and actual costs.
Community Rating by Class
In 1991, the National Association of Insurance Commissioners (NAIC) promulgated a

small group model act that allows health plans to use a modified form of community
rating to underwrite small groups. This modification, referred to as community rating
by class (CRC), also called factored rating, allows a health plan to use tiers on the basis
of experience or duration. We discuss experience rating and durational rating later in this
lesson. Rating classes, such as age, sex, industry, and so on, are overlayed on these
tiers. The premium rate developed using CRC results from calculating the weighted
average of these factors.
In this context, the term experience means a specific group’s historical healthcare costs
and utilization rates. All members of the same class or group pay the same premium,
which is based on the experience of the class or group. The average premium in each
class may not be more than 120% of the average premium for any other class.
A 1995 amendment to this model act eliminated the class rating rules and promulgated
the use of adjusted community rating. Adjusted community rating (ACR), also called
modified community rating, is a rating method under which a health plan calculates the
ratio of a group’s experience to its historical manual rate—which is based on age, sex,
industry, and so on—then multiplies this ratio by the group’s future manual rate. We
discuss manual rating in the next section.
Under ACR, a health plan cannot consider the experience of a class, group, or tier in
developing premium rates. Note that, because NAIC model acts and their amendments
do not carry the force of law, laws based on the 1991 small group model act still exist in
many states. Also, another modified community rating method allows a health plan to
establish an average or index rate, which may or may not be adjusted for demographics.
The health plan may charge premium rates that are plus or minus 25% of the index rate.
The Centers for Medicare and Medicaid Services (CMS) requires health plans that
assume Medicare risk to use ACR so that premium rates reflect expected utilization
levels, rather than the actual costs of healthcare benefits. The Health Maintenance
Organization Act of 1973 (the HMO Act) required federally qualified HMOs to use only
community rating to establish premium rates. Subsequent amendments to the HMO Act
allow the use of CRC and ACR methods.
Manual Rating
Manual rating is a rating method under which a health plan uses its average experience
—and sometimes the experience of other health plans—rather than the purchaser’s
actual experience, to estimate the group’s expected experience. Manual rating is similar
to community rating in that both rating methods use demographics to determine the rate
for a block of business. Manual rates are typically developed with the use of proprietary
data or published morbidity tables, which we discuss in the next lesson.
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In developing manual rates, a health plan assesses primarily its own experience. For
example, a health plan may derive its own average manual rate, perhaps adjusted by a
group’s characteristics, industry, or geographic area. Manual rates are sometimes called
book rates because a health plan often lists them in a rate book, underwriting manual, or
rate manual.
Before rating and underwriting a proposed group, a health plan typically checks the rate
book to see what the manual rate is for a given level of healthcare benefits. Manual rates
are often used to establish premiums for small groups and other groups that have had
no previous plan experience
Experience Rating
Experience rating is a rating method under which a health plan considers a group’s
actual experience, including its healthcare costs and utilization rates, to determine
premium rates. In other words, the health plan analyzes a group’s healthcare costs by
type and calculates the group’s premium in part or in full according to that experience.
Under experience rating, health plans charge lower premiums to groups that have
experienced low utilization rates and higher premiums to groups that have experienced
high utilization rates. Unlike community rating methods or methods that combine the
experience of a number of different groups to determine a manual rate, experience
rating is specific to a particular group.
Because a group’s experience changes over time, a health plan frequently uses at least
two years of the group’s experience to calculate experience rates. In most cases, the
size of the group is important in determining the degree to which experience rating
applies. Generally, health plans experience rate groups that have more than 250
employees, although many health plans have started to use experience rating for groups
of 50 or more employees. Experience rating methods may be either prospective or
retrospective.
Rating Methods
Prospective Experience Rating
Prospective experience rating is an experience rating method that uses a group’s

experience to establish the premium for the next contract period. Often the premium rate
is based on a weighted average of a group’s own experience and the experience of
many small groups. A health plan may pool (combine) the experience of many small
groups to obtain a large enough group to experience rate. Pooling enables small groups
to obtain lower premium rates than would otherwise be possible.
Twelve-month periods are typically used for prospective experience rating for an
employer group. Because prospective experience rating does not carry over gains or
losses from one rating period to the next, health plans that use prospective experience
rating absorb the gains or losses generated by a group’s experience.
Adjusted community rating, discussed earlier in this lesson, is a type of prospective

experience rating. Another type of prospective experience rating is durational rating.
Under durational rating, premium rates increase automatically with group tenure in a
health plan for a specified period, such as six months or a year. For example, a health
plan may charge a large employer group a $120 premium PMPM in the first year, $130
in the second year, and $135 in the third year for a three-year contract for the same level
of healthcare benefits, before inflation. Medical underwriting is often used along with
durational rating for small groups.
Retrospective Experience Rating
Retrospective experience rating is a type of experience rating method under which a

health plan considers both the gains and the losses experienced by a group during each
rating period. The health plan refunds part of a group’s premium, called an experience
rating dividend or experience refund (also called an experience rating refund) after the
rating period is over if the group’s experience has been better than expected during the
rating period. A health plan determines a premium rate, in part, on the basis of its
assumptions about a group’s expected utilization rate or claims costs. At the end of the
covered period, the health plan compares the group’s actual experience with its
expected experience.
On the other hand, if the group’s experience has been worse than expected during the
rating period, the health plan charges the group extra premiums for the excess costs,
either in a lump sum or in future premium increases. Often, when a health plan notifies a
group of a premium rate increase because the group’s experience was worse than
expected, the group will drop its health plan with the health plan and move to another
plan. Therefore, the health plan must include a risk charge in its premium rate to cover
for such losses. We defined risk charge in the Fully Funded and Self-Funded Health
Plans lessons.
Review Question
In evaluating the claims experience during a given rating period of the Lucky Company,
the Calaway Health Plan determined that the claims incurred by Lucky were lower than
Calaway anticipated when it established Lucky’s premium rate for the rating period.
Calaway, therefore, refunded a portion of Lucky’s premium to reflect the better-than-
anticipated claims experience. This rating method is known as:
durational rating
retrospective experience rating
blended rating
prospective experience rating
Incorrect
Yes!
Incorrect
Incorrect
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Retrospective Experience Rating
Because the excess costs will be paid by the purchaser after the covered period, the
purchaser must have a good credit rating to qualify for retrospective experience rating. In
some cases, if a group’s experience is significantly worse than expected, the health plan
may choose not to renew the group’s coverage. In effect, under retrospective experience
rating, a group assumes some of the financial risk associated with its experience.
Many large groups that have low healthcare costs and low utilization rates expect to
obtain either a rate decrease in the next contract period or an experience rating
dividend. The opportunity to obtain an experience rating dividend or to sustain the same
premium or a lower-than-average increased premium in the next rating period is an
incentive to the group to control healthcare costs and utilization. However, many states
prohibit HMOs from using retrospective experience rating.
Note also that the premium determined under retrospective experience rating usually is
higher than the premium under prospective experience rating, because some of the
premium will be returned to the purchaser in the form of a refund. Whether a health plan
uses prospective or retrospective experience rating, the health plan can expect similar
profit levels from either type of experience rating method.
Blended Rating
Blended rating is a rating method that combines experience rating and manual rating.
Under blended rating, a health plan develops a premium rate using a group’s own
experience, weighted by the health plan’s manual rate and the group’s credibility.
Credibility is a measure of the statistical predictability of a group’s experience, which is
expressed as a percentage or in decimal form as a credibility factor. The calculation of
the statistical probability of a group’s credibility is beyond the scope of this course.
Generally, the experience of a large group is generally more credible than that of a small
group.
The values of credibility factors typically fall between 0 and 1.00. The closer a group’s
credibility factor is to 1.00, the more reliable the group’s experience, and the more likely
that a health plan will weight the group’s experience more heavily than it weights the
manual rate in calculating the group’s overall premium rate.
Blended Rating
A credibility factor of 1.00 means that a group’s premium rate is based entirely on the
group’s experience. Most experience rating is a blended rating, unless the group is large
enough to have 100% credibility (that is, a credibility factor of 1.00) assigned to its
experience.
The blended rate is found by (1) multiplying the

experience rate by the credibility factor, (2)
multiplying the manual rate by the difference
between 1.0 and the credibility factor, then (3)
adding the retention to these amounts, as follows:
Review Question
The Norton Health Plan used blended rating to develop a premium rate for the Roswell
Company, a large employer group. Norton assigned Roswell a credibility factor of 0.7 (or
70%). Norton calculated Roswell’s manual rate to be $200 and its experience claims
cost as $180. Norton’s retention charge is $3. This information indicates that Roswell’s
blended rate is:
$186
$189
$194
$197
Incorrect. The formula is (Experience Rate X Credibility factor) + [Manual Rate X

(1.00 - Credibility Factor)] + Retention Charge
Correct. $180 X .7 + [$200 X (1.0-.70] + $3 = $189
Blended Rating
Using a group’s experience may not necessarily be predictive of its future utilization rate
or claims costs, however. A health plan addresses the risk that a group’s experience
may not be independent from one year to the next by lowering (discounting) the group’s
credibility factor by a specified amount or otherwise incorporating this risk into its
blended rate formula.
Other ways that a health plan can incorporate the risks that it assumes into calculating a
group’s credibility factor include:
• Using two or more years of the group’s experience

• Removing the group’s large, unusual claims from the calculation of the
credibility factor
• Excluding a portion of claims beyond a particular amount
• Pooling large claims from many groups to smooth out experience fluctuations
and assessing a pooling charge to cover the cost of these large claims
Blended Rating
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Figure 7A-4 illustrates how a health plan incorporates a group’s experience into
determining a blended rate.
In this case, Legrand would charge Holcomb a $144 premium (based on claims costs)
per member per month (PMPM), plus retention. Note that Holcomb’s blended rate is
greater than its experience rate, but less than its manual rate. The higher a group’s
credibility factor, the closer its blended rate would approach its experience rate.
Renewal Underwriting and Rating
The processes of renewal underwriting and renewal rating, which are sometimes
combined, serve to determine whether a health plan should continue to underwrite the
risk, and, if so, at what premium rate. Renewal underwriting and rating consume a
significant amount of time and effort on the part of both the underwriting function and the
actuarial function.
Renewal underwriting is the process by which a health plan reviews all the selection
factors that were considered when the health plan contract was first issued, then
compares the actual and expected dollar amounts and utilization rates to determine if
the health plan should continue to underwrite the risk. Renewal rating is the process by
9
which a health plan, through reviewing utilization rates, claim costs, and other factors,
determines the dollar amount of premium to be charged to a group or individual in a
renewal contract.
All rating methods, including prospective experience rating, that we described in the
previous sections may be used to determine the initial premium rate for an initial
contract. Often, a health plan can use prospective experience rating when the health
plan obtains a proposed group’s experience from the group’s previous health plan.
Experience information of this type is generally not available for HMOs or groups with
fewer than 100 employees. Note also that prospective experience rating can only be
used in renewal rating and underwriting if a group has some credible experience from its
previous health plan.
Earlier we discussed some typical underwriting guidelines and rating methods that
health plans use to determine initial premium rates for a group. A health plan also
considers several other factors, two of which are summarized in the following sections,
to determine renewal rates. Although we separately discuss these factors, keep in mind
that health plans typically combine several factors in determining renewal premium
rates.
Exposure Period
In the context of renewal rating and underwriting, the exposure period is the amount of
time during which a health plan is financially responsible for any or all risks that it
assumed under a group healthcare contract. A one-year contract period between a
health plan and a group may enable the health plan to more closely correlate the
premium rates it established for that group with the group’s actual utilization rates and
overall experience.
Sometimes, to remain competitive and to minimize dis-enrollment, health plans contract

with groups for two-year or three-year periods. However, the longer the contract period,
the higher the risk that the assumptions, under which the initial premium rate was
established, will not correlate closely with the group's actual and healthcare costs.
Use of Catastrophic Claims Pools
Suppose a group that typically has low utilization rates experiences a catastrophic claim
in one contract period. In this case, a health plan has a number of options with respect to
consideration of that catastrophic claim in the renewal rating process. The health plan
can include all of the catastrophic claim cost in the group’s experience and adjust the
group’s premium rate accordingly. Conversely, the health plan can choose to exclude
the total catastrophic claim from the group’s experience. In either case, the health plan
may consider the probability that a similar claim will occur in the future and adjust the
group’s premium rate to reflect that probability.
Another option available to a health plan is to exclude a percentage of the catastrophic

claim costs from the group’s experience. Although the premium rate might increase for
that group, this increase may be lower than it would have otherwise been, if the total
cost of the catastrophic claim had been included.
The preceding example depicts the impact of a catastrophic claim on one group.
Suppose that, in a given block of business, several groups had catastrophic claims. In
this case, a health plan may deduct the catastrophic claims from the renewal rate
calculation, then incorporate a catastrophic claims pool to spread the cost over all
groups in that block of business.
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Chapter 7 B
Group Underwriting
• Identify the key federal and state laws and regulations that apply to group
underwriting
• Discuss how a health plan adjusts for morbidity factors and other underwriting
risk factors in group underwriting
• Identify and describe the key aspects associated with underwriting the
proposed group and the proposed group coverage
Group Underwriting
In the previous lesson, we discussed the role of rating and underwriting in a health plan.
This lesson focuses on the underwriting of a key market for health plans: large and
medium groups, particularly employer groups. First, we discuss the federal and state
laws and regulations that affect group underwriting (other than small group underwriting,
which we discuss in Small Group Underwriting and Individual Underwriting). Then we
discuss key aspects of group underwriting and group underwriting procedures.
If a health plan is incorporated, then it is subject to all federal and state laws and
regulations that apply to corporations. In addition, health plans that serve the group
market must comply with other laws that concern employee benefit plans, such as laws
that pertain to medical records. In the course of assessing, classifying, and selecting
risk, health plans gather a great deal of personal information about individuals. General
laws and court cases relating to confidentiality of medical information apply to the
handling of this information. Some states also specifically address procedures, including
specific methods for filing and retrieving information and a specified period of time for
retaining files for maintaining medical records.
Federal Laws and Regulations 1
Below is a summary of several key federal laws and regulations that may affect health
plans that offer products, particularly employee benefit plans, and services to the
employer group market. Note that other federal laws and regulations, particularly those
concerning Medicare, Medicaid, and healthcare benefits for federal employees and the
military, have a significant impact on health plans that cater to these markets.
The Health Maintenance Organization Act
The Health Maintenance Organization Act of 1973 (HMO Act), which applies only to
federally qualified HMOs, originally required HMOs to use community rating to determine
premiums. At the time of its enactment, the HMO Act prohibited HMOs from using
experience rating. A 1981 amendment to the HMO Act expanded the allowable rating
options to include community rating by class, which enabled HMOs to consider certain
characteristics of each group—such as the group’s industry and the age, gender, and
marital status of its members—when determining the group’s premium rates.
In 1988, the HMO Act was amended to expand the allowable rating options to include
prospective experience rating (also called adjusted community rating in the context of
federally qualified HMOs). These 1988 changes enabled HMOs to consider specific
characteristics and the utilization and claims cost experience of each group when
determining rates for a future rating (contract) period.
However, the HMO Act continued to prohibit retrospective experience rating, which
would have allowed an HMO to adjust a group’s prior premiums on the basis of the
group’s experience during the prior rating (contract) period. Note that, although federal
qualification is no longer of critical importance to HMOs, federally qualified HMOs must
comply with the HMO Act and its amendments.
Employee Retirement Income Security Act
Employer-sponsored benefit plans that provide healthcare benefits must comply with the
Employee Retirement Income Security Act (ERISA) of 1974, a broad-reaching law
that established, among other things, requirements for the disclosure of plan provisions
and funding information to plan participants. Also contained in ERISA are strict reporting
requirements, including requirements for the preparation and submission of reports to
the Department of Labor and the Internal Revenue Service.
Underwriters appraising the risk of a group that previously had a self-funded plan may
use the documents files under ERISA reporting requirements to assess the risk.
However, when a group previously has been insured by another health plan,
underwriters typically do not rely upon ERISA reports. Instead, the underwriters use
reports provided by the group’s previous health plan to address the group’s claims
experience and to establish premium rates.
Consolidated Omnibus Budget Reconciliation Act
The Consolidated Omnibus Budget Reconciliation Act (COBRA) of 1986 requires

plan sponsors to allow qualified beneficiaries (employees and their dependents) to
continue their group healthcare coverage for a specified period of time following a
qualifying event that causes the loss of group healthcare coverage. Because this
continuation requirement applies to plan sponsors, not health plans and insurers, it has
important implications for group underwriting.
Suppose a plan sponsor elects to terminate its group coverage with a health plan. In this
case, the health plan is not required to continue coverage for the COBRA- qualified
beneficiaries, because COBRA places this responsibility with the plan sponsor. The
successor health plan, in determining whether to accept or decline the risks associated
with this group, would also consider the risks associated with the group’s COBRA-
qualified beneficiaries. Under COBRA, a health plan is not required to cover these
individuals. However, the successor plan must decide whether to cover the COBRA
beneficiaries “outside the policy” as a condition for doing business with the purchaser.
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Review Question
The Lindberg Company has decided to terminate its group healthcare coverage with the
Benson Health Plan. Lindberg has several former employees who previously
experienced qualifying events that caused them to lose their group coverage. One
federal law allows these former employees to continue their group healthcare coverage.
From the answer choices below, select the response that correctly identifies the federal
law that grants these individuals with the right to continue group healthcare coverage, as
well as the entity which is responsible for continuing this coverage:
Federal law: Consolidated Omnibus Budget Reconciliation Act (COBRA)

Entity: Lindberg
Federal law: Consolidated Omnibus Budget Reconciliation Act (COBRA)
Entity: Benson
Federal law: Employee Retirement Income Security Act (ERISA)
Entity: Lindberg
Federal law: Employee Retirement Income Security Act (ERISA)
Entity: Benson
Yes, correct!
Incorrect. COBRA is the federal law that grants individuals with rights to continue
coverage, but the entity responsible is the employer.
Incorrect. ERISA regulates employer-sponsored benefit plans and establishes
reporting requirements and disclosure requirements for plan provisions and
funding
Incorrect. ERISA regulates employer-sponsored benefit plans and establishes
reporting requirements and disclosure requirements for plan provisions and
funding.
Americans with Disabilities Act
The Americans with Disabilities Act (ADA) of 1990 is a federal law that protects
disabled individuals from various types of discrimination. Because of its scope, the ADA
applies to the facilities and activities of all types of health plans. For example, the ADA
requires that a health plan facility must be accessible to wheelchairs. Also, a health plan
must not discriminate against disabled providers.
In addition, underwriting guidelines that exclude or reduce benefits that apply to a

specific disease have been challenged in court as violations of the ADA. However, a
health plan that reduces benefits for a particular service, for example, that does not
discriminate against a particular group of individuals would generally not be in violation
of the ADA.
Suppose a health plan eliminates coverage for allergy shots for asthmatics. In this case,
the health plan may be found in violation of ADA. On the other hand, if the health plan
reduces prescription drug benefits for all employee classes, the health plan is less likely
to be found in violation of the ADA. Further, if a health plan has a sound underwriting
reason for eliminating or reducing benefits that impact only individuals with a particular
disease or disability, the plan may not be in violation of ADA.
Health Insurance Portability and Accountability Act
The Health Insurance Portability and Accountability Act (HIPAA) of 1996 contains
provisions to ensure that prospective or current enrollees in a group health plan are not
discriminated against based on health status (for example, there are rules and limits on
the use of pre-existing condition exclusions). This law also requires guaranteed access
to health insurance for small employers and certain other eligible individuals.
Similarly, HIPAA generally requires the guaranteed renewal of healthcare coverage for
certain individuals and for both small and large groups, regardless of the health status of
any member. These and other requirements restrict a health plan’s ability to accept or
decline certain risks and they may directly impact a health plan’s rate-setting process.
Amendments to HIPAA created the Newborns’ and Mothers’ Health Protection Act
(NMHPA) of 1996 and the Mental Health Parity Act. Recall that the NMHPA, which we
discussed in Provider Reimbursement Arrangements, requires that a health plan cover
hospital stays for childbirth for both the mother and the newborn for at least 48 hours for
normal deliveries and 96 hours for Caesarean births.
The Mental Health Parity Act (MHPA) of 1996 prohibits a health plan, under certain
circumstances, from imposing annual or lifetime dollar benefit limits for mental illness on
a group if there are no such limits for physical illness. The MHPA does not require that a
health plan offer benefits for mental healthcare. However, if a health plan does offer
mental health benefits, then the MHPA mandates that the annual or lifetime limit on such
benefits cannot be less than the benefit limit that the health plan's plan sets for physical
illness.
The MHPA also allows an exemption for employers that can demonstrate (after six
months) that providing mental health parity would increase health plan costs by at least
1%. This exemption means that few health plans offer mental health parity.
Benefit mandates such as the federal NMHPA and MHPA and numerous state laws and
regulations (briefly discussed in the following sections) have a major impact on a health
plan’s underwriting and rating process. Mandated benefits directly increase the cost of
incurred claims, and, to a lesser extent, the associated administrative charges that are
applied to retention in calculating premium rates.
State Laws and Regulations 2
Most state insurance laws contain provisions that in some way affect the underwriting
and rating practices of health plans. Often the purpose of state underwriting laws and
regulations is to protect consumers from unfair discrimination in terms of eligibility. For
example, most states require that any differences in healthcare benefits for members of
an employer group must be based on conditions pertaining to employment.
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This means that an employer group would not be permitted to have separate benefit
levels for certain employees listed in a memorandum sent by the company’s human
resources manager to a health plan. However, the employer group would be permitted to
provide separate benefit levels based on conditions pertaining to employment, such as
hourly or salaried status, job class, or salary range.
In deciding whether or not to accept risk for an employer group, a health plan’s
underwriters must be aware of state group insurance laws that specify the individuals
who can or must be covered under a group policy. For example, some state laws specify
whether or not dependent coverage must be provided. Also, most state laws define
certain types of dependents that must be covered if dependent coverage is provided
under a health plan.
As we mentioned in The Relationship Between Rating and Underwriting lesson, states

sometimes place limits on how much a health plan may charge for healthcare benefits.
Generally, the purpose of these limits is to ensure reasonableness and adequacy in
rating. For instance, in a state that requires rate filings for a particular product, an
insurance department might reject a rate increase because of concerns about the
reasonableness of the proposed rates. Alternatively, a state insurance department might
reject a rate decrease submitted in a rate filing on the grounds that the rates are not
adequate to meet the health plan’s operational costs.
In addition to eligibility and rating requirements, many states have enacted benefit
mandates that have a significant impact on underwriting and rating decisions. Recall
from the Provider Reimbursement Arrangements lesson that mandated benefit laws
require a health plan to cover certain conditions or treatments or to pay a specified level
of benefits for certain conditions or treatments.
Similar to benefit mandates are provider mandates, which, among other things, may
require a health plan to cover the services of certain types of providers or healthcare
facilities. In effect, state mandates help shape the overall plan design developed by an
health plan’s actuaries and underwriters because —for certain portions of the health
plan, at least—these mandates determine what the plan covers and the cost of providing
certain types of benefits.
Benefit mandates add to the cost of healthcare benefits. Benefit mandates also increase
a health plan’s risk because the health plan may have to delay premium rate decreases
or, in some cases, may be prevented from increasing premium rates. Self-funded groups
can avoid such mandates because their self-funded status exempts them from state
insurance regulations.
In the next lesson, we discuss state laws and regulations that govern small group rates.
Other state laws and regulations govern guaranteed issue, guaranteed renewal,
reinsurance pools, and rate certification requirements. Discussion of these additional
laws and regulations is beyond the scope of this course.
Major Risk Factors in Group Underwriting 3
Underwriters may use many information sources to assess and classify the risk
represented by a group seeking healthcare benefits. In this section, we discuss
published morbidity tables, which are available from various sources, including actuarial
associations and actuarial consulting firms.
The term morbidity means sickness, injury, or failure of health. A morbidity rate is the
rate at which sickness and injury occur within a defined group of people. Factors that
may limit the direct application of published morbidity data include such variables as
geographical cost variances, group composition, benefit level, and the timeliness of
reporting cost data. Because of these factors, many health plans develop their own
sources of morbidity statistics.
Major Risk Factors in Group Underwriting
A group’s morbidity rate is of particular concern to a health plan. Generally, in pricing a

health plan, a group’s own morbidity data is the most preferred source. Recall from The
Relationship Between Rating and Underwriting that the use of experience rating usually
results in the establishment of equitable, reasonable, and adequate rates for a large
group.
However, sometimes a health plan may not have sufficient information to effectively
forecast a group’s morbidity, or a health plan may be prohibited by law from using
experience rating. In these situations, a health plan may use the manual rates that it
developed from its aggregate experience, published morbidity data to fill in the gaps,
data from similar groups, or a combination of these approaches. Figure 7B-1 depicts an
example of how a health plan would develop a reasonable morbidity rate for 25-year-old
females.
A health plan may also have to adjust published or proprietary morbidity rates to account
for non-sex-related differences. For example, an HMO with half its plan members from a
steel company that has a significant number of retirees would have to adjust published
morbidity rates to reflect the actual population it serves. Figure 7B-2 summarizes the key
risk factors associated with group underwriting.
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Key Aspects of Group Underwriting 4
To evaluate a group prospect, an underwriter considers the characteristics of both the

group and the requested coverage. While each health plan has its own specific
guidelines for assessing group risk, most underwriters adhere to certain general
underwriting principles.
Group underwriting usually does not involve evaluating individual members, but it does
require careful assessment of a group. After considering the major underwriting risk
factors, a health plan’s underwriters evaluate the risk assessment factors associated
with that group.
If the requested coverage falls within an health plan’s underwriting guidelines, then the
health plan figures the cost of the coverage and of the services that will be provided to
the group. The cost includes the health plan’s expected claims expenses and claims
reserves, risk charges, administrative expenses, selling expenses, and the health plan’s
expected surplus or profit. The health plan’s underwriters use these costs to determine
the appropriate price to charge. The health plan may increase or decrease the premium
rate at policy renewal.
If the requested coverage does not fall within the health plan’s guidelines, where state
law allows, the underwriter adjusts the coverage—and the premium—so that the health
plan more closely meets the health plan’s guidelines. If the underwriter cannot structure
the coverage to the satisfaction of the purchaser, then coverage for that group is denied.
Typically, the underwriter assesses each group according to two primary risk
assessment factors: (1) characteristics of the proposed group and (2) characteristics of
the proposed coverage. Then the underwriter decides whether to approve coverage for
the group. We discuss the risk assessment factors in the following sections.
Characteristics of the Proposed Group
A health plan’s underwriters gather and evaluate several types of information about the
proposed group. The risk of one factor may vary independently of other risks—that is, a
given group may present a greater-than-average risk associated with geographic factors,
but at the same time a lower-than-average risk in terms of age. For this reason,
underwriters are likely to analyze many of a group’s risk assessment factors
simultaneously, then analyze the total risk presented by the group. The following
sections summarize risk assessment factors associated with a group.
Reason for Existence
Generally, health plans decline to cover a group that has been formed for the sole
purpose of obtaining healthcare coverage. In addition, some state laws prohibit insurers
from issuing coverage to such a group. This precaution protects health plans from
antiselection that may occur when several people—all of whom present poor
underwriting risks—join together to purchase healthcare coverage. Where permitted by
state law, some health plans underwrite groups—such as professional organizations and
trade associations—that were formed in part to obtain healthcare coverage.
Type of Group
Most organizations that obtain group healthcare coverage can be classified as one of
three types of groups:
• Employer-Employee Groups
• Multiple-Employer Groups
• Professional Associations
Employer-Employee Groups
Employer-employee groups (private employers and public employers). Large private

employer-employee groups tend to present the fewest underwriting risks because they
typically present a balance of ages and health conditions, which helps to prevent
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antiselection. Further, the opportunity for individual antiselection is minimized because

an employee is limited to the coverage offered through his or her employer.
Generally, full-time employees are healthy and some may have even received a medical
examination before being hired. Because large employers typically coordinate the record
keeping associated with group healthcare benefits, administrative expenses are lower for
the health plan. However, some large groups—such as employers involved primarily in
contracting or subcontracting arrangements, professional sports, or seasonal industries,
for example—typically represent a greater risk than other employer-employee groups.
Public employers—that is, federal, state, and local government employers—present

slightly different concerns to a health plan’s underwriters. Because of budgetary
constraints and changes in elected personnel, many public employers switch health plans
annually to obtain lower premiums. As a result, public employers present a somewhat
higher underwriting risk than do private employers.
Multiple-Employer Groups
Multiple-employer groups (trade associations, negotiated trusteeships, and Multiple-

Employer Welfare Arrangements). When two or more employers in the same industry
provide coverage for their employees through one group plan, the employers have formed
a multiple-employer group.
Individual members of a multiple-employer group or a professional association are not

required to obtain coverage through the group or association. Therefore, the risk of
antiselection is higher for both multiple-employer groups and professional associations
than it is for employer-employee groups. To avoid antiselection in multiple-employer
groups, a health plan follows clearly defined underwriting guidelines, focusing especially
on the size of the group. The health plan also checks the group’s prior coverage and
claims experience.
Professional rofessional Associations
As noted above, antiselection risk is higher in a professional association than it is in an

employer-employee group. One way that an health plan evaluates the risks represented by
a professional association is to consider the industry experience of the agent or broker
that sells a group plan to the association.
If the agent or broker has submitted sound business in the past, the health plan can better
assess the risk represented by this new business. If the health plan is uncertain about
approving coverage for a professional association, then the health plan can require each
association member to submit evidence of insurability.
Group Size
Compared to small groups, large groups present lower overall risks to a health plan.
Historically, many health plans limited group coverage to groups that contained at least
50 or 100 members to avoid the risks associated with underwriting small groups.
Currently, some health plans underwrite groups with as few as two members.
Increasingly reliable information about the morbidity experience of small groups,
increased market competition, and expanded legislation concerning small group
healthcare benefits have contributed to this trend of underwriting small groups. Small
groups still present unique challenges to underwriters. We discuss small group
underwriting in the next lesson.
Review Question
The Arista Health Plan is evaluating the following four groups that have applied for group
healthcare coverage:
• The Blaise Company, a large private employer

• The Colton County Department of Human Services (DHS)
• A multiple-employer group comprised of four companies
• The Professional Society of Daycare Providers
With respect to the relative degree of risk to Arista represented by these four companies,
the company that would most likely expose Arista to the lowest risk is the:
Blaise Company
Colton County DHS
multiple-employer group
Professional Society of Daycare Providers
Correct. Blaise Company would represent the fewest underwriting risks because
they would typically represent a balance of ages and health conditions, helping to
prevetn antiselection
Incorrect. While still a lower risk, typically public employees switch plans annually
tro obtain the lowest premium, presenting a higher underwriting risk than large
employers.
Incorrect. Mutiple-employer groups have a higher risk of antiselection
Incorrect. Professional associations have a higher risk of antiselection
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Age
Although a health plan’s underwriters do not consider the insurability of each member of
a proposed group (except for some small groups), they do examine the age spread of
the entire group. Specifically, underwriters watch for groups with a majority of older
members because these groups tend to experience higher morbidity rates.
A group’s turnover rate usually has a significant effect on the group’s average age. A
group with low turnover tends to increase in average age because fewer new, usually
younger, individuals join the group. Underwriters look more favorably upon a group that
has a steady flow of new—particularly young—enrollees, because such flow helps
maintain the desired age spread in a group.
Sex
A health plan’s underwriters also consider the ratio of females to males in a group.
Actuarial studies show that, as a group, women tend to experience higher morbidity
rates, at ages below 55, than do men as a group. Therefore, a group with a large
proportion of young females is likely to have higher healthcare costs than does a group
with a large proportion of young males.
Stability
In the context of underwriting, group stability means that a group maintains a steady flow
of younger, new members to replace or balance the gradual aging of older members. A
group whose composition either changes too frequently or remains static for a long
period of time presents higher risks to the health plan.
If a group’s members change too frequently, the health plan’s administrative expenses
increase. Sometimes a high turnover rate of group members indicates that members are
joining the group for the purpose of receiving healthcare benefits for a short period of
time. This situation would result in high claims costs and high utilization rates for the
period.
On the other hand, a group whose membership remains relatively stable over time
generally has members that are older than average, compared to the average age of
groups that have greater turnover. Because morbidity increases with age, a group with
low turnover and a high average age of members is likely to produce high claims costs.
A sound rating methodology will accommodate this demographic profile.
If a health plan identifies an imbalance in a group, the health plan may adjust the
premium rates upward to cover the risks associated with higher utilization, higher claims
costs, and higher administrative expenses. Also, health plans can encourage group
stability by specifying which group members are eligible for coverage. For instance,
some health plans set a service requirement for groups. Under a service requirement,
also called an employment waiting period, a person must be employed for a certain
length of time—usually three to six months—before being covered under the plan.
Geographic Location
Many employers and other groups maintain offices or facilities in multiple locations.
When evaluating groups in which group members are geographically dispersed, a health
plan’s underwriters consider each location’s applicable laws and regulations, morbidity
rates, and medical services costs.
Some laws regulating group coverage vary from state to state. Many states have group
coverage requirements relating to required policy provisions, group size, group eligibility,
and mandated benefits. Underwriters consider the laws applicable in each location
where coverage is provided for members of a group.
Nature of Business
The type of work that a group performs affects the degree of risk the group represents to
a health plan. To develop appropriate group underwriting guidelines, health plans use
information on claims experience data showing the likelihood of people in certain jobs to
experience high utilization rates.
Some health plans use pricing factors to reflect the

effect of a group’s specific industry on the
premiums charged to the group. A health plan
develops a pricing factor by using experience-
based statistics. A pricing factor is a number that
illustrates the risk represented by group members
working in a particular industry. The health plan’s
underwriters multiply the pricing factor by the
premium it has calculated for standard risks to
calculate a premium appropriate for the risk
represented by a certain group, as shown:
Instead of using a pricing factor, some health plans issue certain types of coverage to
groups with high-risk characteristics if the group pays a flat extra premium. The extra
premium is charged because the group has one or more characteristics that increase the
risk of illness or injury for its members.
When evaluating risk, a health plan’s underwriters also consider the economic strength
or weakness of an industry. Suppose market trends cause companies in certain
industries to slow production or to lay off workers. In this case, a company’s employees
are more likely to utilize healthcare benefits if they are likely to lose them as the result of
a layoff, for example. Also, the company’s ability to pay premiums may be compromised.
Employee Classes
Group members can be classified in several different and objective ways. Generally, an
employee class is a group of employees categorized by position, earnings, or rank. To
comply with regulatory requirements, health plans generally must establish employee
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classes on a nondiscriminatory basis according to conditions pertaining to employment.

Figure 7B-3 illustrates typical, nondiscriminatory classes established for group coverage.
In calculating premium rates, a health plan’s underwriters carefully consider the mix of
higher-income and lower-income employee classes. Actuarial experience has shown
that higher-income employees are statistically more likely to seek expensive healthcare
or to seek healthcare more often than lower-income employees. Also, lower-income
employees sometimes choose not to enroll in a contributory plan, which may adversely
affect the plan’s level of participation, discussed next. A low participation level, in turn,
can lead to antiselection.
Participation Level
Employer group coverage can be categorized as either noncontributory or contributory.

Recall from the Fully Finded and Self-Funded Health Plans lesson that, in a
noncontributory plan, the enrolled employees pay no portion of the premium for
coverage. Instead, the employer pays the entire premium and coverage is automatic for
all eligible members of the group. Typically, health plans require a high participation level
of eligible employees in noncontributory plans.
In a contributory plan, enrolled employees pay a portion of the premium for their
coverage. Participation in a contributory plan is optional for eligible employees. A health
plan prefers that groups come as close as possible to a 100% participation level
because a high participation level reduces the effects of antiselection.
Most health plans require that contributory plans have a participation level of between
75% and 100% of eligible employees, depending on the group’s size. As group size
increases, a health plan’s risk decreases, so the health plan may lower the minimum
participation level requirement.
Contribution Level
Most health plans also require employers to pay a specified percentage, such as 50%, of
the total premium in contributory plans. This requirement enables a health plan to obtain
a sufficient number of eligible employees to meet the minimum participation requirement,
which in turn lowers the risk to the health plan. Traditionally, many families were eligible
for just one group healthcare plan. Now, families often find themselves in the position to
choose from among two or more health plans.
Sometimes this choice is available because both spouses work for employers that offer
group health plans to eligible employees. In other cases, a spouse’s employer may offer
two or more health plans. Whenever several health plans are competing for individual
enrollees within a group, the health plan’s underwriters must find ways to adjust
minimum participation requirements without increasing the risk of antiselection.
Dependents
Most health plans define a dependent as either (1) a spouse or (2) an unmarried child—
including an adopted child, stepchild, or foster child—who is under age 19, or under age
23 or 25 if a full-time student, and who relies on the employee for support and
maintenance. In addition, most health plans expand their definition of a dependent to
include incapacitated dependent children to age 25.
The following list presents some of the questions that underwriters ask regarding
dependent coverage:
• Is the employee eligible to participate in the group plan?

Usually an employee’s dependent can be covered under a group plan only if
the member is eligible and enrolled in the plan.
• How many employees want to cover their spouses?
If only a few eligible employees choose to cover their spouses, antiselection
may become a factor, because the covered spouses might have existing health
impairments.
• Is an eligible dependent confined to a hospital or under the care of a
healthcare provider on the date that coverage begins for the employee?
Under these circumstances, health plans usually delay the effective date of
group coverage for a dependent until the dependent is discharged from the
hospital. This contractual provision is known as the nonconfinement
requirement.
• Did the employee enroll dependents when he or she became eligible or when
the dependent became eligible (for example, within 30 days for a newborn or
newly adopted child)?
If not, antiselection may occur.
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Review Question
Julio Benini is eligible to receive healthcare coverage through a health plan that is under
contract to his employer. Mr. Benini is seeking coverage for the following individuals:
• Elena Benini, his wife

• Maria Benini, his 18-year-old unmarried daughter
• Johann Benini, his 80-year-old father who relies on Julio for support and
maintenance
The health plan most likely would consider that the definition of a dependent, for
purposes of healthcare coverage, applies to:
Elena, Maria, and Johann

Elena and Maria only
Elena only
Maria only
Incorrect. Most health plans define a dependent as a spouse or an unmarried child

(under the age of 19, or incapacitated, or under the age of 23-25 if a full time
student) who relies on the employee for support and maintenance.
Correct. Most health plans define a dependent as a spouse or an unmarried child



Prior Coverage and Claims Experience
Suppose an employer group requests that its existing coverage be transferred to a

different health plan. In this case, the succeeding health plan’s underwriters would
thoroughly assess the group’s case. This assessment typically includes a review of the
• Reasons for the transfer request

• Amount of premiums paid to the previous health plan
• Group’s claims experience and utilization rates
• Previous health plan’s underwriting guidelines, medical policies, and provider
network arrangements
• Changes in premium rates for the group’s coverage since the coverage
began
The successor health plan also considers the people who currently have claims on file
with the previous health plan. These people must be protected from loss of benefits
when the group switches to the successor health plan. If some employees are not
actively at work, but are not disabled on the effective date of the new coverage, the
successor health plan determines the reason for these members’ absence. They could
be on vacation or taking a leave of absence, or could be sick or injured.
Typically, health plans require eligible employees to be actively at work on the effective
date of coverage. Coverage for eligible employees who are not actively at work on that
date is usually deferred until they return to work. Also, most health plans do not collect
premiums on absent group members until those employees have returned to work on a
full-time basis.
However, if an employee or dependent was covered under the previous health plan’s
health plan and would otherwise lose coverage as a result of the employer’s changing to
a new health plan, the successor health plan usually would provide coverage for these
individuals outside the plan contract. This extracontractual provision is sometimes called
continuity of coverage or no-loss, no gain.
Generally, health plans require three years’ documentation of the group’s
• Previous benefit changes and their effective dates

• Rates billed, premiums paid, claims incurred, and claims paid
• Large or catastrophic claims, including the amount claimed and the current
status of each claim
• Billing statements
• Employee plan description material
• Information about disabled employees and dependents
Note, however, that it may be difficult for health plans to obtain even one year’s
documentation, depending on the employer and its previous coverage.
Characteristics of the Coverage
Although plan purchasers often choose a plan design that is the same as or close to a
standard plan design offered by a health plan, many purchasers choose to customize
their plan designs. An important part of the underwriting function is to ensure that the
proposed coverage falls within the health plan’s parameters and is appropriately priced
to reflect any variations from these parameters. Plan administration and plan changes
must also fit the health plan’s underwriting guidelines.
Plan Design
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When evaluating a proposed plan design from a potential purchaser, a health plan’s
underwriters consider two key elements: (1) Eligibility requirements, and (2) Covered
services/supplies and benefit levels.
Eligibility requirements.
Generally, health plans require that only full-time, permanent employees and their
dependents can enroll in a group plan. Therefore, a health plan’s underwriters verify the
eligibility of each group member.
Under a contributory plan, members who choose to participate usually can enroll in the
plan any time during the 31 days following the date they become eligible for coverage.
Most health plans require employees who do not enroll during the 31-day enrollment
period to provide evidence of insurability before they can subsequently enroll. This
requirement prevents the antiselection that might occur among employees who originally
declined coverage, but later learned that they had a serious health problem.
Some group plans do, however, allow a previously nonparticipating employee who has a
“life event”—for example, an employee acquires a dependent spouse through marriage,
acquires a dependent child, or loses coverage under his or her spouse’s plan—to enroll in
the plan without providing evidence of insurability. In such cases, the nonparticipating
employee must enroll within 31 days of the “life event.”
Covered services/supplies and benefit levels.
The healthcare services and supplies that are covered and the applicable benefit levels
can largely determine a health plan’s financial success. For example, if a health plan
provides an overabundance of benefits, plan members tend to have higher utilization rates
and higher-than-average claims costs.
On the other hand, a health plan that provides minimal benefits or unevenly distributes
benefits among employee classes probably will not appeal to many employees. As a
result, the health plan probably won’t achieve the desired participation level. The health
plan’s underwriters strive to approve plans that reach a balance between these two
extremes.
Some plan purchasers establish benefit plans that avoid unequal distribution of benefits
among members by offering the same benefit for all employees, regardless of job class,
salary, or length of service, for example. Other plan purchasers vary benefit levels
according to specified, objective criteria related to employment.
Plan Administration
Group health plans often require active involvement of the employer or other plan
sponsor to manage and administer benefits. Because the employer often serves as a
link between the group members and the health plan, the employer plays a vital role in
the successful administration of the plan. Effective plan administration is crucial to
keeping plan costs low and helping ensure the long-term satisfaction of both the
employer and the plan members. Therefore, a health plan’s underwriters evaluate the
willingness and ability of a prospective purchaser to cooperate in plan administration.
Specifically, an employer should be able to promote the health plan and encourage all
eligible employees to enroll in the plan. The employer should also be able to maintain
accurate and complete records of plan enrollments and changes in employee eligibility,
as well as the status of each employee’s plan contributions. In addition, the employer
should be able to assist employees with eligibility changes, claims submissions (if
applicable), and routine questions about the plan.
Plan Changes
When an employer group requests an increase in the type or extent of benefits offered
under its health plan, the health plan’s underwriters first consider the group’s claims
experience. As noted earlier, where state laws allow, if the group has had higher-than-
expected claims experience, the group’s request may be denied. Alternatively, the
group’s premium rate may be increased to cover the cost of additional healthcare
benefits.
Conversely, if a group has had lower-than-expected claims experience, the health plan’s
underwriters might determine that additional benefits can be provided without an
increase in premium. Likewise, a group that requests a reduction in its healthcare
benefits might receive a lower premium rate, or a lower premium rate increase, provided
that its claims experience has not been unfavorable.
When an employer wants to offer coverage to employee classes that were previously
excluded from the health plan, the health plan’s underwriters evaluate the proposed
employee classes. Factors considered in this process include:
• Whether the proposed employee classes constitute a minor addition to the

whole group, in which case the underwriter usually approves coverage
• Whether the proposed employee classes comprise a considerable proportion
of the whole group, in which case the underwriter evaluates the age, sex, and
salary of the individuals in each class
• The geographic location of the employees in the proposed employee class—
for example, in situations when one company purchases another company or
establishes a branch office in another location
• Information about previous coverage of the employees in the proposed
employee classes
• Type of industry in which the employees in the proposed employee classes
work, especially if that industry involves hazards that do not exist for the
original group that is covered
Conversions from Group Coverage to Individual Coverage
Group healthcare contracts often contain a conversion privilege, which, under certain
conditions, allows covered plan members who lose coverage under their current group
plan to obtain coverage under an individual healthcare policy. Many states require health
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plans to include a conversion privilege. Under the terms of a conversion privilege, the
health plan must issue an individual healthcare policy to all eligible individuals who
request one, regardless of their medical condition.
Because the health plan cannot decline coverage for an eligible individual, the bulk of
the underwriting for conversion policies is accomplished through health plan design.
Often, health plans provide the minimum covered services and benefit levels that are
required under applicable federal and state laws and regulations. Dental and vision
benefits are rarely provided under conversion policies.
Because healthy employees typically move to another employer group, rather than apply
for individual coverage, the cost of the conversion privilege is high. Often a group plan’s
premium is higher to cover these costs. Premium rates for conversion policies are
subject to the health plan’s rating guidelines for individual coverage, which we discuss in
the next lesson. Note that the introduction of COBRA benefits and the guaranteed issue
requirements for qualified individuals under HIPAA have greatly reduced the need for
conversion policies.
Chapter 8 A
Small Group and Individual Underwriting
• List the common characteristics of small group reform laws

• Explain the effect of the guaranteed issue provision on the small group
markets in which they apply
• Define risk pooling as it relates to small group markets
• Discuss state reinsurance programs for small group carriers
• Identify and describe some characteristics of small groups and individuals
that underwriters consider, where state law permits
Although a large segment of the population typically obtains healthcare through

employee benefit plans, historically, few small employers have offered healthcare
benefits to their employees. During the 1990s, to increase small employer access to
affordable healthcare, many states enacted small group reform laws. The definition of
small group varies from state to state but typically specifies employee groups that
range from 1 to 50 or more employees. Not all small groups are employee-employer
groups—for example, some professional associations fall into small group categories—
but this assignment focuses on private sector employer-employee small groups,
because they represent the largest part of the small group market.
Small Group Reform Laws and Underwriting 1
Small group reform laws vary by state, but most small group statutes include language
that
• Stipulate a uniform benefit design for use with small groups

• Place restrictions on the small group underwriting practices of health plans
• Set requirements with respect to premium rates that health plans can charge
small groups
• Require health plans to disclose plan and rating information to plan
purchasers
Uniform Benefit Design
To make healthcare more affordable and accessible to small employer groups, most
states have developed uniform benefit designs for HMOs and PPOs as well as indemnity
healthcare products. These plans, called low option plans, also called basic plans,
essential plans, or bare bone plans, typically include features such as high annual
deductibles, high copayments, limits on lifetime and annual benefits, and a limited list of
covered services and supplies.
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Many states have also developed standard plans. Standard plans are health plans that
require health plans to offer small employers and their employees a choice of a more
comprehensive healthcare benefit plan than the low option plan. Standard plans
approximate the healthcare benefits available to large employers. Usually states require
that health plans offer at least two health plans. Typically a health plan will offer more
than two plans, however.
Review Question
The Raven Health Plan is domiciled in a state that requires the health plan to offer small
employers and their employees a comprehensive healthcare benefit plan that
approximates the healthcare benefits available to large employer-employee groups. This
type of uniform benefit plan is known as:
a basic plan
a low-option plan
a standard plan
an essential plan
Incorrect. A basic, or low-option plan, typically includes features such as a high

annual deductible, high copayments and a limited number of covered services
Incorrect. A basic, or low-option plan, typically includes features such as a high
annual deductible, high copayments and a limited number of covered services.
Correct. A standard plan provides small employers a comprehensive benefits plan
Incorrect. An essential, or low-option plan, typically includes features such as a
high annual deductible, high copayments and a limited number of covered
services.
Restrictions on Underwriting Practices
Small group laws seek to improve access and affordability by restricting the underwriting
practices that health plans can use to reduce overall risk. Health plans that must accept
larger risks ultimately incur higher costs. Consequently, although the intent of mandated
restrictions on underwriting practices is to improve access to healthcare, one result of
these restrictions is an increase in the cost of providing that healthcare. Several of these
restrictions have been incorporated into the federal Health Insurance Portability and
Accountability Act (HIPAA) of 1996. These restrictions may be divided into two types: (1)
those that apply to employer groups and (2) those that apply to individual group
members.
Underwriting Employer Groups
Most small group laws contain a guaranteed issue provision, and HIPAA now mandates
guaranteed issue in the small group market. A guaranteed issue provision requires
each health plan that participates in a small group market to issue a contract to any
employer who requests healthcare benefits, as long as the employer meets the statutory
definition of a small group.
Typically, in the large group market, a health plan can elect not to issue a contract to a
particular group if the group has had poor claims experience or has a member who is
suffering from a catastrophic illness or injury that would result in substantial healthcare
expenses. Laws pertaining to small groups prohibit this underwriting practice. State and
federal small group laws also contain a guaranteed renewal provision, which prohibits
health plans from canceling a small group’s healthcare coverage because of poor claims
experience or other factors that relate to group underwriting, such as a change in health
status of group members.
Underwriting Individual Members of Employer Groups
Before the enactment of small group reform laws, group insurance laws often set the
minimum number of employees in an eligible employer group at 10 or more. This meant
that employers with fewer than 10 employees were not considered employer groups for
the purpose of group insurance laws. Therefore, insurers and health plans used medical
underwriting for the individual employees of a small employer. In other words, an
employer group could be accepted for healthcare benefits, but specified employees
within that group could be excluded because of health conditions. The small group
reform laws typically changed the definition of an employer group to include employers
with as few as two employees, thereby subjecting small groups to group underwriting
requirements, rather than to individual underwriting requirements.
In the past, one way that health plans could limit risk was to apply waiting periods and
pre-existing conditions exclusions to individuals in certain high-risk categories who might
have otherwise been eligible for group healthcare benefits. Small group reform laws
seek to improve access to healthcare by limiting these restrictions.
Review Question
The following statements are about the Health Insurance Portability and Accountability
Act (HIPAA) as it relates to the small group market. Three of these statements are true
and one statement is false. Select the answer choice containing the FALSE statement.:
A health plan that participates in the small group market is required to issue a
contract to any employer that requests healthcare benefits, as long as the
employer meets the statutory definition of a small group.
A small group must consist of more than 10 employees in order to be underwritten
on a group, rather than an individual, basis.
A health plan is prohibited from canceling a small group’s healthcare coverage
because of poor claims experience.
A health plan that participates in the small group market is limited in placing
restrictions such as waiting periods and pre-existing conditions exclusions to
individuals in high risk categories.
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Incorrect. The guaranteed issue provision requires each health plan that
participates in small group coverage to issue a contract to any employer who
requests, providing they meet the statutory definition of small group
Correct. This is a FALSE statement
Incorrect. The guaranteed renewal provision prohibits health plans from

cancelling a small group's coverage based on poor claims experience.
Incorrect. Health plans are limited in placing restrictions such as waiting periods
and pre-existing conditions exclusions to individuals in high risk categories
Requirements on Premium Rating
To reduce healthcare costs for small groups, small group market reform laws place
restrictions on the rates that health plans can charge small employers. Typically, these
laws prohibit health plans from using experience rating and prescribe a method that
limits the rate spread that health plans can use for all small employer groups. We
discussed experience rating in the Rating and Underwriting lessons. A rate spread limit
is a law that places limits on the spread, or difference, between the highest and lowest
premium rates that a health plan can charge any two small groups.
Many state laws require health plans to use a rating method that is either a pure
community rating or an adjusted community rating. Other state laws are based on the
rating method contained in the unamended 1991 NAIC model small group laws and
regulations. This rating method, which is referred to as community rating by class (CRC),
allows health plans to use up to nine rating classes with prescribed minimums and
maximums in each class. Also, the rate spread cannot be more than 120% from the
highest to the lowest block of business, which is usually defined by market approaches.
Requirements for Disclosure of Plan and Rating Information
Small group laws typically include disclosure requirements that specify the types of
information that health plans must share with plan purchasers to educate them and to
help them make informed choices. Some states require that health plans obtain approval
for all marketing pieces and that they file a copy of the approved pieces with the state
insurance department before these materials are distributed for use. From a financial
standpoint, these requirements increase a health plan’s costs to the extent they mandate
activities the health plans would not otherwise perform.
The Small Group Market
The small group market has at least three characteristics that make it attractive to health
plans. First, the small group market contains a large number of potential plan members.
Second, this market is growing, because the number of small businesses in the United
States is growing. Third, compared to large groups, small groups are much less likely to
have healthcare coverage.
We have already mentioned regulatory costs and underwriting limitations as
disadvantages to health plans that are entering into or already operating in the small
group market. The market also presents financial risk to health plans for at least three
other reasons.
First, besides the costs of regulatory restrictions, the variation in these regulations from
state to state add costs to the operations of health plans that seek to enter markets in
more than one state.
Second, in many segments of the small group market, employee turnover is high, and
high turnover adds to the administrative costs of serving small groups.
Third, the owners of small businesses often have much more information concerning
their health and the health of their families and their employees than the health plan has,
which means that this market is subject to a greater risk of antiselection than is the large
group market. Antiselection occurs in small groups because business owners are more
likely to seek healthcare coverage if they believe that they, their family members, or their
employees are likely to have high healthcare costs.
Over time, health plans and their underwriters have gathered increasingly reliable
information about the morbidity experience of small groups. Generally, in comparison to
2
large groups, small groups tend to
• Less closely follow actuarial predictions regarding morbidity rates

• Have more frequent and larger claims fluctuations
• Generate more administrative expenses as a percentage of the total premium
amount the group pays
As a result of these market characteristics, an underwriter can have difficulty determining

an appropriate premium for a small group.
Although small group laws have made healthcare coverage more accessible to groups
that previously would have been declined, these same laws have actually reduced
access to healthcare benefits for others. By limiting the ability of a health plan to reject
individual employees within an accepted group and by restricting premium rate
methodology, these laws have caused premiums to increase for many small groups.
High premium rates are typically the most important barrier to coverage for any group or
group members. Thus, for example, a small group with a heavy composition of young
males who are in good health might, because of small group laws, experience premium
rate increases that make the cost of healthcare coverage prohibitive to some members
of the group, thereby limiting their access to healthcare benefits.
Where state laws allow, health plans sometimes use an underwriting method called
pooling to help more accurately estimate a small group’s probable claims costs and to
calculate an equitable premium. Pooling is a method of determining a group’s premium
in which underwriters treat several small groups as one large group for assessment
purposes. The more plan enrollees (or proposed enrollees) that are grouped in a pool,
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the better the underwriter’s chances of accurately estimating the whole group’s claims
costs.
Underwriting the Small Group 3
Underwriting small groups traditionally takes place on two levels: (1) evaluating the
business entity, and (2) examining the health status and other characteristics of each
individual to be covered. Unlike underwriting large groups, variation in coverage is not a
major factor for small groups. Small group plan designs are typically kept standard.
With the passage of small group reform laws, the approach health plans take to
underwriting small groups has become much more important than in the past. These
laws impose limitations on a health plan’s ability to reject or rate-up (increase rates to
reflect worse-than-average risks) specific individuals within a group.
In underwriting small groups, both the characteristics of the members and of the
employer itself are considered. Examples of these characteristics include the nature of
the employer’s business, the expected level of plan participation on the part of the
employees, and prior claims experience. The small group underwriter examines many of
the same member and employer characteristics that the large and medium group
underwriter examines. The rating structure used by the health plan, which is more and
more often dictated by small group law, has an important bearing on the significance
placed upon certain of these characteristics.
Review Question
In a comparison of small employer-employee groups to large employer-employee

groups, it is correct to say that small employer-employee groups tend to:
more closely follow actuarial predictions with respect to morbidity rates

generate more administrative expenses as a percentage of the total premium
amount the group pays
have less frequent and smaller claims fluctuations
expose an health plan to a lower risk of antiselection
Incorrect. Small groups less closely follow actuarial predictions of morbidity

rates.
Correct. Small groups generate more administrative expenses as a percentage of

the total premium amount the group pays
Incorrect. They have more and fequent and larger claims fluctuations.
Incorrect. This market exposes the health plan to a greater risk of antiselection.
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Financial Viability
A health plan incurs substantial costs in selling, underwriting, and issuing coverage to a
group. These costs are proportionally greater for small group purchasers. To retain a
small group purchaser as a client long enough to recoup these acquisition expenses, the
business must be financially viable. Such concern cannot be taken lightly; a significant
number of small businesses fail each year.
Nature of Employer’s Business
As we saw in our discussion of large groups, the type of business and the duties
performed by a group’s employees are also related to expected future claims costs.
Certain types of businesses are exposed to higher health risks. Some of these risks are
clearly work-related, such as a job that requires handling hazardous chemicals. Other
risks are related to lifestyle issues. For example, employees of a motorcycle dealership
are more likely to ride motorcycles and might present a greater risk than employees of
an accounting firm.
Traditionally, some small group carriers would not cover certain industries or
occupations; others would charge a premium surcharge for coverage. The list of
ineligible industries and industry rate-ups varies by health plan. Today, however, many
states no longer allow industry rating; others limit the size of the surcharge. However,
except in states that require guaranteed issue, health plans generally still retain the right
to reject groups due to the nature of the business in which they are engaged.
Group Size
Group size is another important group characteristic, affecting both expected claims
levels and per member acquisition and maintenance expenses. The larger the group, the
more lives over which the morbidity risk can be spread. For a group of 25 as opposed to
a group of 5, an individual employee’s health status will be a smaller factor in the
employer’s decision to purchase coverage and the level of benefits chosen. Also, the
administrative expenses incurred in covering the larger group are lower on a per
member basis than those for the smaller group.
Historically, health plans offered coverage at lower rates and used less stringent
underwriting as employer group size increased. However, one typical objective of small
group reform laws is to mandate that small group health plans pool the group-size risk
over their entire small group portfolios, by either disallowing or limiting variations on
premium rates by group size. For example, states that require health plans to use
adjusted community rating generally do not allow adjustment for group size. This can
create additional risk for a health plan that provides healthcare coverage in small group
markets.
Participation Level
To qualify for medical coverage, a small group is expected to meet certain participation
requirements set by the health plan. As we saw in the previous lessons, these
requirements provide the health plan some protection against antiselection at the point
of sale by prohibiting a significant number of employees (presumably the most healthy)
from declining the coverage. Participation requirements also help protect the health plan
from case stripping, a process in which a few employees and/or dependents with
expected high medical costs remain under the plan, but over time, the healthier plan
members drop coverage or purchase less expensive group coverage elsewhere.
The majority of states continue to allow health plans to set participation levels as a
requirement for coverage, even where coverage is otherwise guaranteed issue. Often,
however, the participation requirements are limited by law. For example, a health plan
may not be allowed to require that more than 70% of eligible employees sign up for
benefits as a condition of offering the group coverage. Some states, however, require
that, in cases where employees have coverage from other sources such as a spouse’s
plan, the health plan cannot consider these employees when determining participation
levels.
Contribution Level
Another underwriting consideration that is particularly important for small groups is the
employer’s contribution to the cost of healthcare coverage. As we saw in Rating and
Underwriting lessons, the higher the percentage of the total cost the employer pays, the
higher the employee participation tends to be. Generally, health plans require that the
employer make some contribution to the cost. Although large employers frequently
contribute 80% or more of the cost of coverage, small employers typically cannot afford
such high contributions. It is not uncommon for small employers to pay a portion of the
employee’s premium (50% for instance), but require the employee to pay the full cost of
dependent coverage.
Employer concern over the cost of these employer contributions often results in a
decision by the employer not to sponsor a plan. The lower the employer contribution rate
(and therefore the participation rate), the more likely it is that the employees who enroll
in the health plan will be less healthy than the entire group as a whole. Some states will
not allow a small group to be covered unless the employer contributes a minimum level
of the premium and the group meets minimum participation levels.
Health Status and Prior Coverage
In underwriting a group as a whole, a health plan’s underwriters gather and review

information regarding the health status and prior coverage of the group. If the group is
obtaining healthcare coverage for the first time, discovering the reasons for seeking
coverage at this time can point to other areas that should be investigated more fully. For
example, the spouse of a valued executive may have contracted what is likely to be a
costly medical condition.
If the group is changing health plans, information regarding the prior coverage is an
important underwriting consideration, particularly today because most states require
portability of coverage (usually without regard to the differences in healthcare benefits).
Such portability does not allow a health plan to apply a pre-existing conditions provision
to those enrollees who were previously covered, which consequently increases the
health plan’s risk.
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To the extent possible, underwriters investigate the motives of the group for changing
carriers, seeking answers to questions such as these:
• Is the group increasing healthcare benefits or just seeking more competitive

premium rates?
• Is the group seeking to add employees who were not covered under the prior
health plan’s health plan and would have been considered late entrants under
that plan?
• Are certain dependents being added who were not covered by the prior plan?
Individual Underwriting Considerations 4
The key to successfully underwriting a block of small employer healthcare programs is to

assure a reasonable mix of healthy and unhealthy members. If a health plan’s
underwriting guidelines are too liberal compared to those of the competition, the health
plan’s block of business could attract a disproportionate share of unhealthy enrollees
and be exposed to antiselection.
Many small group laws restricting underwriting and rating practices put limits on the
ability of health plans to single out individuals within an employee group by rejecting
them or by rating them up. Although individual risk evaluation techniques continue to be
used, they are now employed by underwriters in making a decision about the group’s
rates, rather than about whether to offer coverage to particular individuals.
Enforcement of Eligibility
The underwriter, using information in the application for coverage, checks for the
eligibility of each employee and the employee’s dependents. Eligibility checks tend to be
more critical for underwriting the smallest groups because of the number of family
businesses that seek healthcare coverage and the temptation of a family business to
present unhealthy relatives for coverage. In such cases, investigating each employee’s
and dependent’s eligibility at the time of issue may be less cost-effective than conducting
underwriting after a claim has been submitted.
Review Question
One way that a health plan can protect itself against case stripping is by requiring:
employees covered by a small group plan to contribute 100% of the cost of the
healthcare coverage
the small group to have no more than 10 members
a minimum level of participation in order for a small group to be eligible for
healthcare coverage
its underwriters to consider the characteristics of the employer, but not of the
group members, when underwriting the group
Incorrect. When employers contribute more to the cost of health care coverage,
employees are more likely to participate
Incorrect. The larger the group, the more lives over which morbidity risk can be
spread
Correct. Though participation limits can be linited by law, most health plans can
require a minimum level of participation in order for a small group to be eligible
for healthcare coverage.
Incorrect. The underwriters consider the characteristics of the group.
Pre-Existing Condition Limitations
Portability requirements enacted under HIPAA and by most state small group reform
laws came in response to employees’ reluctance to change employers for fear of loss of
health coverage. Portability requirements increased the risks faced by health plans and
introduced new underwriting considerations. Where previously an underwriter might
have accepted a group knowing that the pre-existing condition exclusion period would
provide adequate short-term protection to make the case profitable, with portability such
a group would need to be reassessed, since the health plan would essentially be buying
claims at the outset of issuance.
Portability laws vary in their treatment of new and late entrants to a health plan. For
example, HIPAA allows a pre-existing exclusion period of 12 months for new entrants
and 18 months for late entrants (each of which is reduced by qualified prior coverage).
Therefore, underwriters distinguish between new and late entrants to avoid the extra
antiselection risk introduced by later entrants.
Individual Medical Assessment
Both the employees of a small group and their dependents are usually individually
medically underwritten, even though small group reform prohibits health plans from
singling out individuals for rejection or substandard rate-ups.
In the absence of laws mandating otherwise, underwriting standards grow stricter as

group size gets smaller. Some medical conditions that may not be acceptable in a two-
member group, because of the high expected claim cost, could be acceptable when
compared against the premiums generated by a 20-member group. Even in a 25-
member group, however, one especially expensive ongoing medical condition can
assure that the group will be unprofitable at any reasonable premium level.
Individual Medical Assessment
While such an underwriting approach had been relatively straightforward in the past,
small group reform laws passed in the last decade require objective and
nondiscriminatory application of underwriting criteria, regardless of group size. As such,
the underwriting criteria must assure objectivity and yet recognize the risk implications
inherent in small groups.
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Health plans use various underwriting approaches. Some enrollment applications use a
short-form questionnaire that asks a few broad questions; others ask a long list of
detailed questions. Examples of these supplemental sources are attending physicians'
statements (APS) and clearinghouses of medical and insurance information.
Gathering underwriting information, however, increases costs for the health plan. These
costs must be compared to the gains the health plan expects to achieve by using this
information to reduce claims costs.
Small Group Rating Approaches
Small group reform laws have, as we have noted earlier, caused a health plan’s small
group underwriting to become more like large group underwriting. State laws have also
increasingly limited the range between the highest and lowest rates among small
groups.
Many of the factors used in determining small group rates are consequently the same as
those used to rate large groups, as we discussed in Group Underwriting lesson. These
factors are the type of group, the age of the group members, the ratio of males to
females in the group, the geographical location of the group, the size of the group, and
the nature of the group’s business.
Rating Structures
In the past, as a result of the underwriting and pre-existing condition exclusions used in
the small group market, initial claim costs per member started out very low, but
increased rapidly as the selection and pre-existing condition exclusions wore off,
eventually leveling off after the third year.
This phenomenon, coupled with competitive pressures for sales, led to the practices of
durational and tiered rating, in which low entry rates were offered to groups at issue
followed by fairly significant rate increases in the subsequent renewal periods, especially
for groups with prior adverse claims experience. These practices caused healthier
groups with good experience to shop for a health plan that offered cheaper premium
rates or that would place the group on the lowest rating tier. Less healthy groups had to
either accept the hefty rate increases or cancel their coverage, and face a new pre-
existing conditions period from a new carrier, or risk the possibility of not being accepted
for new coverage.
The legislative and regulatory response was the adoption of the limits we have referred
to throughout this lesson. These new rules limited durational and tiered rating to a
specified maximum range, and in some states disallowed durational rating while still
permitting limited tiered rating. More recently, states have been compressing the
allowable rate ranges or moving to adjusted community rates. Many states have
established specific risk pooling programs for small group business. These can be
categorized into (1) reinsurance programs and (2) risk-adjustment formula programs.
Reinsurance Programs
Many states that require guaranteed issue of at least two mandated plans (sometimes
referred to as Standard Plans and Basic Plans) have established health coverage
reinsurance programs for small employer groups. These programs develop reinsurance
pools into which a carrier can place entire groups or individuals enrolled in a group plan.
In contrast to the commercial reinsurance we discussed in Capitation and Plan Risk, the
reinsurance offered through these programs is administered by not-for-profit entities
whose board members are appointed by the state insurance commissioner for each
state. The purpose of these programs is to reinsure health plans and other carriers who
offer guaranteed healthcare plans to small employers. These carriers are sometimes
referred to as small employer carriers.
Under these programs, a small employer carrier can reinsure either an entire small
group, or specific individuals within a group. The programs pool the risks of several small
employer carriers and enable these carriers to offer guaranteed issue plans to small
employers without taking on the entire risk of catastrophic loss often present in
guaranteed issue plans. As we have seen, this risk is higher than usual in small group,
guaranteed issue plans because they are particularly vulnerable to antiselection.
Reinsurance Programs
Typically, the reinsurance board sets a “base” reinsurance premium for the coverage on
a plan. This base reinsurance premium is derived from the typical premiums for small
employer healthcare plans that have benefits similar to benefits of the plan being
reinsured. This base reinsurance premium is then multiplied by a factor of 1.5 in the
case of reinsurance on entire groups, or a factor of 5 for reinsurance on individuals. The
result of the base reinsurance premium multiplied by the appropriate factor is the
reinsurance premium.
To obtain reimbursement under the program, a small employer health plan may have to
meet certain cost-sharing requirements. For example, the small employer health plan
seeking the reinsurance might have to pay a $5,000 deductible and 10% of the next
$50,000 on a claim covered by reinsurance. Any shortfalls in the pool are funded
through assessments of the participating health plans.
Review Question
The following statements are about state health coverage reinsurance programs.
The reinsurance offered through these programs is administered on a for-profit basis by

the federal government.
The purpose of these programs is to reinsure MCOs and other carriers who offer
guaranteed healthcare plans to small employers.
These programs must reinsure only an entire small group, not specific individuals within a
group.
Any shortfalls in the pool established by these programs are funded by the state
government.
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Incorrect. Reinsurance offered by these programs are administered by not-for-

profit entities whose board members are appointed by the state insurance
commissioner for each state.
Correct. Many states that require guaranteed issue of at least two mandated plans
have established health coverage reinsurance programs for small employer
groups.
Incorrect. The programs reinsure either an entire small group, or specific

individuals within the group.
Incorrect. Shortfalls in the pool are funded through an assessment of the

participating health plans.
Risk-Adjustment Programs
Some states have developed risk-adjustment formulas to be applied to the premium that
the state reinsurance program charges to participating small employer carriers. These
formulas attempt to produce an equitable reallocation of premiums reflecting differences
in risk among participating health plans. However, establishing effective risk adjustment
systems such as this has proven to be difficult due to the complexity of the process and
a lack of experience and technology in this area.7
Underwriting Individual Healthcare
Healthcare coverage is provided to millions of Americans as an employee benefit, but

millions more people are covered under individual (sometimes called nongroup) health
policies that they have purchased. Indemnity carriers rather tha health plans write most
individual coverage, but in some markets health plans will underwrite individual
healthcare coverage. In this section, we examine the underwriting considerations for this
coverage. We begin by briefly discussing applicable laws and regulations.
Laws That Apply to Individual Underwriting
Many state laws that apply to the individual healthcare market are similar to small group
laws in that both sets of laws seek to improve healthcare access and affordability. For
example, many state laws on individual healthcare benefits require guaranteed issue
provisions and place restrictions on pre-existing conditions provisions. Also, some small
group laws, which define a self-employed individual as a “small group,” are actually
applying their small group laws to individual healthcare benefits. States that do not
address individual healthcare benefits defer to the HIPAA for specific requirements.
Underwriting Substandard Risks
Health plans use an underwriting manual that contains information needed to underwrite
individual coverage. The manual usually describes and evaluates a number of
impairments. The underwriter can accept, rate, or (if state law allows) decline an
application according to the degree of risk the applicant presents to the health plan. If an
applicant represents a risk greater than standard, and if the risk is not so great that the
underwriter must decline the application, the underwriter can rate the application and
accept the risk with a rated policy.
A rated policy is a policy issued to a person considered to have a greater-than-average

risk of loss. To ensure that the risk accepted is within the health plan’s guidelines, a
rated policy may be issued with
• A premium rate higher than the rate for a policy issued to a person with an
average or less-than-average risk of loss
• Modifications and exclusions
• Any combination of a higher premium rate, modifications, and exclusions
To evaluate the risk represented by an applicant, underwriters use a numerical rating

system based on standard morbidity. The standard premium is based on 100% of
standard morbidity. The underwriter indicates degrees of extra risk as debits, which are
converted to rating percentage. After assigning debits to an applicant, the underwriter
next uses a rating schedule, which is a table that enables an underwriter to convert the
total of the debits to a rating percentage. Each health plan develops its own rating
schedule. The rating percentage from the rating schedule is added to the percentage
(100) that represents the standard risk for which a standard premium is charged.
Where state laws allow, a health plan might include an impairment rider on an individual
policy. For underwriting purposes, an impairment is any aspect of an applicant’s
present health, medical history, health habits, family history, occupation, or activities that
could increase that person’s expected morbidity risk. An impairment rider, also known
as an impairment waiver or an exclusion rider, is a policy attachment that excludes from
coverage any loss that (1) arises from a specified disease or physical impairment or (2)
concerns a specific part of the body. An impairment rider might be used with a health
policy if the applicant has a chronic condition for which future treatment seems likely.
An impairment rider excludes from coverage a medical condition, a disease or disorder

of a specified body part, or both. To help an applicant to understand clearly what
condition is being excluded from coverage, each impairment rider is worded in simple,
straightforward terms. A health plan’s medical director and legal department can help an
underwriter draft a rider to suit the circumstances of a specific case, assuming that the
laws that apply to the health plan allow impairment riders. To save the underwriter time
in producing an impairment rider, most underwriting manuals suggest wording for a large
number of conditions that generally warrant the use of such riders.
Key Elements of Individual Underwriting
In underwriting individual coverage, several key elements are critical. The following
sections discuss these elements.
Insurable interest
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Insurable interest is the condition in which a person would suffer a genuine loss if the
covered event were to occur. Under individual healthcare, the requirement for insurable
interest is met when the applicant can demonstrate a risk of economic loss if he or she
requires medical care.
Antiselection and Moral Hazard
A health plan’s underwriters are aware that antiselection and moral hazard can be
factors in some applications if the individuals seeking coverage have certain types of
impairments such as nervous conditions and chronic depression or chronic pain. In
general terms, moral hazard is a characteristic that exists when the reputation, financial
position, or other circumstances of an applicant indicates that the person is more likely
than most people to misrepresent a condition, cause a loss intentionally, or fail to limit a
loss once it has occurred.
Impairments such as nervous conditions and chronic depression or chronic pain do not
necessarily result in undue numbers and amounts of claims, but some of them do, and
health plans often face difficulties in determining the validity of such claims. Some health
plans exclude coverage for conditions like these by using riders; other health plans do
not issue policies to applicants with these or other serious impairments.
In contrast, health plans do not usually exclude benefits for impairments that are
considered temporary, because such impairments are not statistically indicative of
possible antiselection or moral hazard. For instance, if an individual seeking coverage
has a sprained shoulder or has undergone successful shoulder surgery a month before
applying for coverage, but has no previous history of shoulder problems, most health
plans would issue a policy without excluding shoulder or joint problems.
Health History
The individual underwriter pays particularly close attention to the applicant’s health
history and seeks complete information about certain impairments that warrant in-depth
scrutiny. The underwriter focuses especially on impairments associated with two types of
concerns: (1) future medical treatment and (2) probability of accidents.
Certain impairments are of considerable significance in underwriting individual coverage

because these impairments have been shown statistically to result in higher-than-
average claims resulting from future medical treatments. Such conditions as arthritis,
back injuries, spinal curvature, recurring bronchitis, gallstones or kidney stones, and mild
neuroses are examples.
Health History
Individual underwriters also give consideration to medical conditions that may result in a
higher-than-average probability of accidents. Some impairments, such as epilepsy,
vertigo, narcolepsy, numbness in hands and feet (neuropathy), paralysis, and impaired
eyesight and hearing are often associated with accidents and are examined thoroughly.
In addition to looking at the probable effects of impairments, the underwriter examines
information relating to health conditions that have been diagnosed or treated recently.
Some conditions, especially certain types of cancer, are considered more serious when
they have been recently discovered or treated.
Health History
Some conditions that have been stable for a number of years as specified in a health
plan’s underwriting manual may not negatively affect an applicant’s rating because the
condition is not considered to have a significant potential effect on the future health of
the applicant. Even a history of acute illness, such as pneumonia, may not be significant
if the applicant has recovered fully.
An underwriter can accept some applicants for coverage after a period of time following
treatment for an impairment. Moreover, an underwriter does not consider each
impairment in isolation, but tries to obtain a clear understanding of the possible
connections between various impairments and their combined effect on the applicant’s
health.
Finally, the health underwriter pays special attention to factors in the life of an applicant
that can decrease or increase the probable effect of an impairment on the person’s
health. Suppose that an individual who is seeking coverage has been diagnosed with
mild to moderate asthma and also smokes. Such a person is underwritten more
conservatively than is a person who has asthma but does not smoke.
Existing Healthcare Coverage
Individual underwriters check the application to determine the amount and type of
healthcare coverage that the applicant already has in force. Health plans attempt to
ensure that an individual has adequate coverage, but that such coverage does not result
in excessive benefits or profit for the individual. Experience shows that people with
excessive amounts of healthcare coverage tend to overutilize their coverage.
Lifestyle
If an applicant participates more frequently than average in some avocations—as

examples, road racing, mountain climbing, hang gliding, or horse racing—the
underwriter usually adds an impairment rider to the policy. Underwriters also thoroughly
investigate applicants who have a record of substance abuse, including drugs and
alcohol. If an applicant has a poor driving record, as shown by numerous citations,
arrests, or accidents on the applicant’s motor vehicle record, most health plans severely
limit benefits or decline coverage if state law allows. The underwriter pays special
attention to any indication that an applicant has a record of driving under the influence of
alcohol or other substances (DUI). Some health plans do not approve coverage for
applicants who have had a DUI conviction during the past three years.
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Chapter 9 A
Pricing a Health Plan
Price sensitivity in the marketplace is a key factor in how a health plan determines a
health plan’s premium rate. Although it is important for health plans to competitively price
their products, health plans must be able to do so while effectively assessing the risk. In
other words, a health plan must first determine whether to accept the risk that a
prospective group represents. If the health plan decides to assume the risk, then the
health plan must establish a premium rate that covers the risk and provides the health
plan with a profit on the plan.
Increased market competition has underscored the need for proactive rating and
underwriting in a health plan. The ability to effectively perform these functions has
become critical for health plans, which have to address in their pricing strategy ongoing
market trends and factors, some of which are listed in Figure 9A-1.
Margins 1
A health plan that assumes risks incurs the costs of those risks. To ensure their solvency
and profitability, health plans use margins in calculating the costs associated with the
risks that they assume. The amount by which a product’s price exceeds its costs is
called the product’s margin, also called the spread or profit margin. The following
sections discuss the use of margins in pricing a health plan. Note that the same pricing
principles also apply to a health plan’s other healthcare products.
Once a health plan’s actuaries have analyzed and forecasted a health plan’s costs, the
health plan generally determines a premium that exceeds the plan’s expected costs to
provide the plan with an appropriate profit. To analyze product costs and margins, a
health plan generally divides a health plan’s costs into two categories: (1) the costs of
the benefit payments associated with the plan and (2) all other plan expenses.
A health plan also generally considers that a health plan’s costs are offset, or reduced,
by a third factor: the investment income that is earned on plan premiums. Investment
income may be negligible on some healthcare products, however. Generally, a product’s
overall margin, which is added to the product’s price, can be thought of as having three
components: an underwriting margin, an expense margin, and an investment
margin.
Some health plans combine or net the expense margin and the investment margin into
one margin. Other health plans may use other margins in pricing a product. Regardless
of the approach a health plan uses to develop margins, the health plan’s purpose is the
same: to provide enough income to meet current and future claims obligations and to
provide a profit. Before we discuss the underwriting, expense, and investment margins,
we first discuss a health plan’s expected, assumed, and actual margins with respect to
pricing a health plan.
The underwriting margin is the difference between a health plan’s actual benefit costs
and the benefit costs (medical expenses) that a health plan assumes in its pricing.
The expense margin is the difference between the amount actually needed to cover a
health plan’s nonmedical expenses and the assumed expense level that a health plan uses
to price the plan
The investment margin is the difference between the amount of investment income that a
health plan earns and the amount of investment expenses that a health plan incurs.
Expected Margins, Assumed Margins, and Actual Margins
At the pricing stage, a health plan has either an expected value or an assumed value. An
expected value is a value that a health plan’s actuaries believe is most likely to occur.
In contrast, an assumed value is the value a health plan’s actuaries use in calculating
the premium on a health plan. An actual value is the value that actually occurs after the
plan has been in force. Unlike expected values and assumed values, which are
estimates developed before the pricing decision is made, actual values are only
available after a health plan has been in force—in other words, after the pricing decision
has been made.
In calculating a plan’s premium, actuaries frequently assume different values from those
they expect to occur. For example, if a health plan’s actuaries have observed a 50%
utilization rate for mammography screening, then the actuaries may assume a 75%
utilization rate in pricing a health plan. In another example, a health plan’s actuaries may
use 200 inpatient days per 1,000 (expected value) rather than 180 inpatient days per
1,000 (actual value) in pricing a health plan.
An expected margin is the profit margin that a health plan intends to produce and
believes is most likely to occur. An assumed margin is the difference between a health
plan’s assumed value and its expected value for the premium that the health plan
charges for a health plan. A health plan’s actual margin, which emerges after the health
plan has been in force, is the difference between the assumed values and the actual
values for the plan’s benefit costs, expenses, or investment income. Keep in mind that
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assumed margins and expected margins are built into the price of a product. Actual
margins are not known during the pricing process; they are known only after the product
has been in force.
The actual margin may be higher or lower than the assumed margin. In addition, one of
the components of total margin—the underwriting margin, the expense margin, or the
investment margin—may be higher than expected and another component may be lower
than expected.
Expected Margins, Assumed Margins, and Actual Margins
Suppose a health plan observes that a health plan’s actual morbidity is lower than its
assumed morbidity and that the plan’s actual administrative expenses are higher than its
assumed administrative expenses. In this case, the plan’s actual underwriting margin
would be larger than its assumed underwriting margin. However, the plan’s actual
expense margin would be lower than its assumed expense margin.
A product’s total margin—whether actual, expected, or assumed—can be composed of

any combination of the three margin components (underwriting, expense, and
investment). For example, a health plan may base a health plan’s price on a large
underwriting margin, a moderate expense margin, and a very small investment margin.
The health plan may base the price of another product on relatively large underwriting
and expense margins and a moderate investment margin.
A health plan can analyze margins and profitability at several different levels, including
the
• Product level (for example: HMO, POS, and PPO)

• Market level (for example: large group, small group, and individual
purchasers
• Company level (for example: all products and markets combined)
Thin Margins and Wide Margins
A product is often described as having a thin margin or a wide margin. With respect to a
product’s underwriting margin, expense margin, and investment margin, a thin margin
is a narrow or small margin and a wide margin is a relatively large margin, expressed in
monetary or percentage terms. Specific products tend to have relatively thin margins;
other products tend to have wider margins. For example, administrative-services-only
(ASO) contracts usually have thin margins. Often, margin width is a function of group
size in that large group business typically has a thinner margin than small group
business. Figure 9A-2 lists several factors that help determine the size of a product’s
margin.
Actuaries typically conduct several iterations of premium rates and margins before
arriving at the price and margins that will be used for a particular product such as a
health plan. After the plan has been on the market, actuaries monitor its performance.
Where possible, actuaries adjust the margins and price to improve plan performance.
Thin Margins and Wide Margins
Note that, even after a health plan has been in force, determining the plan’s actual
underwriting, expense, and investment margins may be difficult. Some medical
expenses may be known, but actual costs for incurred but not reported (IBNR) claims
are more difficult to determine.
Actual administrative expenses may also be difficult to determine. For example, a health
plan must decide what portion of the salaries paid to employees in the claims function
should be allocated to the administrative expenses of a particular health plan.
Consequently, the determination of an existing plan’s actual margin is as much a result
of the allocation method that a health plan uses as it is of the plan’s true profitability. We
discuss the underwriting margin, the expense margin, and the investment margin in
more detail in the following sections.
Underwriting Margins 2
Generally, both the level of underwriting risk that a health plan assumes in providing
benefits and the market competition it encounters directly affect the size of the assumed
underwriting margin in a health plan. For example, a smaller assumed underwriting
margin reduces a health plan’s price, thus making the plan more competitive. Therefore,
the more competition a health plan faces in the marketplace, the smaller the plan’s
assumed underwriting margin.
A health plan can take steps to reduce its exposure to underwriting risk and thereby
adjust its underwriting margin. One way that a health plan can reduce underwriting risk is
to use stop loss insurance, which we discussed in Capitation and Plan Risk. Because a
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health plan’s underwriting risk can arise from a number of sources, the plan can also
look at the sources of those risks and find ways to control or manage them. Common
sources of underwriting risk include (1) lack of a health plan’s experience in forecasting
underwriting results, (2) the number and length of rate guarantees, and (3) antiselection.
We briefly look at two of these sources and how they might be controlled in order to
improve a health plan’s underwriting margin.
Underwriting Margins
A health plan takes on a greater underwriting risk when it has no direct experience on
which to base its morbidity forecasts. For example, a just-introduced health plan may
have no credible morbidity experience, so it may include a proportionally greater
underwriting margin than that of an established health plan. In this case, effective
utilization controls and provider reimbursement arrangements help to minimize the
impact that the lack of credible experience has on a health plan’s underwriting margin.
A health plan may also use a shorter or longer price or premium rate guarantee for
specific groups. Suppose a health plan offers a particular health plan to two groups,
Group ABC and Group XYZ, which are similar in size. The health plan offers a two-year
premium rate guarantee to Group ABC and a one-year guarantee to Group XYZ. In this
case, the health plan may offer the longer price guarantee to retain Group ABC’s
business in a competitive environment because Group ABC has lower utilization rates
than does Group XYZ.
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Expense Margins 3
Earlier in this lesson, we defined a product’s expense margin as the difference between
the product’s actual expenses and the expenses that a health plan assumed in pricing
the product. The expense margin, therefore, is the part of the retention charge that is
intended to contribute to the health plan’s profit (or surplus, for those health plans that
must company with state insurance requirements).
Recall from Assignment 5 that a product’s retention charge, also called expense charge
or simply retention, is composed of (1) the expected operating expenses necessary to
support the product, (2) a risk charge that is designed to cover contingencies, and (3)
the product’s expected expense margin. In traditional individual insurance products, the
retention charge is frequently called loading. Note that the retention charge does not
include medical expenses or investment expenses.
Recall also from Assignment 5 that a product’s risk charge helps to ensure that a health
plan will be able to fulfill its contractual obligations even under difficult circumstances.
Contingencies are unexpected events that cause expenses, investment earnings,
morbidity rates, or other factors to vary significantly from a company’s forecasts.
Keep in mind that the actual expense margin on a health plan is not known until after
that plan has accumulated experience. When any of the expense factors in the retention
charge varies from a health plan’s expectations—causing the health plan’s revenues to
decrease or its expenses to increase—the negative result is called an adverse deviation.
Note that a favorable deviation—a situation in which a health plan’s revenues increase
or its expenses decrease—can also occur
Review Question
The Essential Health Plan markets a product for which it assumed total expenses to
equal 92% of premiums. Actual data relating to this product indicate that expenses equal
89% of premiums. This information indicates that the expense margin for this product
has:
a 3% favorable deviation
a 3% adverse deviation
an 11% favorable deviation
an 11% adverse deviation
Correct. The difference between the assumed expenses, as a percent of premium

92% and the actual expenses as percent of premium 89% is the 3% favorable
deviation.
Incorrect. When the actual amount of any expense varies from the health plan
expectations, causing revenues to increase or expenses to decrease is called
favorable deviation.
Incorrect. The deviation is the difference between assumed and actual premiums.
Incorrect. When the actual amount of any expense varies from the health plan
expectations, causing revenues to increase or expenses to decrease is called
favorable deviation. The deviation is the difference between assumed and actual
premiums.
Investment Margins 4
For many health plans, investment income is insignificant because their cash inflows
(premiums) and cash outflows (provider reimbursement payments) occur at the same
time. As a result, these health plans have little cash to invest to earn investment income.
In such cases, the development of assumed investment margins and comparisons of
assumed and actual investment margins may be irrelevant. Other health plans develop
investment margins on their products because investment income is a large dollar
amount, even if not a significant percentage, of their total revenues.
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One factor—the interest margin—determines the

size of a product’s investment margin. A product’s
interest margin is the difference between the
product’s assumed interest rate or assumed
crediting rate and the actual interest rate earned by
a company on the assets supporting that product:
Investment Margins
The assumed interest rate is the interest rate that a company assumes when pricing a
product. A crediting interest rate is the interest rate that a company uses to credit
investment return to a product. A health plan builds an assumed interest margin into the
price of a health plan by assuming an interest rate that is lower than the interest rate that
the health plan actually expects to earn on its investments. A crediting interest rate is not
built into a product’s investment margin, however. A health plan determines the actual
interest margin by calculating the actual interest rate that was earned on a product’s
investments.
Purchasers are generally unaware of the interest rates a health plan assumes when
pricing products. A health plan establishes a premium rate, based on a specific assumed
interest rate, that will generate enough revenues to pay the benefits promised by a
health plan. The funds that a health plan uses to pay plan benefits generally come from
two sources: (1) premium income from plan premiums that are paid by purchasers and
(2) investment income from interest and dividend income earned by the health plan from
investing those plan premiums.
Again, investment income is a less significant factor than healthcare benefit expenses
and administrative expenses in pricing a health plan because benefit expenses are
typically 82% to 90%, and administrative expenses are typically 10% to 18%, of a plan’s
premium. In many cases, a health plan’s investments must be short-term; because
short-term investments earn lower interest income than long-term investments, the
interest income may be negligible. Also, many health plans must comply with statutory
requirements concerning the type of investment and the amount of risk that they are able
to assume.
Pricing Factors
We have seen how a health plan considers the risks associated with healthcare benefit
expenses and administrative expenses in pricing a health plan. Other factors also limit
the range within which a specific health plan’s premium must fall. For example, market
forces determine the maximum price that a health plan can charge for a health plan. If a
plan’s premium is too high, compared to the premiums of other plans, then, given a
choice between two plans, most employers will contract with the health plan that offers
lower-priced plans.
On the other hand, the minimum price that a health plan can establish for a health plan
is determined by the costs that the health plan expects that the plan will incur. The plan
premium must be high enough to cover the plan’s costs of paying for both the delivery of
healthcare benefits and the costs of selling and administering the plan.
Statutory requirements are another factor that may influence a plan’s minimum or
maximum price. Also, the existence of a number of plan options, which occurs when
employers offer employees two or more health plans, affects the premium of each health
plan.
Market Forces Set the Upper Limit on Price
Although price is not the only point of competition among products, price is certainly a
primary concern. Generally, as the price of a particular product increases, compared to
the prices of competing products, the quantity sold of that product decreases. Suppose a
health plan establishes too high a premium for a health plan, relative to the premiums on
competing plans. In this case, the number of employers and other purchasers who
contract with the health plan for this plan will be so low that premium income will be
insufficient to meet plan costs and contribute to the health plan’s profit or surplus.
Market Forces Set the Upper Limit on Price
Therefore, market competition imposes an upper limit on a plan’s price, although the
exact level of this upper limit on price can change over time. When making decisions
among competing plans, purchasers also consider other plan characteristics. Keep in
mind that competitive forces are dynamic—not static—and the demand for a specific
product or category of products can change.
In this context, demand refers to the quantity of a product that purchasers will buy at
different price levels. Generally, the greater the demand for a product, the more of the
product that purchasers will want at a given price. Also, the greater the demand for a
health plan’s product, the higher the product’s maximum price. Figure 9A-3 lists some
factors that influence the demand for healthcare products.
Costs Set the Lower Limit on Price
Just as the demand for a product creates an upper limit for a product’s price, the costs
associated with developing and supporting the product usually set a lower limit on the
product’s price. If a health plan prices a health plan in such a way that the plan’s benefits
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and expenses are greater than its revenues, then the health plan cannot make a profit
(or add to surplus) on the plan.
Market forces and product costs provide the limits of the dollar range within which a
product can profitably be priced. If a health plan prices a health plan above the level
indicated by the demand for the plan, then the plan will not achieve adequate sales. As a
result, the plan will not provide enough revenues to fulfill the health plan’s profit goals for
the plan. If a health plan is priced below cost, however, its revenues will be lower than its
costs, so the health plan will incur a loss on the plan.
Costs Set the Lower Limit on Price
In some situations, a healthcare product’s price, as indicated by the market, could be

lower than the price necessary for a health plan to cover its costs on the product. As a
result, no market price will allow the product to be profitable to the health plan. If a health
plan finds one of its products in such a situation, the health plan can take one of the
following courses of action:
• Reduce the costs associated with providing the product

• Stimulate an increase in demand for the product—for example, by
redesigning the product to make it more attractive to purchasers—but without
significantly increasing the product’s costs
• Sell the product at or slightly below cost in an effort to enter a new market or
to increase market share in an existing market
• Withdraw the product from the market, because the product is not attractive
enough to purchasers to be sold at a profit.
Despite the possibility that, in a particular situation, a health plan might offer one or more
products at a price below cost, the costs of the health plan’s entire portfolio of products
cannot exceed the revenues earned from all products. Otherwise, the health plan will be
unable to operate profitably and eventually will face insolvency.
Regulatory Impact on Health Plan Prices
Costs and competitive forces impose limits on the prices of all products. However, laws
and regulations may place additional constraints on product prices. For example, some
statutory requirements dictate the range of prices that a health plan can charge for a
product by requiring that the health plan develop plan premiums on the basis of
community rating. Regulations can also have an indirect impact on the prices that a
health plan may charge for its healthcare products. Often, federal and state laws
concerning benefit mandates increase the cost of providing and administering healthcare
products, which in turn places upward pressure on plan premiums.
Rating in a Multiple-Choice Environment 5
A multiple-choice environment is any situation where purchasers or individuals have a

choice between several of a health plan’s products. Individuals might be independent
and have a wide range of choice, or might be part of an employer group and have more
limited choice of product options. Healthcare products or services can include any and
all items in an employee benefit plan or, for individuals, any item that can be chosen on
an optional basis.
The development of premium rates for healthcare coverage in a multiple-choice

environment presents a challenge to a health plan’s standard rating formulas, which
normally just focus on a product’s expected benefit costs. The existence of choice may
also encourage antiselection, which can result in greater costs for healthcare products
that attract a significant number of high utilizers of healthcare services.
Rating in a Multiple-Choice Environment
When a health plan offers more than one type of health plan, the basic pricing strategy is
for the health plan to determine the aggregate premium necessary to cover the
aggregate cost of claims for all plans. Although the health plan should price each plan on
a somewhat independent basis, the aggregate premium is the most important
consideration. Other factors that health plans consider in pricing several health plans—
such as an HMO, a PPO, and an HMO with a POS option—in a multiple-choice
environment include the
• Actuarial value of each plan option’s benefits, provider reimbursement

arrangements, utilization management differences, retention charges, and
expense margins
• HMO/non-HMO enrollment mix
• In-network and out-of-network provider utilization under the non-HMO option
• Relative cost of benefits for those plan members who enroll in a non-HMO
option, compared to the costs for those plan members who enroll in the HMO
Note that this discussion focused on a specific scenario: one health plan that offers
several plan options. Issues concerning rating in a multiple-choice environment also
exist in a scenario under which two or more health plans offer several plan options to an
employer group. A detailed discussion of pricing strategies under various scenarios is
beyond the scope of this course.
Trend Analysis 6
A trend represents the change in dollar amount or ratio of an index over a period of
time. Examples of trends in health plan products include the direction and/or magnitude
of cost per service or of per member per month (PMPM) costs. Health plans identify and
monitor several key trends in order to establish premium rates for health plans. Because
of the potentially significant impact that trends can have on a health plan’s financial
performance, it is critical that the health plan devise a system of long-term trend
analysis.
Trend analysis, also called trend percentages or index-number trend analysis, is a type
of financial analysis designed to identify changes in a company’s financial statement
values over the course of several financial reporting periods. A health plan may conduct
7
trend analysis to compare a health plan’s financial information across different

accounting periods, such as months, quarters, or years. Trend analysis may use either
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dollar amounts or ratio values. We discuss trend analysis in the context of a health
plan’s financial performance in Financial Statement Analysis in health plans.
Choosing meaningful time periods and units of measurement is critical in conducting

trend analysis. Maintaining consistency in tracking trends is also important. Suppose a
health plan conducts trend analysis on a health plan on a quarterly basis. In this case,
each year, the health plan will use the same quarterly time periods in conducting trend
analysis. Similarly, a health plan that elects to analyze the trend associated with PMPM,
for example, would use this same unit of measure in subsequent time periods.
Over time, a change in one trend may have a significant impact on cost per service or
PMPM. Therefore, health plans not only monitor each trend separately, but also with
respect to each trend’s possible impact on another trend. For example, an increase in
outpatient utilization usually results in an increase in drug utilization. In addition, health
plans typically conduct trend analysis on each product, such as an HMO, PPO, or HMO
with a POS option. For each product, health plans regularly monitor key trend elements,
including provider reimbursement trend, which also consists of residual trend.
Provider Reimbursement Trend
Provider reimbursement trend represents the change in the reimbursement that a

provider receives over time for the same service. For most health plans, the provider
reimbursement trend has the most impact on total trend. A health plan usually monitors
the provider reimbursement trend by tracking utilization and provider contract changes
that affect reimbursement.
Examples of provider reimbursement trends include a 10% increase in the per diem
levels for a particular hospital and an 8% increase in a primary care physician’s
capitation rate. To calculate the financial impact of provider reimbursement trend on
premium rates, health plans generally analyze each type of provider reimbursement
trend by product, then by type of service within each product.
Residual Trend
The residual trend, also called the residual component of trend, is the difference
between total trend and the portion of the total trend caused by changes in
provider reimbursement levels. The residual trend results from a number of
causes, which Figure 9A-4 summarizes.
Unlike the provider reimbursement trend, the residual trend is more difficult to quantify.
However, careful monitoring of the provider reimbursement trend helps a health plan to
estimate more accurately the residual trend. The magnitude of the residual trend often
determines the degree of effort that a health plan spends in analyzing the trend’s various
components. Also, the pattern of the residual trend may indicate specific areas that
should be more closely analyzed.
Analyzing a health plan’s experience helps a health plan to quantify the total trend rate.
Monitoring trends provides a health plan with vital information for more accurate cost
projections and health plan pricing, which, in turn, provides the plan with greater stability
in the marketplace.
Review Question
Residual trend is the difference between total trend and the portion of the total trend
caused by changes in provider reimbursement levels. Consider the following events that
could affect an health plan’s provider reimbursement levels:
• Event 1 — The disenrollment of a large group with unusually high utilization

rates
• Event 2 — The introduction of a new treatment for infertility
• Event 3 — A serious flu epidemic
• Event 4 — A shift in inpatient medical services from obstetrical care to neonatal
intensive care
One cause of residual trend is change in intensity, which would be represented by:
Event 1
Event 2
Event 3
Event 4
Incorrect. Event 1 represents a change in utilization trend
Incorrect. A new treatment in fertility would represent a change in technology
Incorrect. A serious flu epidemic would represent a change in fluctuation
Correct. Change in intensity represents changes in the level of intensity of

services provided.
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Chapter 9 B
Rate-Setting in Health Plans
In Rating and Underwriting, we introduced key underwriting principles and rating
methods used in health plans. In Small Group Underwriting and Individual Underwriting
discussed the issues and risks associated with underwriting small groups and
individuals. In the previous lesson, it discussed the components used in determining a
health plan’s premium. This lesson builds on this foundation with examples of premium
rate-setting for an HMO.
HMO Premium Rate Calculations
As with any major managed care methodology, there is no one right way to calculate a
premium rate for a health plan. While various state regulatory requirements, federal
guidelines for federally qualified HMOs, and actuarial and industry standards set some
parameters, individual health plans have plenty of room to develop their own specific
models for rate-setting a health plan.
Most health plans have customized the rate-setting process to meet their specific needs.
Still, there is a classic model on which many health plans base their own specific rate-
setting model. This basic rate-setting model starts with an actuarially determined
premium PMPM.
This premium includes a calculation of all plan benefit costs, administrative costs, and a
provision for profit or surplus. The rest of the rate-setting process involves converting
this PMPM amount into premium rates for the applicable rating categories. In our
example, we follow the rate-setting process for a non-federally qualified HMO.
Recall from Rating and Underwriting that premium rates are typically categorized and
quoted by "tier" based upon the dependents covered with the subscriber. Recall from
Healthcare Management: An Introduction that a subscriber is a person, including an
eligible employee, who is able to enroll in the HMO directly and that a dependent is a
person whose enrollment eligibility is contingent on that of the subscriber. Our HMO
example uses five different tiers:
• One-Tier (Composite) Rates
The same premium applies, regardless if the subscriber is single or has any
number of covered dependents.
• Two Tier Rates—(1) Single and (2) Family.
The family rate includes any combination of subscriber plus dependents.
• Three Tier Rates—(1) Single, (2) Couple, and (3) Family.

Couple means the subscriber plus spouse (or partner). In some plans, couple
means the subscriber plus any one dependent. In this context, the family rate
applies to the subscriber plus all other combinations of two or more dependents.
• Four Tier Rates—(1) Single, (2) Couple, (3) Family, and (4) Subscriber plus
child(ren).
Here, couple means subscriber plus spouse (or partner), family means
subscriber, spouse (or partner), plus additional dependents. The fourth tier
means subscriber with no spouse (or partner), plus any number of other
dependents
• Five Tier Rates—(1) Single, (2) Couple, (3) Family, (4) Subscriber plus
children, and (5) Subscriber plus child.
The definitions are the same as a four-tier plan except the split of the fourth tier
Rate Ratios
To convert the premium PMPM into single rates for any of these tiers, a health plan
applies a formula, which considers the assumed mix and family size of each of the rate
categories, and the rate ratio for each tier. While the basis for the formula is constant, it
must be adjusted for each tier. For example, the calculation for a two-tier rate is different
than the calculation for a four-tier rate.
What is a rate ratio? A rate ratio is the "markup" factor from a single rate to any other
rate category. Suppose the rate ratio for a couple rate category is 2.0. In this case, you
would multiply the single premium times 2.0 to get the premium for the couple rate
category. Suppose a family rate has a rate ratio of 2.7. To calculate the family rate
premium, you would multiply the single premium times 2.7.
How are rate ratios determined? They are assigned by a health plan to a health plan.
Rate ratios should consider family size, but most often they are based on competitive
factors, including the ratios that competitors are using and what ratios employers and
other plan sponsors are requesting.
A rate ratio for a rate category can be arbitrarily increased or decreased, but the
premiums for other rate categories will be affected as well. The end result of a typical
family rate ratio is that the family rate is subsidized by the single premium rate. In other
words, the single rate is somewhat higher than it otherwise should be, and the family
rate is somewhat lower than it otherwise should be.
The reason for this subsidization has to do with employer contributions and coordination
of benefits. Many groups contribute 100% of the subscriber premium, but contribute only
a portion (or none) of any other rate category. Therefore, in open enrollments in a
multiple-choice environment, family rates become more price competitive.
Also, some subscribers with families choose single coverage and let their spouse
include all dependents on the spouse’s health plan. A higher single rate helps to
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maximize revenues for the health plan that enrolls only the subscriber, and not his or her
spouse and dependents.
The exact formulas for the single rate, couple rate, family rate, and so on, are beyond
the scope of this course. Rate adjustments may be applied to the beginning premium
PMPM. This means the premium PMPM is multiplied by a risk adjustment factor to
increase or decrease the starting premium rate. The most common adjustments are for
age and sex, where groups composed of people of younger ages get a lower risk
adjustment factor, resulting in a lower premium rate, than those composed of people at
older ages. There are countless other adjustments, including effective date, location,
industry class, and group experience.
Review Question
The following statements are about rate ratios used by health plans. Select the answer
choice containing the correct statement:
While rate ratios consider family size, they are most often based on competitive
factors, such as the ratios being used by competitors and the ratios that plan
sponsors are requesting.
If the rate ratio for a couple rate category is 2.0, then the single premium is divided
by 2.0 to derive the couple rate category premium.
A rate ratio can only be increased if the health plan has obtained regulatory
approval.
The effect of a typical family rate ratio is that a family rate is somewhat higher than
it otherwise should be, and the single rate is somewhat lower that it otherwise
should be.
Correct. Rate ratios are often based on competitive factors.
Incorrect. The single premium is multiplied by 2.0 to derive the coupe rate
category premium.
Incorrect. A rate ratio is assigned by the health insurance plan to the health plan
product
Incorrect. Typically the family rate is subsidized by the single rate.
Pricing Policy and Pricing Strategy
The above discussion focused on the calculation of a health plan’s premium rate
calculation for an HMO. The premium rate formula that a health plan uses to develop
premium rates depends in part on the health plan’s pricing policy and pricing strategy.
Pricing Policy
A health plan’s pricing policy typically addresses how the health plan will calculate plan
premiums. A health plan’s pricing strategy indicates the health plan’s approach to the
type of market—for example, commercial, small group, or Medicare—and the level of
premiums charged, compared to those of competing products. Figure 9B-1 outlines the
effects that a health plan’s pricing policy may have on its market.
Pricing Strategy
The pricing process for most health plans involves the calculation of expected claims
costs that result from utilization of (1) in-network providers, (2) out-of-network providers,
and (3) out-of-area providers for a health plan. These various claims costs are then
combined, according to the health plan’s assumptions on how often each type of
utilization will occur. Other costs, such as administrative expenses, and a provision for
profit or contribution to surplus are then added to the expected claims costs.
A health plan also considers several other items in the process of calculating premium
rates. Note that all items will not be applicable in every situation. Figure 9B-2 lists some
critical items that health plans consider in pricing a health plan.
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Pricing Traditional Indemnity Plans
In some health plan products that include an out-of-area or out-of-network component, a

health plan must be able to effectively price traditional indemnity benefits. The estimation
of claims costs is also a key element in pricing traditional indemnity benefits.
Cost Sharing 1
Cost sharing features in a traditional indemnity plan often include deductibles,

coinsurance, out-of-pocket maximums, and plan maximums. One example is a $100
deductible, 80/20 coinsurance, a $1,100 out-of-pocket maximum (including the
deductible), and a $1,000,000 lifetime maximum benefit. In terms of who pays charges
for medical benefits, the plan pays 80% of charges between $100 and $5,100, and
100% of the charges over $5,100, until the lifetime maximum is reached.
A health plan’s actuaries incorporate the effects of a health plan’s cost sharing features
into the plan’s price by developing a claims probability distribution, from which the value
of the plan deductible can be derived. Factors that are considered in developing a claims
probability distribution include the range of charges, the frequency of charges, the
average charge, annual claims costs, and the accumulated frequency of those costs.
Cost sharing features are more complex in determining family deductibles and out-of-
pocket maximums. Typically, a health plan’s actuaries develop family claims probability
distributions from available claims data or by adjusting individual claims probability
distributions to derive family deductibles and out-of-pocket maximums. A complete
discussion of this derivation is beyond the scope of this course.
Besides calculating the value of the deductible and coinsurance from a claims probability
distribution, a health plan’s actuaries also consider adjusting for utilization. Suppose a
health plan’s actuaries have data for the claims probability distribution for Plan A (a $100
deductible, 80% coinsurance plan) and they are trying to price Plan B (a $500
deductible, 80% coinsurance plan).
In this case, the actuaries would most likely adjust downward for utilization because Plan
B has a higher deductible (higher cost sharing feature). Although it may be difficult to
determine how much a utilization adjustment is a result of cost sharing, a health plan can
monitor the claims probability distribution of each block of business and adjust rates
when necessary.
Pricing PPOs 2
Pricing a PPO plan is typically based on pricing techniques of traditional indemnity plans.
To price an indemnity plan, actuaries would start with the claims experience of an
existing indemnity plan. If the indemnity plan had no information or no credible
information on claims experience, then the actuaries would adjust for various risks and
conduct a trend analysis on the resulting claims.
The first step in pricing a PPO would be to develop a base indemnity claims cost,
which results from adjusting the indemnity plan as though the entire eligible group of
employees had been enrolled in the indemnity plan. Once actuaries have developed the
base indemnity claims cost, the claims cost for the in-network PPO plan and the out-of-
network indemnity plan can be developed.
To develop the expected claims costs for the in-network PPO plan, a health plan’s
actuaries adjust the base indemnity claims costs to reflect pertinent characteristics of the
plan, including the
• Specific network plan design

• Provider discount arrangements
• Impact of utilization review and any other cost containment procedures
Actuaries develop the expected claims costs for the out-of-network indemnity plan and
any out-of-area plan in a similar manner. After developing these expected claims costs,
actuaries then consider which employees would be likely to select which provider
groups. Such assumptions, generally called selection assumptions, can be developed
using a range of approaches.
Regardless of the approach used, however, the health plan’s actuaries must first
determine which employees are in the network service area. For these employees,
actuaries estimate what percentage of employee utilization will be in-network utilization.
This percentage may be broken down by age, sex, active versus retiree status, type of
medical service, and so on.
In practice, however, typically one or two overall percentages are determined. For
example, the percentage calculation is often based on how many employees will use the
network and assumes that these employees will use in-network providers 100% of the
time.
Other assumptions about employee in-network utilization include the number of in-
network providers, benefit differences among plans offered, employee contribution
levels, the ease of provider access, historical data, and the mix of medical services that
employees may need.
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The issue of selection is inherent in such assumptions. Employees tend to select

providers according to the likelihood of utilization, the relative contribution cost, and their
out-of-pocket expenses. Sometimes this selection takes the form of choosing an in-
network provider for a perceived less serious illness or for new medical services, and a
non-network provider for ongoing care or perceived life-threatening illnesses. This
phenomenon will usually adversely affect the claims experience of the indemnity plan.
Next, the health plan’s actuaries will use risk adjustment factors to adjust the existing
claims costs for selection issues. Once that has been done, the actuaries then weight
the in-network and out-of-network costs to arrive at a composite claims cost for the PPO
plan.
Pricing a health plan or several health plans in a multiple-choice environment—for

example, an HMO, a PPO, and an indemnity plan—combines many of the techniques
described above. The first step is to develop a base indemnity claims cost, then the in-
network and out-of-network PPO claims costs. The health plan’s actuaries also price the
HMO as described earlier in this lesson.
Again, each of these claims costs must be adjusted for migration (movement among
plan options) and antiselection. To avoid the risk presented by selection issues, some
health plans develop claims costs for each plan component after actual plan selection is
known, before developing the actual premium for each plan.
Chapter 10 A
Accounting Principles and Concepts
• Outline the main points of the entity concept and the going-concern concept
respect to financial reporting in health plans
• Explain the key qualitative factors that affect accounting information and give
examples of such factors in health plans
Accounting is a system or set of rules and methods for collecting, recording,

summarizing, reporting, and analyzing a company’s financial operations. Accounting
1
provides us with an established system for categorizing, measuring, and monitoring a

company’s financial condition, including what the company owns, what it owes, what it
earns, what it spends, and what it retains.
To successfully manage a complex, dynamic company, the company’s managers must

have ready access to all sorts of financial transaction records and reports. Accounting
provides a structured way of summarizing and reporting the information contained in a
company’s financial records so that a company’s managers can stay abreast of the
company’s financial condition and profitability. In so doing, accounting enables a
company’s managers to make informed decisions about managing the company’s
resources.
One of the major benefits gained from accounting is that it improves our ability to make
the types of important economic decisions required in today’s business environments.
The more we know about the potential impact a particular decision may have—on a
company’s financial position, its cash flow streams, or employee morale, for example—
the better prepared we are to weigh the alternatives and make the best decision
possible.
Financial accounting focuses on communicating a health plan’s financial information to

meet the needs of the health plan’s external users. In Health Plan Financial Information,
we discussed several external users of a health plan’s financial information. Recall that
these external users include health plan members, providers, payors and purchasers,
strategic alliance participants, outside agents and brokers, creditors, stockholders,
potential investors, and regulators.
A health plan communicates or reports the summarized results of numerous transactions

through using specified formats for its financial statements. Financial statements are
statements, including the balance sheet, the income statement, the cash flow statement,
and the statement of owners’ equity, that report major financial events and transactions
of a company. Besides using financial statements to comply with financial reporting
2
requirements, a health plan’s financial statements are used to make decisions about the
health plan’s future direction and ongoing operations
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Health plans must prepare and present their financial statements to or for their external
users according to applicable laws, regulations, and accounting principles and practices,
particularly generally accepted accounting principles. Generally accepted accounting
principles (GAAP) are a set of financial accounting standards that all publicly traded
U.S. stock companies (including wholly owned subsidiaries) must follow when preparing
and filing financial statements.
Health insurers and health plans that fall under the jurisdiction of state insurance
departments are required by law to prepare certain financial statements in accordance
with statutory accounting practices. Statutory accounting practices (SAP) are a set of
financial accounting standards that specifically focus on the requirements of insurance
regulators and policyholder interests (specifically solvency). Note that a company that
3
must comply with statutory requirements can follow both sets of accounting principles for
financial reporting, depending on the purpose for reporting financial information. In other
words, the use of GAAP and SAP in companies that must comply with both sets of
requirements is not mutually exclusive. Note that, whenever we discuss GAAP, we mean
U.S. GAAP and that, whenever we discuss SAP, we mean codified statutory
requirements.
Most of the fundamental accounting principles and concepts we discuss in this lesson
apply to both U.S. GAAP and statutory accounting practices; we note where they differ.
The differences that occur reflect the specific purpose of GAAP and SAP. In addition to
serving as blueprints for recording and reporting a company’s business activities, these
principles and concepts have a predictive quality. By predictive quality, we mean that
financial information based on accounting principles and concepts should enable a
health plan’s external and internal users who analyze the health plan’s financial
statements to develop a reasonably accurate estimate of a company's financial strength
or earnings potential.
4
Figure 10A-1 summarizes the key accounting concepts, characteristics, and principles
that influence reporting of financial information. We discuss the overall framework and
information quality in more detail in the following sections.
Entity Concept
An entity is the basic economic unit for which a company maintains distinct accounting
records and reports. The economic unit may be an individual, an organization, a
corporation, a subsidiary of a corporation, or a partnership. The entity concept, also
known as the accounting-entity concept or the business-entity concept, states that a
company must account separately for the business activities of each economic unit.
Thus, to help avoid confusion, an individual who owns a business should separate
personal accounting records from business accounting records. The entity concept
enables anyone who looks at a collection of accounting records to know to whom or to
what organization the records refer.
Under the entity concept, a company can define its own accounting entities. For
example, a corporation is an entity for accounting purposes. Within the entity of the
corporation, however, there can be many additional entities. If a health plan owns
subsidiary companies, and each subsidiary prepares its own financial statements, then
each subsidiary is an accounting entity. Further, accounting entities within the health
plan can be smaller portions of the company itself, such as divisions, departments, lines
of business, profit centers, and so on. Typically, entities at lower levels of a health plan
maintain detailed records of accounting transactions; these records in turn are
summarized and consolidated into the health plan’s overall financial reports.
To understand and interpret a company's financial information, and to compare this

information with information about one or more other companies, an interested user
must first be able to identify which entity the company's financial statements represent:
Is it the parent company alone? An individual subsidiary? Or a consolidation of the
parent company and one or more subsidiaries? The use of GAAP and SAP in financial
statements benefits users of financial information because each set of accounting
principles and practices specifies the requirements concerning how a health plan
accounts for all its financial activities.
Accounting principles provide two methods for identifying the correct entity. First, a
company must clearly label each entity's financial statements with the entity's name. If
the statements are for the Keycard Company only, then the headings should read
"Keycard Company." If the statements are consolidated financial statements for Keycard
and its subsidiaries, then the headings should read "Consolidated Financial Statements
of Keycard Company." Suppose Keycard is the parent company of two subsidiaries: an
HMO and an insurance company. In this case, the HMO and the insurance company are
accounted for as separate entities; in turn, their financial results would be included in
Keycard’s consolidated financial statements.
Second, the Financial Accounting Standards Board (FASB), a private organization

whose purpose is to establish and promote GAAP in the United States, requires that the
activities of a parent company's various business operations be disclosed in the
company’s annual report to stockholders. Typically, these disclosures are made in notes
and supplementary information that accompany a company's consolidated financial
statements. These notes describe in detail the source of the amounts represented on the
consolidated statements. The National Association of Insurance Commissioners (NAIC)
prescribes statutory accounting practices.
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Going-Concern Concept
The going-concern concept means that accounting processes are typically based on
the assumption that a company will continue to operate for an indefinite period of time.
Thus, unless there is evidence to the contrary, accounting does not assume that a
company is about to be liquidated.
From another perspective, liquidation typically reflects the process of converting a

company's assets (things owned by a company) to cash, usually to pay off all of a
company's liabilities. (Endnote 6) For example, suppose the state insurance
commissioner, acting for the state court, takes control of and administers an insolvent
HMO’s business. In this case, all of the HMO’s business and assets are transferred to
other carriers or are sold to satisfy the HMO’s outstanding obligations, and the HMO’s
business is terminated.
The going-concern concept is an underlying premise of GAAP. It is not, however,

entirely presumed under SAP. Because SAP focuses on an insurer’s or a health plan’s
solvency, the use of SAP in specified financial requirements focuses on the liquidation
value of the health plan or insurer. The emphasis on liquidation under SAP is commonly
referred to as the liquidation concept. Generally, the statutory approach values assets
more conservatively than does the going-concern concept under GAAP.
However, statutory accounting is not exclusively concerned with an insurer’s or a health

plan’s liquidity or solvency. For this reason, we say that SAP follows a modified going-
concern concept. Financial statements prepared according to statutory accounting follow
a modified going-concern concept because the primary objective of SAP is to ensure
that an insurer or health plan is solvent, that is, that the insurer or health plan can meet
its current and future obligations to its insureds or policyholders.
The going-concern concept affects financial reporting in the following ways. First, this
concept allows a company to defer (postpone) certain costs because they contribute to
future earnings. In other words, as long as the company is continuing its business, its
costs can be spread out over a reasonable period during which the company can
generate revenues to offset these costs.
For example, a health plan that purchases an expensive computerized switchboard for a
call center expects the switchboard to help generate earnings for several years, not just
during the accounting period in which the health plan purchases the switchboard.
Because of the going-concern concept, the health plan can defer some of the cost of the
equipment to future years. We discuss this process, known as capitalization, later in this
lesson. Second, the going-concern concept assumes that a company will pay its
liabilities over time as scheduled, not immediately or in full during the current accounting
period. Thus, a company will pay its current liabilities in the current accounting period
and its future liabilities out of earnings the company generates in future accounting
periods. Figure 10A-2 summarizes the entity concept and the going-concern concept.
Review Question
All publicly traded health plans in the United States are required to prepare financial
statements for use by their external users in accordance with generally accepted
accounting principles (GAAP). In addition, health insurers and health plans that fall
under the jurisdiction of state insurance departments are required by law to prepare
certain financial statements in accordance with statutory accounting practices (SAP). In
a comparison of GAAP to SAP, it is correct to say that:
GAAP is established and promoted by the National Association of Insurance

Commissioners (NAIC), whereas SAP is established and promoted by the
Financial Accounting Standards Board (FASB)
the going-concern concept is an underlying premise of GAAP, whereas SAP tends
to focus on the liquidation value of the MCO or the insurer
GAAP provides for a single method of valuing all of a health plan’s assets,
whereas SAP offers the health plan more than one method for valuing its assets
the principle of conservatism is fundamental to GAAP, whereas SAP generally is
not conservative in nature
Incorrect. GAAP is established and promoted by the Financial Accounting

Standards Board (FASB).
Correct. The going-concern concept is an underlying premise of GAAP, whereas

SAP tends to focus on the liquidation value of the MCO or the insurer.
Incorrect. Both GAAP and SAP offer moret han one acceptable method for
calculating or valuing assets.
Incorrect. SAP values assets more conservatively than does the going-concern
concept under GAAP.
Accounting Information Qualities
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Because quality information in a company's financial statements is critical for the sound
operation of the company, the FASB mandates that accounting information must exhibit
certain qualitative characteristics. It must be reliable, relevant, consistent, comparable,
material, and conservative. These qualities help assure that a sophisticated analysis of a
company's financial statements will provide an accurate and useful understanding of the
company's financial condition.
Reliability
With respect to accounting information, reliability means that the information

contained in financial statements is accurate, objective, and free from bias and
misrepresentation. Reliability is a necessary quality of all information contained in a
company's financial statements and the accompanying notes and supplementary
information. Reliable information faithfully and fairly represents a company's financial
position or profitability and does not mislead an interested party. A company must record
and report accounting information in such a manner that outside experts, such as
external auditors, can verify that the information is truthful and based on objective
measurements.
For example, when the total dollar amount of fee-for-service (FFS) payments to
providers equals the amount recorded for such payments in a health plan's accounting
records and source documents, then the information is considered to be reliable. If
information is to be reliable, a health plan must record a given transaction in a consistent
manner each time a similar transaction occurs. An independent third party must be able
to evaluate and interpret specific amounts on a financial statement easily and through
standard techniques.
Note, however, that there are many areas in which judgment must be used to determine
the particular dollar amount of a business transaction. It is important that the methods
and estimates be fair. For example, the amounts of incurred but not reported (IBNR)
claims, deferred acquisition costs, and premiums due and unpaid must be accounted for
objectively and reasonably. The majority of an insurer’s financial obligations consist of
IBNR claims.
Relevance
In accounting terminology, relevance means that accounting information is useful,

timely, and likely to affect an interested user's decisions about a company. Relevant
accounting information explains how a company has performed during the past
accounting period, helps users project how the company is likely to perform in the future,
and appears on a timely basis so that users can act on the information.
The quality of relevance sometimes conflicts with reliability and objectivity. For example,
information that a health plan is planning to market a new product is relevant because it
could affect an investor’s decision to purchase the health plan’s stock. This information
is also relevant because it could affect the marketing strategies of the health plan’s
competitors. However, if the health plan has not yet developed the product, there is no
certainty that the health plan will actually market the product. Therefore, although the
information is relevant, is lacks reliability and objectivity. In this case, the health plan
would probably not report it as accounting information. For accounting purposes,
reliability and objectivity outweigh relevance because accuracy and verification are key
components of a company’s accounting records and financial statements.
Consistency
In accounting terminology, consistency means that a company's financial statements

use the same accounting policies and procedures from one accounting period to the
next, unless there is a sound reason for changing a policy or procedure. A company
violates the concept of consistency if it changes an accounting policy without disclosing
the financial effects of the change. Meaningful and comparable financial statements are
a direct result of accounting consistency. Consistency enables interested parties to
compare one company's financial performance over time if the company consistently
uses the same accounting policies and methods.
For example, both GAAP and SAP may offer more than one acceptable method for
calculating or valuing a particular account disclosed in the financial statements.
Therefore, a company's management should choose the methodology appropriate to the
nature of the company's operations, then apply that methodology consistently across
accounting periods. However, a company does not have to use the same methodology
for every account. For example, a health plan may use one valuation method for its
provider bonus account and another valuation method for its claims payable account, as
long as the health plan applies each valuation method consistently across accounting
periods and discloses the method of valuation used for each item.
Consistency
Sometimes, however, a company may change its accounting policies and procedures
entirely. For example, a health plan might legitimately make such a change because
• Changes in GAAP or SAP require it

• Regulatory bodies such as the Internal Revenue Service (IRS) require it
(Note that tax accounting often results in different valuations between items
on GAAP-prepared and SAP-prepared financial statements)
• Changes in the health plan's structure, goals, or procedures make the old
accounting policies ineffective
• Changes in the business environment make the old accounting policies
obsolete
• The health plan determines that using different accounting policies and
methods will more accurately and fairly present the information in its financial
statements
Consistency
Under GAAP, a company must fully disclose the impact of any change in accounting
policies in its financial statements for the affected accounting periods. Interested parties
can then consider the impact of these changes in their financial analysis of the company.
A company should explain in a note to the financial statements the following accounting
changes:
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• Any and all changes in accounting policies or principles (for example, a

change in the method used to value IBNR claims)
• Changes that affect the specific entity being reported (for example, a change
to the consolidated financial statements of a parent company rather than to
the individual financial statements for the parent company and each
subsidiary)
Figure 10A-3 is an excerpt from a hypothetical health plan's notes to the financial
statements regarding changes in accounting policies.
The effect of an accounting change can be documented on a
• Retroactive basis
for example, an adjustment to correct a material error in a previous accounting

period
• Cuttent basis
for example, an adjustment to the previous year’s net income to determine the
current year’s net income
• Prospective basis
• for example, spreading the effects on income over the current and future
accounting periods
Mathematical errors or incorrect account classifications do not qualify as accounting

changes. Therefore, a company treats an adjustment made on a retroactive basis to
disclose the effects of an accounting change separately from an adjustment made to
correct an accounting error. Because accounting changes affect a company's financial
statements, an independent auditor must note in its opinion whether the company has
consistently applied the same accounting policies and procedures over time. The auditor
must also comment on the validity of the accounting change.
Comparability
Comparability means that a company's financial statements enable an interested party
to identify similarities and differences in financial information across accounting periods
and among different companies. For this reason, GAAP requires that every annual
report must include five years of historical data and comparative financial statements -
three years for income statements and two years for balance sheets.
To encourage comparability, accounting principles also define and specify the basic
format of standard financial statements. Comparability and consistency are interrelated
because they both require a company to use the same accounting policies and
procedures from one accounting period to the next, unless there is a valid reason to
make a change. As with consistency, comparability requires a company to disclose the
nature and impact of any changes to its accounting policies or procedures. While the
concept of comparability enables users to compare and note trends in a company’s
financial performance from one accounting period to the next, the value of such
comparisons is virtually useless if the concept of consistency is not applied to the
financial statements.
Comparability
The effectiveness of comparability also depends on the use of uniform accounting

principles and concepts among different companies. Although publicly traded health
plans, publicly traded health insurance companies, and mutual health insurers may all
follow GAAP, within GAAP itself there are a number of acceptable methods of valuing
assets and liabilities, recognizing revenues and expenses, and calculating net income.
Unfortunately, diversity in the use of GAAP and SAP can reduce the effectiveness of
comparing financial statements between two different companies.
In the United States, state laws and regulations govern the implementation of SAP, with
which all insurers and specified health plans must comply. Although many states have
adopted the NAIC model laws, each state’s definition may vary with respect to the
calculation of a particular account value, for example, and these variations can affect
comparability.
Materiality
The accounting concept of materiality requires that companies disclose all significant
information in their financial statements. Significant or material information is information
that, if a company omitted it or presented it in a misleading manner, could substantially
affect an interested user's opinion of the company.
Materiality has two related aspects. First, materiality requires a company to include in its
financial statements all significant accounting information. This aspect relates to the
concept of full disclosure, which we discuss later in this lesson. Second, materiality
relieves a company from having to report all items as if each item carried the same
financial significance. For example, under materiality, a company does not have to treat
a pencil with the same significance as its automated accounting system. Both are
assets, but the automated accounting system has greater materiality than a pencil.
In practice, whether accounting information is material or not relies heavily on the

judgment of a company's accountants and management. Materiality also may vary from
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company to company. The purpose of an entity’s financial reports, the size of the entity,
and common sense, among other factors, significantly impact materiality. Further, what
is material to one user of financial information may not material to another user. For
example, a $100,000 financial obligation means something different to a health plan that
is starting up than it does to a multibillion dollar established health plan.
In another example, a large health plan may consider office supply purchases of less
than $5,000 to be immaterial. However, a much smaller health plan may establish a
lower minimum requirement, perhaps $100, for materiality purposes. The subject of the
information also helps to determine its materiality. For example, a health plan may
decide that a $2,000 difference in the way it calculates a particular expense is
immaterial, but a $2,000 difference in cash is material. Most companies establish a
percentage of net income below which a monetary amount is immaterial. A health plan
may decide, for example, that only dollar amounts that are greater than 4% of the health
plan’s net income are material to its income statement. The health plan would include
items that are below this threshold, but it would not separately list them on its financial
statements.
However, the combined effect of many individually immaterial items may produce an
aggregate result that is material to the company's financial information. For this reason,
the magnitude of a transaction or the dollar amount or percentage relationship to an
account classification is only one clue as to the transaction's materiality. The effects that
an item may have on a company's solvency and profitability can also determine its
materiality. Ultimately, though, the rule for applying the concept of materiality is as
follows: If the disclosure, the lack of disclosure, or the misrepresentation of an item of
information could lead interested users to change their opinions about the company's
financial strength or profitability, then the item is material in nature.
Conservatism
By its nature, accounting is conservative. This quality helps to offset the tendency of
many businesses (and many people) to overstate their successes and understate their
failures. In accounting terminology, conservatism is the choice of a financial reporting
method that results in the projection of lower values for a company's assets, higher
values for its liabilities and expenses, and a lower level of net income than would be the
case if a company used a more optimistic reporting method.
The intent of accounting conservatism is to protect customers, investors, the general

public, and the companies themselves from unforeseen occurrences and from problems
that can arise from an imprudently optimistic point of view. According to the principle of
conservatism, a company (1) records revenues only when they are certain; (2) records
expenses when they are expected, not necessarily certain; (3) reports losses
immediately; and (4) reports gains only after they actually occur.
Although both SAP and GAAP financial reporting are conservative in nature, the degree
of conservatism may differ in the fields of accounting. Ultimately, which type of financial
accounting is more conservative depends on the purpose and the actual financial
statement under consideration. Generally, conservatism is more fundamental to SAP
than to GAAP because SAP reporting is oriented towards consumer protection from
insurer or health plan insolvency.
Companies, however, must keep accounting conservatism in perspective, because
excessive conservatism can lead to inaccurate or misrepresented financial statements.
For example, an overly conservative stance in one accounting period can result in
skewed financial information in the next accounting period.
Because of the possibility of bias, conservatism must remain secondary to the qualitative
characteristics of reliability, consistency, and materiality. A company should apply
accounting conservatism to its financial statements only if such conservatism does not
violate more important financial reporting concepts. Figure 10A-4 summarizes the
qualitative characteristics of accounting information.
Review Question
The following transactions occurred at the Lane Health Plan:
• Transaction 1 — Lane recorded a $25,000 premium prior to receiving the

payment
• Transaction 2 — Lane purchased $500 in office expenses on account, but did
not record the expense until it received the bill a month later
• Transaction 3 — Fire destroyed one of Lane’s facilities; Lane waited until the
facility was rebuilt before assessing and recording the amount of loss
• Transaction 4 — Lane sold an investment on which it realized a $14,000 gain;
Lane recorded the gain only after the sale was completed.
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Of these transactions, the one that is consistent with the accounting principle of
conservatism is:
Transaction 1
Transaction 2
Transaction 3
Transaction 4
Incorrect. According to the principle of covservatism a health plan would report

gains only after they actually occured.
Incorrect. The principle of conservatism projects relatively low values for its
assets and net income, and relatively high values for its liabilities and expenses.
Incorrect. The principle of conservatism projects relatively low values for its
assets and net income, and relatively high values for its liabilities and expenses.
Correct. According to the principle of conservatism a health plan would report

gains only after they actually occured.
Chapter 10 B
Principles for Maintaining Accounts
• Discuss the main points in the cost concept, the measuring-unit concept, the
full-disclosure concept, and the time-period concept with respect to financial
reporting in health plans
• Discuss the realization principle and the matching principle with respect to
revenue and expense recognition under generally accepted accounting
principles
• Distinguish between accrual-basis accounting and cash-basis accounting
To ensure that a company maintains its accounts according to the qualitative

characteristics discussed in the previous lesson, the accounting profession has
developed specified concepts, principles, and guidelines that all companies should
follow. Among these ideas are the cost concept, the measuring-unit concept, the full-
disclosure concept, the time-period concept, the realization principle, the matching
principle, and the various accounting bases. We discuss each of these in the following
sections.
Cost Concept
An extension of the going-concern concept is the cost concept, also called the
historical-cost concept, initial-recording concept, or the acquisition-cost concept, which
states that companies should report items on their financial statements according to the
actual cost of those items at the time of purchase. For example, the value of an asset
that a company will report in its accounting records is the actual amount paid for an
asset—its historical cost—not the asset's current market value.
The current market value, also called fair market value or simply market value, is the
price at which an asset can be sold under current economic conditions. On the date of
purchase, an asset's historical cost is equal to the asset’s book value. An asset's book
value is the value at which the asset is "booked," recorded, or carried in the company's
accounting records, specifically its general ledger. Periodically and systematically, an
asset’s book value may be adjusted under specified circumstances.
An underlying assumption of the cost concept is that the original acquisition cost
represents the asset's market value at the time of purchase. The basis for this
assumption is the concept of reliability, because a company's acquisition cost of an
asset is more objective and reliable, for example, than is an appraisal of the asset's
current market value or a manager's opinion of the asset's value. Also, a company can
objectively verify the asset's historical cost through source documents such as sales
invoices or property deeds.
Conversely, while the historical cost of an asset offers objectivity and reliability, it may
lack relevance, particularly for assets held for a long period of time. When investors and
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other interested parties consider the value of a company's assets, they are usually less
interested in the value of those assets at the time of purchase than in their current
market value.
The only certain way to identify an asset's current market value is to sell the asset. All
other methods of determining current market value are only estimates, and estimates
can be misleading. Appraisals, management influence, and constant market fluctuations
make it difficult to assign current market values to many assets. Further, the cost and
time required to determine the current market value of many assets on a recurring basis
is impractical for most companies. Therefore, accounting authorities have decided that
the reliability provided under the cost concept generally outweighs the loss of relevance.
Review Question
The Wallaby Health Plan purchased an asset two years ago for $50,000. At the time of
purchase, the asset had an appraised value of $52,000. The asset carries a value on
Wallaby’s general ledger of $47,000, and its current market value is $80,000. According
to the cost concept, Wallaby would report on its financial statements a value for this
asset equal to:
$47,000
$50,000
$52,000
$80,000
Incorrect. $47,000 is the book value for this asset.

Correct. The cost concept states that companies should report an asset on their
financial statement according to the actual cost at purchase.
Incorrect. $52,000 is the appraised value at the time of purchase
Incorrect. $80,000 is the current market value of this asset.
Measuring-Unit Concept
The measuring-unit concept, also called the stable-monetary-unit concept, the unit-of-
measurement concept, or the stable-dollar concept, states that a company should record
the amounts associated with its business transactions in monetary terms, such as U.S.
dollars. There are two assumptions regarding the measuring-unit concept: (1) that the
appropriate unit of measure for business transactions is money and (2) that the
measuring unit's value is stable over time. Recall that a company includes in its financial
statements only those transactions that it can represent in monetary terms.
In the United States, companies report virtually all financial statement items in dollar
amounts. Some exceptions occur on financial statements. For example, the number of
outstanding shares of a company's common stock is not a dollar amount. Similarly,
verbal descriptions of a company's accounts as well as supplementary information and
notes to the financial statements provide valuable accounting information that is not
given solely in dollar amounts. Ultimately, though, the bulk of accounting information
consists of monetary values.
The measuring-unit concept has two major limitations. First, significant items or facts
that do not have a precise, measurable monetary value are not quantified or included in
a health plan’s financial statements. These items include, for example, a health plan's
effectiveness in providing customer service, the morale of its employees, its intellectual
capital, its goodwill (in effect, the value of the health plan’s brand name), and the
condition of the health plan's property, plant, and equipment. These factors, while
significant, are not easily measurable in monetary terms.
Second, unlike most measuring units, money is not stable over time. From one year to
the next, for example, the square footage of land in an acre does not change. However,
the value of a dollar changes over time. The amount of office supplies that a dollar will
buy this year may not be the same amount it will buy next year. Therefore, if the
purchasing power of a measuring unit changes significantly, then the measuring-unit
concept can limit our ability to analyze and compare a company's financial statements
over time.
Suppose a company purchases a piece of real estate for $50,000. Ten years later, it
sells the real estate for $100,000. The company then reports a $50,000 capital gain (the
excess of sale price over purchase price) on the sale of the real estate. However, if the
purchasing power of the dollar has declined by half during the 10-year period, the
company is no better off in terms of purchasing power than it was 10 years before. That
is, because $50,000 ten years ago could buy the same amount as $100,000 today, the
company has made no real "gain" in purchasing power because of the changing value of
the dollar, which is the measuring unit.
Despite these limitations, accounting authorities still consider the measuring-unit concept
to be a valuable tool. Like the cost concept, the measuring-unit concept provides
objectivity and reliability, even though its relevance may fluctuate as the value of the
measuring unit itself fluctuates. Accounting authorities prefer that companies avoid the
subjectivity involved in continually estimating the changing value of a measuring unit.
They do, however, recognize that when significant changes occur in a measuring unit's
value, users of a company’s financial information should become aware of the fact. For
example, during periods of high inflation (a general increase in the price level of goods
and services), the FASB has required U.S. companies to disclose in their annual reports
the potential impact that high inflation has on the dollar values listed in their financial
statements.
Review Question
The Montvale Health Plan purchased a piece of real estate 20 years ago for $40,000. It
recently sold the real estate for $80,000 and reported a capital gain of $40,000 on this
sale. Even though the purchasing power of the dollar declined by half during this period
and Montvale realized no actual gain in purchasing power, Montvale recorded in its
accounting records the $40,000 gain from this sale. This situation best illustrates the
accounting concept known as the:
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measuring-unit concept
time-period concept
full-disclosure concept
concept of periodicity
Correct. The measuring unit concept states that a company should record the
amounts associated with its business transactions in monetary terms.
Incorrect. The time-period concept states that a company's financial statements

should report business operations during a specified time period (usually one
month, one quarter, one year).
Incorrect. A full-disclosure concept states that financial statements must contain

all material information about a company, and the company must disclose any
additional information, that by its ommission, may mislead an interested user of
the account information.
Incorrect. The concept of periodicity oif the same as the time-period concept. The
time-period concept states that a company's financial statements should report
business operations during a specified time period (usually one month, one
quarter, one year).
Full-Disclosure Concept
The full-disclosure concept, also called the adequate-disclosure concept, states that
financial statements must contain all material information about a company and that the
company must disclose any additional information or fact that, by its omission, could
mislead an interested user of the accounting information. The full disclosure concept
implies the inclusion of every item that is material, relevant, reliable, and comparable, as
well as understandable, to provide to an interested user a fair presentation of a
company's financial statements.
The full-disclosure concept points to the critical role of notes, schedules, and
supplementary information that accompany financial statements. The full-disclosure
concept does not require the inclusion of excessive details, however. For example, an
independent financial analyst is no better informed about a company's financial strength
if the company clutters its balance sheet with detailed descriptions of every government
security that the company owns. In this case, summary information is more useful.
Typical disclosures are notes and supplementary information regarding the nature and
substance of contingent liabilities (to provide a cushion against various special risks),
other commitments, significant lawsuits, potential losses, and the accounting methods
and policies used in preparing the financial statements. Beyond these points, other
information requiring disclosure is open to professional judgment. Decisions rendered in
recent U.S. court cases have broadened the definition of the types of information that
must be disclosed, so company management has tended to disclose supplementary
information as a matter of course. The Securities and Exchange Commission (SEC), the
FASB, and other sources of accounting standards have also reinforced the importance
of fair, accurate, and complete financial statements.
Time-Period Concept
The time-period concept, also called the concept of periodicity, states that a company's
financial statements should report the company's business operations during a specified
time period. This time period, called an accounting period, is a specified length of time
during which a company's business transactions are recorded, summarized, and
reported.
Typical accounting periods are one month, one quarter, and one year. Any specific
accounting period is in itself arbitrary, given the assumed indefinite life associated with
the going-concern concept. However, the alternative to artificially imposed accounting
periods is to postpone a company's financial statements until the end of the company's
life, when all debts are paid and all investor claims are settled. Because many
individuals need financial information periodically during the life of the company, the
time-period concept has evolved.
The time-period concept assumes that a company can identify an accounting period,
reach a suitable cut-off date, and provide summary financial information as of that date.
All regulated companies must file certain financial statements at the end of each one-
year period. Most companies also produce financial statements or reports more
frequently. These statements, such as monthly budgets and quarterly statements, are
known as interim financial statements or interim reports to distinguish them from annual
accounting period statements and reports.
Nearly two-thirds of all companies use the calendar year—that is, from January through
December—as a standard accounting period. Most health plans select an accounting
period based on the calendar year because this is the accounting period required for tax
reporting and Annual Statement purposes. Other companies choose to operate on a
fiscal-year basis. A fiscal year is simply a 12-month accounting period chosen by a
company. A fiscal year may or may not coincide with the calendar year.
The drawback to the time-period concept is that a company does not complete all of its
transactions within one accounting period. A company continues doing business and
making transactions without regard to the artificial constraints of periodicity. This is an
extremely important issue for health plans because of the variable nature of the many
liabilities stemming from enrollees’ ongoing illnesses. First, many illnesses or accidents
occur in one accounting period but are not reported until subsequent accounting periods.
Second, the treatment of many illnesses and accidental injuries, as well as the length of
provider contracts, often extend beyond one accounting period.
Because not all transactions are easily identified with a single accounting period, a
company's management must ask the question, "When should we record each revenue
and each expense?" To help answer this question, accountants have developed two
principles, the realization principle and the matching principle, to match revenues and
expenses to each other and to the appropriate accounting period.
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Much of the rest of this lesson describes the principles behind the accounting process
that answers this question. We will begin by discussing some of the intricacies of two
terms that we will use throughout the rest of this lesson: costs and expenses.
A cost is the amount of a company's resources (assets) consumed or used for any
purpose. A cost may be classified either as an expense or an asset. If a cost represents
resources that are consumed during the current accounting period, then the cost is
considered an expense. An expense is a reduction in a company's assets that applies to
the current accounting period. As a very simple example, if a health plan buys office
supplies today and uses them all today, the cost of the supplies is an expense for the
health plan. Because expenses represent resources consumed during the current
period, they are sometimes referred to as expired costs. Employee salaries, office rent,
and utility charges are all expenses because they are costs paid in exchange for
resources consumed during the current accounting period.
If, however, a cost represents a resource that can provide benefits for future periods,
then that cost may be considered an asset. Suppose a health plan buys a computer
system that the health plan assumes will provide it with benefits for the next five years.
Because the cost of the computer system will provide benefits in future accounting
periods, this cost is accounted for as an asset of the health plan.
Fast Definition
An Annual Statement is a document that presents information about a U.S. insurer’s or
HMO’s operations and financial performance, with an emphasis on demonstrating the
insurer’s or HMO’s solvency.1
Recognition of Revenues and Expenses
We have seen that costs eventually become, or are recognized as, expenses. Both
expense recognition and revenue recognition are critical in determining the amount of a
company’s net income for an accounting period. In accounting terminology, recognition
refers to the process of classifying an item in a financial statement as one of the
following accounting elements: assets, liabilities, owners' equity (or net worth), revenues,
or expenses. These accounting elements are defined in Figure 10B-1.
Generally, a company recognizes revenue when a product is sold and delivered, when a
service is completed, or when cash changes hands as part of a business transaction.
For an item to be recognized, the item must be one of the accounting elements. In
addition, the item must be measurable, relevant, and reliable. Although revenue
recognition (the realization principle) and expense recognition (the matching principle)
are interrelated, we describe them separately.
The Realization Principle
Just as a health plan’s costs do not always become expenses in the same period the
costs were incurred (for example, IBNR claims), a health plan does not necessarily
receive all of its revenues in the same accounting period in which it earned them (for
example, premium revenues). As a result, the health plan follows certain guidelines to
match the revenue with its proper accounting period, that is, the period in which the
health plan has earned the revenue. Under GAAP, the realization principle, also known
as the revenue principle or revenue recognition principle, states that a company should
recognize revenue when it is earned. Generally, revenue is earned at the time a service
is rendered or when a good passes from the legal ownership of a company to the legal
ownership of the customer.
The realization principle requires a company to recognize revenues during the

accounting period in which they have been earned, regardless of when cash changes
hands. If the company does not receive immediate payment in cash, a legal and
reasonable expectation should exist that the client or customer will remit payment in full.
A clothing store earns revenue when it sells a sweater, an auto repair shop earns
revenue when it repairs a car.
The realization principle applies primarily to the receipt of a health plan’s premiums or
government program payments such as Medicare. A health plan earns revenue when it
provides promised healthcare coverage. However, health plans typically receive
premiums in advance of the period during which healthcare services are provided.
Suppose a health plan receives an employer’s premiums in advance of when the
premiums are earned (for example, at the beginning of the month of coverage). In this
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case, when the premiums are received for healthcare services provided to or for plan
members, the health plan would account for them as an asset, such as Cash, with an
offsetting liability, such as a claims liability account.
The Matching Principle
While the realization principle governs revenue recognition, the matching principle
governs expense recognition. The matching principle states that a company should
recognize expenses when the company earns the revenues related to those expenses,
regardless of when the company receives cash for the revenues earned.
A company also matches losses with revenues during the appropriate accounting period.
The realization principle and the matching principle work in tandem. First, a company
reports revenues according to the realization principle. Next, the company identifies,
quantifies, and matches the expenses required to earn those revenues. Then the
company records the expenses according to the matching principle. The match between
revenues and related expenses does not mean that the amounts for revenues and
expenses must be equal. However, this process ensures that a company’s net income
for an accounting period does not appear artificially or misleadingly high or low due to a
mismatch in the timing of expense and revenue recognition. Figure 10B-2 summarizes
the principles, concepts, and guidelines that all companies should follow for maintaining
accounts.
By following the guidelines set forth in the matching principle, a company can prepare its
statement of operations with an accurate net income or net loss amount for the
accounting period. Under GAAP, three approaches to expense recognition are generally
allowed: (1) associating cause and effect, (2) systematic and rational allocation, and (3)
immediate recognition.
Associating Cause and Effect
Some costs have a direct association with specific revenues. This direct relationship is
known in accounting as associating cause and effect. Using the approach of
associating cause and effect, costs that can be recognized as having a direct
relationship to certain future earnings or specific elements of revenue are charged to
earnings of future accounting periods instead of being charged to the current accounting
period.
The process of deferring the recognition of expenses until future accounting periods is
known as capitalization. For example, a health plan that uses agents for small group
business or individual healthcare coverage would spread agent commissions over the
premium-paying period of healthcare coverage. Industry experience, and, in some
cases, regulations, determine what items can be capitalized, rather than expensed in the
current accounting period.
Review Question
The Proform Health Plan uses agents to market its small group business. Proform
capitalizes the commission expense relating to this line of business by spreading the
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commissions over the premium-paying period of the healthcare coverage. This approach
to expense recognition is known as:
systematic and rational allocation

matching principle
immediate recognition
associating cause and effect
Incorrect. Systematic and rational allocation expenses an assets cost over its
estmated useful life
Incorrect. This principle states a company should recognize expenses when the
company earns the revenues realted to those expenses.
Incorrect. Immediate recognition is when a company recognizes all applicable
costs and expenses during the current accounting period.
Correct. Under this method, costs that can be recognized as having a direct
relationship to future earnings are charged to the earnings of future accounting
periods.
Recognition of Revenues and Expenses

Systematic and Rational Allocation
Sometimes a direct association of cause and effect between expenses and revenues is
not clearly recognizable or measurable. In such cases, a company uses another method
to match revenues and expenses known as systematic and rational allocation.
Systematic and rational allocation is an approach to expense recognition that
expenses an asset's cost over its estimated useful life, regardless of when the company
realizes revenues from using the asset.
One example of such systematic allocation is asset depreciation. Depreciation is the

process of spreading (allocating) the cost of an asset over the asset's estimated useful
life. As with the method of associating cause and effect, a company capitalizes costs
under systematic and rational allocation. Assume that a health plan spends $1,000,000
one year to buy and install a new computer system. The health plan’s management
cannot know for certain how long the system will provide financial benefits or what its
financial benefits will be. Without a recognizable and measurable association between
cause and effect, the health plan’s management uses the expense recognition approach
to capitalize the cost in the present accounting period, recognize the cost as an asset,
and begin systematic and rational allocation.
Suppose the health plan estimates that the useful life of the computer system is eight
years, anticipates no salvage value (dollar value at the end of the computer system’s
life) for the system, and uses the straight-line method of depreciation (which applies an
equal dollar amount of depreciation for each year of the computer system’s life). In this
case, the health plan records $125,000 ($1,000,000 ÷ 8) as a full year's expense during
each year of the system's estimated life. After eight years, the health plan will have
expensed (allocated) the entire $1,000,000 cost of the computer system.
Immediate Recognition
Sometimes a company cannot match its incurred expenses with earned revenues within
an accounting period, nor can it match the expenses with revenues that it expects to
generate in the future. Under GAAP, sometimes expenses cannot be matched with
revenues, and incurred costs provide no objectively recognizable future benefits. Neither
associating cause and effect nor systematic and rational allocation is an applicable
approach for expense recognition. In such cases, the company uses the immediate
recognition approach.
Under immediate recognition, a company recognizes all applicable costs as expenses

during the current accounting period. Immediate expense recognition is common under
SAP. The fees that a company pays to lawyers and consultants are typically reported as
expenses under the immediate recognition approach under both GAAP and SAP. Some
expenses, such as utility bills, cannot be attributed to one particular type of revenue
earned. In such cases, a health plan reports these expenses in the accounting period in
which they occur, whether or not the health plan can match these costs directly with
revenues earned.
Immediate Recognition
A company can change its approach for recognizing expenses if the nature of a cost
changes over time. For example, suppose a health plan capitalizes the cost of computer
equipment. The company recognizes the cost associated with the equipment over
several accounting periods. But before the end of its estimated useful life (and before its
total cost has been recognized and expensed), the equipment becomes obsolete and is
discarded. At this point, the health plan can use the immediate recognition approach to
recognize the remainder of the cost as an expense and write this amount off as a lump
sum in the current accounting period. Figure 10B-3 summarizes these approaches to
expense recognition.
Accounting Bases
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The realization principle and the matching principle are both central concepts for a
manner of accounting called accrual-basis accounting. Another base of accounting that
health insurers and some health plans use in certain circumstances is cash-basis
accounting. In the remainder of this lesson, we discuss accrual-basis accounting and
cash-basis accounting.
Accrual-Basis Accounting
In accrual-basis accounting, a company records revenues when they are earned and
expenses when they are incurred, even if cash has not actually changed hands. Accrual-
basis accounting records revenue according to the realization principle and expenses
according to the matching principle. The purpose of the accrual basis of accounting is to
record a transaction when the company incurs a financial obligation either as the payor
or payee. Thus, accrual-basis accounting enables an interested party to view the
consequences of obligations incurred by a company whether or not the company
ultimately completes a business transaction.
For this reason, the accrual basis is suitable for measuring a company's profitability,
which is a primary focus of GAAP. For this reason, accrual-basis accounting is a central
concept in financial accounting conservatism. The FASB mandates the use of accrual-
basis accounting in financial statements. Both GAAP and SAP require companies to
record their financial transactions on an accrual basis.
Accrual-Basis Accounting
Accrual-basis accounting provides information on the consequences of transactions,

including a company's earnings potential and financial performance. Companies that use
accrual-basis accounting must make adjusting entries to their accounting records at the
end of each accounting year to match revenues and expenses in their financial
statements for that accounting period. Typical adjusting entries include
• IBNR claims
• Unearned premiums
• Unpaid employee wages and salaries
Fast Definition
Adjusting entries account for transactions that apply to more than one accounting
period.
Cash-Basis Accounting
Cash-basis accounting is a system in which a company recognizes revenues or

expenses only when it receives or disburses cash. Thus, neither the realization principle
nor the matching principle applies under cash-basis accounting. Instead, cash receipts
and cash disbursements are two of the most important components of cash-basis
accounting. A cash receipt is a check, money order, electronic funds transfer (EFT), or
other cash transaction that is remitted to a company as some form of payment. A
company records a cash receipt in the same accounting period in which it receives the
cash. A cash disbursement is the payment of cash by a company to a recipient.
Cash-Basis Accounting
Under cash-basis accounting, a company records a cash disbursement in the same

accounting period in which it remits payment. In a pure cash-basis system, a company
makes no entries to record unpaid bills or pending income. Also, the company calculates
net income by subtracting paid expenses from revenues received. In addition, health
insurance companies and health plans that fall under the jurisdictions of state insurance
commissioners must report some items on a cash basis for statutory reporting purposes.
Accrual-basis accounting helps to match expenses with revenues, a process that

typically enables companies to develop more relevant, reliable, and comparable financial
statements. Because cash-basis accounting does not apply the realization principle or
the matching principle, misleading financial statements can result. For this reason, few
companies use a pure cash-basis accounting system. Further, under GAAP, financial
statements must report the results of noncash transactions, such as depreciation, as
well as cash transactions that occur during an accounting period.
Most cash-basis accounting is actually a combination of cash-basis and accrual-basis

accounting, known as modified cash-basis accounting. For example, because certain
premium revenue may not be legally collectible (such as certain premiums for individual
healthcare coverage), it can only be recorded on a health plan’s books when it is
received. On the other hand, a health plan’s investment income is legally collectible and
earned as of the due date. A health plan therefore typically recognizes investment
income when it comes due rather than waiting until the income is received.
Many medical groups use modified cash-basis accounting. Many hospitals use accrual-
basis accounting, except for large capital expenditures. Also, the nature of health plans
may lend itself to modified cash-basis accounting if its use would not result in misleading
results concerning IBNR claims, for example. These and other factors are considered
before a health plan determines whether to use a particular base of accounting.
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Chapter 10 C
Financial Statements
• Describe the components and purposes of a health plan’s balance sheet, income
statement, cash flow statement, and statement of owners’ equity
• Explain the importance of notes and supplementary information
• Provide an example of the relationships among the various financial statements
A health plan’s financial statements are analyzed by both internal and external parties.
Internally, for example, managers use a company's financial statements to identify
general business trends so that they can develop appropriate strategies for improving
performance in problem areas. Similarly, by studying a company's financial statements,
external parties such as investors, rating agencies, and regulators learn about the
company’s financial activities. They gain insight into its financial soundness and its
profitability. As a result, they are better able to make informed decisions about the
company's financial prospects.
In this lesson, we introduce you to the primary financial statements and reports used to
communicate accounting information to external users. General-purpose financial
statements prepared according to GAAP comprise a health plan's annual report. Health
plans that are regulated by state insurance departments also prepare an Annual
Statement, which must conform to SAP. This lesson focuses on GAAP and the annual
report.
An annual report is the yearly report that a company's management sends to its
stockholders, policyholders, and other interested parties to describe the company's
performance during the previous year. By law, for-profit, publicly owned health plans
must provide an annual report to stockholders.
Generally, the financial statements included in the annual report must be prepared
according to GAAP. Typically, if a mutual insurance company provides an annual report
to its stockholders, the company prepares its financial statements according to SAP.
Not-for-profit health plans are not required by law to provide interested parties with an
annual report. However, some not-for-profit health plans may send an annual report to
their policyholders and to other interested parties as part of communicating their service
strength, for example.
Most companies regard the annual report as an important document, not only from an
accounting point of view, but also from a promotional point of view. An annual report is
an opportunity for a company to promote itself to its current owners and to potential
investors and customers. Generally, companies print their annual reports on high-quality
paper and include numerous illustrations and graphs.
A company's typical annual report consists of

• A letter from the president to stockholders or policyowners
• A description of financial highlights
• Financial statements (balance sheet, income statement, cash flow statement,
and statement of owners' equity)
• Notes to the financial statements and supplementary information
• An independent auditor's report
The heart of the annual report consists of the four financial statements and
accompanying notes and supplementary information. These financial statements contain
the information that accounting specialists believe is essential for an external user to
gain a general understanding of the financial condition, activities, and prospects of the
company providing the report. This lesson focuses on these four financial statements
and their accompanying notes and supplementary information.
The preparation of financial statements is the end product of financial accounting. The
dollar amounts in a health plan's financial statements represent thousands, millions, and
even billions of dollars. Companies usually round these amounts off to the nearest
thousand or million. The heading of every financial statement generally includes three
pieces of information: (1) the name of the company to which the financial statement
applies, (2) the name of the statement, and (3) the date of the statement or the
accounting period covered by the statement. The date that appears on a company's
financial statements is generally the last day of the company's fiscal year or other
applicable accounting period.
Fast Definition
A mutual insurance company is an insurance company owned by its policyowners.1
A company that owns more than 50% of the stock of a subsidiary company will usually
compile its financial statements for the annual report on a consolidated basis.
Consolidated financial statements are financial statements that include the assets,
liabilities, owners' equity, revenues, and expenses of the subsidiary company with those
of the parent company. Because the parent company controls the subsidiary company,
the parent and its subsidiary are considered a single operation, despite being separate
legal entities.
Parent companies usually provide separate financial information for each subsidiary or
line of business in the annual report. Maintaining separate financial information is
particularly useful in management decision making. Separate financial information on
subsidiaries and lines of business is also useful for external parties in situations in which
a parent company is considering the sale of a particular subsidiary.
Balance Sheet
The balance sheet is a snapshot of a company's financial position as of a specified date

and summarizes what a company owns (assets), owes (liabilities), and its owners’
investments in the company (owners’ equity or net worth). We defined assets, liabilities,
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and owners’ equity in Principles for Maintaining Accounts. The amounts listed on the
balance sheet represent the company’s summarized account balances on the date
shown at the top of the balance sheet. In this context, a balance sheet is a static
measure of a company’s financial position.
The essential components of the balance sheet are the three account classifications:
Assets, Liabilities, and Owners' Equity (sometimes called Net Worth). Every business
compiles a balance sheet. The main purpose of the balance sheet is to measure the
owners' wealth—typically this means what remains after subtracting what a company
owes from what it owns on a specified date. Figure 10C-1 illustrates the basic
components of the balance sheet for a typical health plan. Figure 10C-2 presents an
example of GAAP-prepared consolidated balance sheets for a for-profit stock company.
Balance Sheet
Not every company or even every health plan has exactly the same account titles as on
the balance sheet depicted here. For example, within the three balance sheet account
categories, some balance sheet accounts are unique to health plans, such as the liability
account Medical Claims Payable. A detailed discussion of each item that appears on a
health plan’s balance sheet is beyond the scope of this course.
A balance sheet is fundamental to accounting

because it demonstrates a company's fulfillment of the
basic accounting equation:
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Not-for-profit health plans typically used the term net worth in place of owners’ equity.
Consider the basic accounting equation as follows:
• The left side of the equation (Assets) represents what a health plan, as a
separate legal entity, owns.
• The right side of the equation (Liabilities and Owners' Equity) represents what
the health plan owes to its creditors and stockholders or policyowners.
Similarly, on the account form of the simplified balance sheet, the left side reports on the
health plan's assets, and the right side reports on the health plan's liabilities and owners'
equity. The total of the left side of the balance sheet must equal the right side—they
must balance—just as in the basic accounting equation.
Remember that the annual report presents GAAP-prepared financial statements that
focus on the company as a going concern. Thus, a balance sheet answers the following
general question: As of a certain date, what and how much does a company own, what
and how much does it owe, and what remains for the company's owners? For a health
plan, a large portion of what it owns (assets) consists of various investments, such as
bonds and other debt securities, stocks and other equity securities, provider networks,
premiums receivable, and goodwill.
Most of health plan’s obligations (liabilities) are medical claims payable and ongoing
healthcare benefits to plan members and individual policyowners. When you review a list
of a health plan’s assets, you see, in summary form, what the health plan's managers
purchased with the funds provided by the health plan's creditors, policyowners, and
stockholders.
Under GAAP, a company uses a variety of methods to value its assets depending on the
type of asset and its purpose. For example, a company generally lists its holdings of
common stock at their current market value as of the balance sheet date. Besides
current market value, other balance sheet accounts may be valued according to
historical cost, amortized cost (book value), or the lower of cost or market. The lower-of-
cost-or-market rule values certain assets at historical cost or current market value,
whichever is lower.
The rules for valuing each balance sheet account classification may differ between
GAAP and SAP. You should be aware that the GAAP-prepared balance sheet that a
health plan presents in its annual report differs from the SAP-prepared balance sheet it
presents in the Annual Statement. For example, SAP might result in lower values for
admitted assets than would be presented on a GAAP-prepared balance sheet. Admitted
assets are those assets that state insurance law permits to be included on the Assets
page of the Annual Statement. 2
A balance sheet contains much valuable information about a company's financial

position. However, it does not reveal how or why the company obtained particular assets
or liabilities. By comparing several years of the company's balance sheets, it is possible
to form some conclusions about the dollar amounts associated with each account
classification. It is also possible to discern certain company performance trends, such as
whether the company is increasing its assets or its liabilities over time.
However, to fully understand the balance sheet in the annual report, you must study the
accompanying notes and supplementary information that apply specifically to the
balance sheet. These notes, which may appear on the same page as the balance sheet
or in a separate section of the annual report, are an integral part of the balance sheet.
We discuss these notes later in the lesson.
Income Statement
An income statement shows how much money a company has realized from its
operations during an accounting period, and, ultimately, to what extent the company's
general operations during that period resulted in an increase or decrease in its assets. A
company's income statement answers the question: Do revenues exceed expenses? If
so, the company earns net income. Net income is the excess of an entity’s total
revenues over its total expenses. A net loss results when an entity’s total expenses
exceed its total revenues. We defined revenues and expenses in Principles for
Maintaining Accounts. Thus, the basic formula for the income statement is
Earlier we compared the balance sheet to a snapshot of a company's financial position

as of a specific date. A balance sheet is in essence a static measure of a company’s
financial position on a particular date. In contrast, the income statement is a moving
picture of a company's financial performance over a specific accounting period. In this
context, an income statement can be described as a dynamic measure of a company’s
operations over time.
Figure 10C-3 shows the general form of a health plan's income statement. Figure 10C-4
depicts the consolidated income statements for Sheridan Health Networks, Inc. As you
can see in Figure 10C-4, Sheridan first lists its sources of revenues. Next, Sheridan
subtracts its expenses from its revenues to obtain its earnings before income taxes.
Then, Sheridan subtracts income taxes to obtain its net income or net loss for the
accounting period.
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While the balance sheet measures a company's financial condition, the income
statement measures profitability, which is one key to survival for all health plans. Profit is
the extra income above that needed to pay for all costs associated with providing
benefits, and this profit contributes to the health plan's retained earnings, an owners'
equity account. We discuss retained earnings later in this lesson.
A company must disclose in its GAAP-based income statement any gains or losses that
result from transactions involving (1) the disposition of a business segment called
discontinued operations or (2) any extraordinary items that are not likely to occur in the
future. In addition, the company must disclose the impact of any changes in accounting
policies on income statement accounts. Figure 10C-5 defines gains, losses, and
extraordinary items.
Because they occur independent of a company's normal business operations, gains and
losses appear separately on a company’s income statement to avoid distorting the
company’s income from continuing operations. Suppose a health plan suffered a
$1,000,000 extraordinary loss as a result of a fire at its home office. The health plan
would separate this $1,000,000 extraordinary loss from its income from continuing
operations.
Proceeds that a health plan receives from the sale of its home office furniture represent
a gain or a loss, not revenue, because the health plan's primary business involves
providing healthcare benefits, not selling furniture. A retail furniture store, however,
includes the proceeds from the sale of furniture from its inventory in a revenue account
because selling furniture is part of its primary business operations. Thus, the account
classification of a company's gains and losses depends on the company's core business
functions.
Income Statement
Earlier we stated the basic formula for the income statement as
We can now expand this basic formula to include gains and losses:
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Net income ultimately determines, among other things, whether owners' equity will
increase and whether a publicly traded health plan will be able to pay cash dividends to
stockholders. Net income increases owners' equity while a net loss decreases owners'
equity. Generally, this bottom line figure—so called because net income is usually found
on the last line of the income statement—indicates whether a company is profitable and
is likely to remain in business, at least for another year.
Cash Flow Statement
The third major financial statement presented in a company’s annual report is the cash
flow statement. The cash flow statement, also called the statement of cash flows,
provides information about a company's cash receipts (inflows) and cash disbursements
(outflows) during a given accounting period.
The cash flow statement reconciles the cash the company has on hand at the beginning
and at the end of the accounting period. In providing information about a company's
cash flows, this statement also provides insight into a company's operating, investing,
and financing activities. It answers the following questions:
• How did the company raise cash during the accounting period?
• How did the company spend cash during the accounting period?
• Did the company have to sell assets or borrow funds to generate cash?
• What are the company's likely prospects for generating cash in the future?
• What is the relationship between the company's cash flows and its net
income?
• Is new product development being financed with debt (borrowing money) or
equity (offering company stock for sale)?
Figure 10C-6 depicts the typical components of a company’s cash flow statement.
Figure 10C-7 illustrates Sheridan’s consolidated, GAAP-based cash flow statements.
Like the income statement, the cash flow statement is a dynamic measure that shows a
change over time. In essence, the cash flow statement is a rearrangement of the
changes that occurred between the current and previous balance sheet, which as we
noted earlier, is a static measure of a company's financial position. The importance of a
positive cash flow cannot be overemphasized. A company may have billions of dollars
worth of assets, but if it does not have enough cash on hand to cover current expenses,
then it may be insolvent—that is, unable to pay bills and obligations as they come due.
Many health plans are cash rich because premiums are received in advance of the
provision of healthcare services. If a health plan does not accurately estimate its IBNR
claims, the health plan may be unable to pay those claims as they come due. On the
other hand, having too much available cash may result in idle cash that is not being put
to more productive use. As you might expect, managing cash effectively is one of a
company’s most important tasks.
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A company prepares the cash flow statement from information obtained in its balance
sheet and its income statement. The cash flow statement is similar to a check register in
that both show the amount and the source of any increases or decreases in receipts
(cash inflows) and disbursements (cash outflows). In accounting terminology, a cash
inflow is a source of funds. The cash received by a health plan when it sells an asset
becomes a source of funds. A cash outflow is a use of funds. A cash payment to
purchase a bond is a use of funds. With respect to balance sheet and income statement
accounts, a company's cash inflows—its sources of cash—increase as a result of:
• Selling an asset for cash (a decrease in an asset account other than Cash)
• Establishing a reserve for IBNR claims (an increase in a liability account)
• Issuing common stock (an increase in a stockholders' equity account)
• Receiving premiums (an increase in a revenue account)
Cash outflows have the opposite effect on an insurer's balance sheet and income
statement accounts. A company's cash outflows—its uses of funds—increase as a result
of:
• Purchasing an asset (an increase in an asset account other than Cash)

• Paying claims (a decrease in a liability account)
• Repurchasing a company’s own common stock (a decrease in a stockholders'
equity account)
• Paying expenses (a decrease in an expense account)
You can calculate a company's net cash flow for an accounting period by using the
following formula:
The net cash inflow or outflow represents the net increase or decrease in cash for the
accounting period. Net increase or decrease is also known as the net change in cash.
Theoretically, the net change in cash equals the difference between the cash balance
(as shown on the balance sheet) at the beginning of the period and the cash balance at
the end of the period.
For example, a cash flow statement dated for the year ended December 31, 2000,
accounts for the difference in the cash balance between the company's December 31,
1999, balance sheet and its December 31, 2000, balance sheet. Changes in a
company's cash flow occur as a result of three activities:
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Operating activities are transactions associated with a company’s major lines of

business; these transactions directly determine a company’s net income. A health
plan’s operating activities are generally associated with the sale and maintenance of
healthcare services. These activities include (1)selling healthcare benefit contracts
and providing administrative services, (2)administering and adjudicating claims
payments, (3)paying expenses associated with healthcare services, (4)developing
and maintaining provider networks, and, to a lesser extent, (5)receiving investment
income (such as bond interest and dividend income on stocks).
Investing activities are transactions that involve the purchase or sale of assets and
the lending of funds to another entity. A health plan’s investing activities include (1)
purchasing and selling bonds, stocks, real estate, equipment, and other assets, and
(2) investing and disposing of subsidiaries.
Financing activities are transactions involving borrowed funds and cash payments
to or from owners of a stock company. Financing activities include transactions
associated with (1) issuing, repurchasing,or retiring common stock and (2) borrowing
and repaying funds loaned by creditors. Financing activities for not-for-profit health
plans include transactions that involve additional paid-in capital or contributed
capital.
Review Question
Changes in a company’s cash flow occur as the result of three activities: operating
activities, investing activities, and financing activities. Activities that would be considered
financing activities include:
issuing common stock

purchasing bonds
receiving investment income
paying expenses associated with healthcare services
Correct. Issuing common stock is a financing activity

Incorrect. This is an example of investing activities
Incorrect. This is an example of operating activities
Incorrect. This is an example of operating activities
Cash Flow Statement
If for any of the three activities the cash inflows exceed the cash outflows, the result is a
net cash inflow from or provided by that activity. If the reverse is true, then the result is a
net cash outflow used in or used by that activity. For example, under operating activities,
if the company receives $10,000 in revenue and pays $8,000 in expenses, the cash flow
statement shows a $2,000 net cash inflow provided by operating activities. Further,
under investing activities, if the company sells $150,000 worth of bonds and purchases
$160,000 of another corporation’s common stock, the cash flow statement would show a
$10,000 net cash outflow generated by investing activities.
The distinction among the cash flows from operating, investing, and financing activities is
important when a company prepares its cash flow statement. Companies use one of two
methods—the direct method or the indirect method—to prepare this statement. The only
difference between the two methods is in the computation of cash flows from operating
activities.
When using the direct method to prepare the cash flow statement, a company
determines net cash flow from operating activities by taking its major types of operating
cash receipts and then subtracting each major type of cash disbursement. The
difference between cash receipts and cash disbursements is the net cash for the period.
Although this method seems straightforward, it can be quite expensive and time
consuming to track every cash transaction.
Therefore, many companies uses the indirect method, which begins with the net
income figure as reported on the income statement, then reconciles this amount to
operating cash flows through a series of adjustments (additions and subtractions). Cash
flows from investing and financing activities are calculated the same under either
method. The cash flow statement depicted in Figure 10C-7 was prepared using the
indirect method.
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Statement of Owners' Equity
The final financial statement we discuss is the statement of owners' equity, which
shows the changes that occurred in the Owners’ Equity portion of the balance sheet.
Stock companies typically call this statement the statement of shareholders’ equity or the
statement of stockholders’ equity. Not-for-profit health plans often refer to this statement
as the net worth statement. Mutual insurers may voluntarily include in their GAAP-based
annual report a similar statement called the statement of policyholders’ equity or
statement of policyowners' equity.
A stock company uses the statement of owners' equity to reconcile, or explain, any
changes in equity accounts that occur from one balance sheet to the next. This
reconciliation is similar to the reconciliation of changes in cash on the cash flow
statement.
Events that cause owners' equity accounts to change include the (1) issuance of stock,
(2) purchase of treasury stock, (3) retention of net income, and (4) payment of cash
dividends on stock. Figure 10C-8 lists and describes the typical components of a stock
health plan’s statement of owners’ equity. Figure 10C-9 provides a simplified example of
Sheridan Health Networks’ consolidated statements of stockholders' equity.
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Review Question
The following information was presented on one of the financial statements prepared by
the Rouge Health Plan as of December 31, 1998:
Assets
Current assets $ 950,000
Other assets 100,000
Total Assets $ 1,050,000
Liabilities
Current liabilities $ 800,000
Other liabilities 100,000
Total Liabilities $ 900,000
Stockholders’ Equity
Common stock $ 50,000
Additional paid-in capital 100,000
Total Liabilities and Stockholders’ Equity $ 1,050,000
This type of financial statement is called:
a balance sheet
an income statement
a statement of owners’ equity
a cash flow statement
A : Incorrect
B : Incorrect
C: Correct
D: Incorrect
Notes and Supplementary Information
Although not considered separate financial statements, notes and supplementary

disclosures to financial statements are an integral part of a company's annual report.
Therefore, analysts do not review a company's annual report without reading the notes
and supplementary information.
Notes to the financial statements, which are factual in nature and disclose the details
behind some of the amounts presented in the financial statements, usually accompany
or immediately follow the financial statements in a company's annual report. These notes
enable users to understand some of the more complex items in the published financial
statements. Notes also appear on the financial statement pages themselves, either in
footnote form or as parenthetical comments beside a particular line on the financial
statement.
Supplementary information usually follows the notes in an annual report. An explanatory

note for a company's fixed assets, such as company-occupied real estate, is one
example of the additional information that you may obtain from notes to the financial
statements. The balance sheet generally lists one total for Property, Plant, and
Equipment. An accompanying note or supplemental information will disclose the
depreciation method and itemize each component of this particular asset. The notes to
the financial statements often take up a significant amount of space in a company's
annual report.
Financial Statement Integration
A company's financial statements are integrative—that is, they relate to, explain, and
complement each other. The income statement and the cash flow statement are
dynamic measures and provide the critical links between the changes in two consecutive
balance sheets, which are static measures. Recall that net income in the cash flow
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statement minus cash dividends paid to stockholders equals the change in retained
earnings on the balance sheet between two accounting periods.
Another relationship between the balance sheet and the income statement is that an
increase in various expenses (income statement accounts) decreases cash or increases
short-term or long-term liabilities (balance sheet accounts), depending on the nature of
the expense. Note also that ..
• The $56,851 of net income on Sheridan Health Network’s income

statement appears in the statement of owners’ equity and helps explain
the change in owners’ equity
• The net income figure of $56,851 is also a cash flow provided by operating
activities on the cash flow statement
• The owners’ equity section of the balance sheet is a summary of the
figures obtained from the statement of owner’s equity, which includes the amount
of net income
A net loss in the income statement results in a decrease in retained earnings in the
statement of owners' equity. A net loss is also a cash outflow generated by operating
activities on the cash flow statement. Net income is thus the balancing figure between
retained earnings on the statement of owners' equity and retained earnings on the
balance sheet.
The indirect method of preparing the cash flow statement demonstrates the
interrelationship between the income statement, the balance sheet, and the cash flow
statement. Recall that, under the indirect method, the cash flow statement begins with
net income, which is taken directly from the income statement. This figure is then
adjusted up or down according to changes on the balance sheet, such as increases or
decreases to claims liabilities, and expenses due and accrued.
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Chapter 11 A
The Strategic Plan
• Define strategic planning, mission statement, and vision statement

• Explain the steps in a health plan’s typical strategic planning framework
• Describe the purpose of a SWOT analysis and list some attributes that health
plans evaluate to determine their strengths, weaknesses, opportunities, and
threats
Like the practice of medicine, strategic planning is both an art and a science. Key
personnel must buy into a health plan’s strategic planning process and commit to the
health plan’s strategic plan. The strategic plan itself must be reality-based and operate
according to sound finance and accounting principles. The execution of the plan by
personnel is the art, and the operation of sound accounting principles is the science.
Besides developing an overall strategic plan, a health plan must develop a strategic
financial plan to support the financial aspects of the health plan’s strategic plan. We
discuss the development of a health plan’s strategic financial plan in the next lesson.
Strategic planning is the process of identifying an organization’s long-term objectives

and the broad, overall courses of action that the organization will take to achieve those
objectives. In the context of health plans, strategic planning is the development of a
1
roadmap of how a health plan will achieve success. Before developing this roadmap,
however, it is essential that a health plan first define its purpose and where it would like
to go.
The Strategic Planning Process
While there are many frameworks that define the strategic planning process, in this
lesson we discuss a simplified strategic planning process, as illustrated in Figure 11A-1.
The first step in the strategic planning process is to define an organization’s mission and
vision statements. Then the organization conducts both an internal analysis and an
external analysis of its current position. Next, the organization develops its strategic
plan, followed by its strategic financial plan. Implementation and ongoing monitoring of
the organization’s strategic plan follows.
Define Mission and Vision Statements
A health plan defines its purpose and direction by
defining its mission and vision. A mission
statement is a statement that succinctly sums up an
organization’s reason for existence and overall
purpose. It is essentially the reason for the
2
organization’s existence. One example of a health

plan’s mission statement is
A vision statement, also called a vision, is a
statement of an ideal that an organization would like
to achieve; it is intended to inspire enthusiasm and
commitment in the organization’s employees. The 3
vision statement defines whether or not the

organization is successful in fulfilling its mission. An
example of one health plan’s vision statement is
Review Question
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As the first part of its strategic planning process, the Lakeland Health Plan developed
the following statements:
• Statement 1 — We will be recognized as the leader in the healthcare industry in

all of our markets by the end of the next decade.
• Statement 2 — We will deliver and finance quality healthcare at a reasonable
cost to our customers.
From the answer choices below, select the response that correctly identifies these
statements as vision statements or mission statements.
Statement 1: vision
Statement 2: vision
Statement 1: vision
Statement 2: mission
Statement 2: vision
Incorrect. While Statement one is correctly identified as a vision statement,

Statement two is not a statement of an ideal that an organization would like to
achieve
Correct. Statement one is a statement of an ideal that an organization would like

to achieve, and statement two is a statement that succiently sums an
organization's reason for existence and overall purpose.
Incorrect. While statement two is correctly identified as a mission statement,

statement one is not a statement that succiently sums an organization's reason
for existence and overall purpose
Incorrect. Statement one is not a statement of an ideal that an organization would

like to achieve, and statement two is not a statement that succiently sums an
organization's reason for existence and overall purpose.
Conduct an Environmental Analysis
Figure 11A-1 shows that once a health plan has determined where it wants to go by
defining its mission and vision statements, the health plan must then perform an
assessment of the current internal and external environment it which it operates. One
way of performing this assessment is by using a SWOT analysis. A SWOT (Strengths,
Weaknesses, Opportunities, and Threats) analysis is a means of organizing
information so that an organization can assess the current playing field and determine
possible changes in the environment and options for internal adjustments in response to
those changes. 4
An assessment of a health plan’s strengths and weaknesses looks at the health plan’s
internal capabilities relative to the strengths and weaknesses of its competitors.
Similarly, an assessment of a health plan’s opportunities and threats is a view of external
market attractiveness from the health plan’s perspective.
Ideally, a health plan would be the strongest competitor in an attractive market, and the
health plan’s strategic plan would focus on exploiting the health plan’s strengths to
sustain its competitive advantage. If the health plan were a strong competitor in an
unattractive market, then the health plan may use its resources to strengthen the market
through advertising. Alternatively, the health plan may choose to build market strength
within a more attractive market.
However, after performing a SWOT analysis, a health plan may find that it is a weak
player in an unattractive market. In this case, the health plan would probably develop a
quick exit strategy. If the market is attractive, but the health plan is a weak player in that
market, the health plan will either focus its strategy on improving its market position or
exiting that market to use its resources to become stronger in other attractive markets.
Because local market share is critical to a health plan, a national health plan needs to
develop strategic plans that are appropriate to the local markets in which they compete
and in their national operations. Besides market share, a health plan may perform a
SWOT analysis to analyze its relationships with the major providers in each market in
which it conducts business.
Strengths and Weaknesses
In the process of developing a strategic plan, the health plan first prepares an objective
assessment of its internal strengths and weaknesses relative to its competitors. Over
time, these strengths and weaknesses will change. For example, if a previous SWOT
analysis had identified as a weakness the benefit design of the health plan’s key
product, and the current SWOT analysis may conclude that the new benefit design is a
strength. There is no single list of attributes that a health plan must evaluate, but Figure
11A-2 explains how several key attributes relate to the healthcare industry.
Note that many of these attributes are linked. For example, distribution, quality, and
service are closely related in that convenient access to healthcare is usually perceived
as a positive component of service and quality.
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Opportunities and Threats
Threats and opportunities are external factors that could impact the future business of
the health plan. It is critical that a health plan constantly evaluate these external factors
and take appropriate action to defend against the threats and seize the opportunities. In
some cases, threats can be turned into opportunities.
For example, legislation that increases expenses for one type of health plan, such as an
HMO, is certainly a threat to a health plan that has a high market penetration of HMO
membership. On the other hand, such legislation can also be an opportunity for the
health plan to increase the market share of its PPO business.
Similarly, changing medical practice patterns can be both a threat and an opportunity,
depending on whether or not a health plan has at least anticipated the changes and
adjusted its plan benefits and price appropriately. The most difficult part of determining a
health plan’s threats and opportunities for a SWOT analysis is evaluating whether or not
current trends in external factors will continue. Figure 11A-3 describes some changes
which are typical threats to, and opportunities for, a health plan.
Fast Definition
A brand is a name, number, term, sign, symbol, design, or combination of these elements
that is used to identify one or more products with a firm and to differentiate these
products from other, competing products.5
Develop the Strategic Plan
A health plan that has developed its mission and vision statements and evaluated its
current position using the SWOT analysis, is ready to develop its strategic plan. The
health plan’s strategic plan must take advantage of the health plan’s strengths and
opportunities and defend against its weaknesses and threats.
One framework for developing an health plan’s strategic plan involves using the
marketing variables—product, price, place (also called distribution), and promotion—in
combination with human resources and information technology. A health plan can
manipulate these four marketing variables as needed in the strategic planning process to
help the health plan achieve its goals.
Human resources are a critical component of a health plan’s strategic plan because, in
health plans, often the product is less important than the size and the quality of the
product’s provider network. Another critical element of a health plan’s strategic plan is
information technology, which is essential to provide healthcare services and to comply
with financial reporting requirements. Let’s examine these marketing variables in more
detail.
Product, Price, Place, and Promotion
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A health plan’s strategic plan must address how the health plan will differentiate its
products (product and price), as well as where and how it will sell them (place and
promotion) . A health plan can differentiate its products by offering a wide variety of
6
benefit choices or achieving a superior brand name for quality and service.
Alternatively, the health plan can choose to differentiate itself on price alone. The
provider network is among the most important parts of a health plan’s product because
the provider network directly affects the health plan’s ability to deliver quality care at a
competitive price. A health plan can also differentiate its products through the use of
alternate distribution channels or advertising formats that its competitors are not using.
The strategic plan also addresses the geographic service areas in which the health plan
chooses to compete. Expansion strategies may be called for if the health plan feels it
can obtain a competitive advantage in an attractive market. In this context, expansion
can be achieved either by (1) entering the market and building a market share, or (2)
acquiring an existing market share from a health plan that has been operating in that
market.
In addition, a health plan’s strategic plan addresses how the health plan will promote its
products. For example, a health plan can choose to sell its products through a direct
sales force or through brokers and agents. Most health plans use both.
Human Resources
Investments in technology, brand, distribution systems, and the like are important, but to
achieve its strategic goals, a health plan will also have to hire and retain highly
committed employees who tend to outperform their competitors. Perhaps this is the area
where a sustainable competitive advantage is most viable for many health plans. For this
reason, a health plan’s strategic plan also typically includes a plan for attracting and
retaining the right employees, who are critical to achieving the health plan’s mission and
goals.8
Information Technology
Health plan is an information-intensive industry. Therefore, an information technology

(IT) strategy is another critical element in successfully implementing a health plan’s
strategic plan. A health plan faces risks and benefits in adopting new IT systems,
whether it develops the systems internally or purchases them externally. Being the first
health plan in a particular market to implement a state-of-the-art IT system may lead to a
service advantage or cost advantage, or both.
If the IT system fails to perform as expected, however, that failure could lead to large
cost increases and extensive service problems. Consequently, a health plan should
consciously decide whether to be a leader or fast follower in the use of new IT systems.
This decision should be a part of the health plan’s strategic plan. Because acquiring a
new IT system is a considerable expense, a health plan typically conducts a financial
evaluation of potential IT capital expenditures, and monitors promised results, as a
critical part of its IT strategy. If the health plan chooses the right IT system—for example,
an excellent call center management system or medical management system—then the
health plan will enjoy a competitive advantage until competitors are able to purchase or
develop an IT system with similar or superior qualities.
Implement and Monitor the Strategic Plan
Once the health plan has developed its mission and vision statements, conducted a
SWOT analysis, and developed its strategic plan, it must identify the specific actions that
it will take to implement the strategic plan. For example, a statement like “we will achieve
a sustainable cost advantage” does not describe how the cost advantage will be
accomplished. An example of a more specific action item to achieve a cost advantage is
a statement like “we will renegotiate our hospital contracts to obtain a 10% unit cost
reduction.”
A health plan must assign responsibility to specific managers for carrying out such action
items. To achieve their assigned action items, the health plan’s managers should also
have the authority and support necessary to undertake their assigned action items. The
implementation of a health plan’s strategic plan is a complex process. As a result, some
parts of the health plan’s strategic plan will not go exactly as expected.
Adjustments to the original strategic plan may become necessary. For this reason,
health plans typically also develop contingency plans, which are plans designed to
minimize the possible negative impacts and take advantage of opportunities that
changes in the health plan’s operational environment may present. Contingency plans
are typically used only if the health plan’s strategic plan is not working. Most contingency
plans contain corrective actions. We discuss in the nesxt lesson how a health plan uses
contingency planning in developing its strategic financial plan.
A health plan must monitor the effectiveness of its strategic plan in supporting the health
plan’s mission and vision statements. To determine whether or not a health plan is
achieving its vision, the health plan faces a critical task: it must develop and apply
means of measuring where it stands in relation to its goals. These measures, called
metrics, are developed around key dimensions, such as
• Quality—for example, the National Committee for Quality Assurance’s (NCQA’s)

Health Plan Employer Data and Information Set (HEDIS)
• Service—for example, average telephone wait time
• Finance—for example, cash flow or net income
Leadership could be defined in terms of market share (service), public policy influence
(quality), financial success (finance), or a combination of all three. Other metrics of
interest to health plans include the health plan’s market share and growth rate. To
measure progress toward achieving a health plan’s stated vision of being the recognized
industry leader, the health plan may measure its outcomes against the performance of
other health plans.
Fast Definition
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The National Committee for Quality Assurance (NCQA) is a nonprofit group that
accredits health plans, managed behavioral healthcare organizations (MBHOs), credential
verifying organizations (CVOs), and physician organizations.9
The Health Plan Employer Data and Information Set (HEDIS) is a performance
measurement tool, administered by the NCQA, that is designed to help healthcare
purchasers and consumers compare the quality offered by different health plans.10
Chapter 11 B
The Strategic Financial Plan
• Distinguish between a health plan’s strategic financial plan and operational

budget
• Describe the purpose of the financial planning function in for-profit and not-
for-profit health plans
• Define debt and equity with respect to a health plan’s capital structure
• Define cost of capital and the capital asset pricing model
• Calculate a health plan’s weighted average cost of capital
• Explain the purpose of a health plan’s pro forma financial statements
• List some key drivers of a health plan’s pro forma income statements and
balance sheet
• Define sensitivity analysis and describe how a health plan uses the
optimistic, most likely, pessimistic scenario modeling and Monte Carlo
simulation
After a health plan has developed a draft of its overall strategic plan, the health plan can
begin developing its strategic financial plan. One of the main goals of a health plan’s
strategic financial plan is to assess the long-term financial feasibility of the health plan’s
overall strategy. The focus on long-term goals distinguishes a strategic financial plan
from an operational budget, which is a component of the strategic financial plan that has
a short-term focus.
A strategic financial plan is a long-term plan, expressed in monetary terms, that

describes how an organization will achieve the goals established in the overall strategic
plan. An operational budget is a short-term budget that covers all or part of an
organization’s operations. Figure 11B-1 presents a comparison of a health plan’s
1
strategic financial plan and its operational budget. We discuss budgets and other short-
term financial management tools in Management Control.
A health plan’s strategic financial plan must be consistent with the health plan’s financial
policy and realistically project the desired financial results with an acceptable level of
risk. Before we discuss the development of a health plan’s strategic financial plan, we
examine the role of financial planners in a health plan and the development of a health
plan’s financial policy.
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The Financial Planning Function
A health plan must be financially sound to fulfill its mission and meet its vision. The
financial planning function in a health plan ensures that the health plan remains
financially healthy and complies with all external and internal financial reporting
requirements. This statement is true whether the organization is a publicly held, for-profit
health plan or a not-for-profit health plan.
Both types of organizations need to generate cash and accounting profits to reinvest in
core business functions to ensure ongoing operations. The tasks associated with the
financial planning function are typically performed by a health plan’s employees in the
finance, accounting, investments, and/or contracting areas. The difference in the finance
role between for-profit and not-for-profit health plans is relatively minor, as shown in
Figure 11B-2.
Financial Policy
In setting financial policy, a health plan essentially determines the amount of financial
risk the health plan is willing to accept. Typically, there is a tradeoff between the
possibility of faster growth and the assumption of higher financial risk.
Although a health plan should establish adequate internal controls to ensure that its
assets are not being misused, some health plans may want to, or even have to, tolerate
more financial risk with respect to their assets than other health plans tolerate. However,
there can be negative consequences if a health plan assumes too much risk. The
following scenarios show the potential consequences associated with a health plan's
assumption of too much financial risk.
• If a health plan experiences several catastrophic cases during the year as a

result of relaxing its underwriting guidelines to enter a new market. This
scenario could cause the health plan’s capital and surplus to fall below the
minimum thresholds set by regulators.
• If a health plan increases the amount of its debt significantly to develop a new
product. This scenario could cause the health plan’s activity ratios to fall
below levels set forth in debt covenants, which stipulate the conditions with
which the health plan must comply for the health plan to continue to borrow
money. (We discuss activity ratios in Financial Statement Analysis in health
plans.)
• If a health plan invests in long-term assets such as real estate, which
generally cannot be sold quickly for cash. This scenario could cause a
temporary cash shortage for the health plan, which would be unable to pay its
providers, creditors, or vendors on a timely basis.
Any of the above examples of financial risk can lead to a health plan’s insolvency if not
quickly corrected. Health plans, therefore, must set policies to minimize the exposure to
these financial risks, which relate to capital structure, the cost of capital, and
investments.
Financial Policy
Capital Structure
Like all companies, health plans have essentially two sources of capital: equity and debt.
Equity is a form of ownership in an organization. In an existing organization, equity can
typically be generated through (1) surplus or retained earnings or (2) a stock issue.
Equity owners of a for-profit organization expect a return on their investment and
eventually hope to receive future profits, either through dividends or through an increase
in the stock price.
The other key source of capital is debt, which is a form of creditor interest in an
organization. Debt can be obtained typically through (1) bank loans or (2) a bond issue.
An organization’s debt holders are also investing in the organization and expecting
periodic interest payments and the eventual return of their principal (the borrowed
amount). Depending on the amount of debt and equity an organization has, the
organization may have either a debt structure or an equity structure.
Fast Definition
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A Stock Issue is the sale of a company’s stock, which represents a stockholder’s

ownership interest in the company.3
A bond Issue is the sale of a bond, which is a certificate of indebtedness, under which a
company contractually agrees to pay a specified interest rate on the borrowed amount
over a specified time period, and also agrees to pay the total amount borrowed on a
specified future maturity date.4
From an organization’s perspective, debt is obviously more risky than equity, but is
almost always less expensive than equity. Debt is less expensive than equity for the
following two reasons:
1. Compared to an organization’s equity holders, its debt holders have a prior legal
claim to the organization’s assets. From the investors’ perspective, debt has less
risk than equity, so investors typically are willing to accept a lower return on debt.
2. Because the interest that an organization pays on its debt is tax deductible (for a
for-profit organization), the tax shield (or savings) lowers the total cost of the
organization’s debt. Although not-for-profit organizations typically do not pay
income taxes or receive the benefit of the tax shield, they can sometimes issue
debt and pay tax-free interest to the investor, who in turn accepts a lower interest
rate.
The Cost of Capital
To manage the financial risks associated with conducting its business, a health plan
needs to determine what it costs the health plan to obtain capital by each of the different
capital financing methods. An organization’s cost of capital is the overall rate of interest
or dollar amount that the organization pays for the long-term funds that it employs. 5
Calculating a health plan’s cost of debt is relatively easy. It is essentially the same as the
average interest rate the health plan is paying to debt holders, adjusted for the tax
shield.
Estimating a health plan’s cost of equity is a bit more complicated, however. The cost of
equity is usually calculated using the capital asset pricing model (CAPM), which uses
beta and the market return to help investors evaluate risk-return tradeoffs in making
investment decisions. According to the CAPM, the cost of equity is equal to an investor’s
risk-free rate—for example, the interest rate on a U.S. Treasury bond—plus an
adjustment that considers the market rate, at a given level of systematic
(nondiversifiable) risk. Investors can diversify to eliminate nonsystematic (diversifiable)
6
risk. In the CAPM, beta is a measure of systematic risk.
Fast Definition
The risk-free rate is the rate of return that can be earned on a virtually risk-free
investment.9
Treasury bonds are U.S. Treasury debt securities that are issued with maturities of more
than 10 years—usually 20 years or longer.10
Systematic (nondiversifiable) risk is the risk attributable to forces that affect all
investments, and therefore are not unique to any given investment.11
Nonsystematic (diversifiable) risk is the portion of risk of a specific investment that

results from uncontrollable or random events and that can be eliminated through
diversification.12
A common misconception is that a not-for-profit health plan has a zero percent cost of
equity since it has no investors expecting a return. Because not-for-profit health planlth
plans obtain their equity primarily from retained earnings, their cost of capital is typically
related to operating costs. Also, a not-for-profit health plan’s customers, which can be
thought of as its owners, value their cash and will want it used in such a way that will
generate value for them. Therefore, a not-for-profit health plan might reasonably apply a
beta from a similar publicly held company in calculating its cost of equity.
After a company determines its cost of debt and its cost of equity, then the company can
calculate its weighted average cost of capital. The weighted average cost of capital
(WACC) is the overall cost that a company pays to obtain new funds from all sources. 7
Fast Definition
Beta is a measure of systematic risk; a number that shows how the price of an investment
responds to market forces.8
Capital Structure
Suppose a health plan’s capital structure consists of 25% debt and 75% equity and that
the health plan’s average after-tax cost of debt is 5% and its cost of equity is 11%. Using
WACC, the health plan has a weighted average cost of capital of 9.5% [(5% × 25% debt)
+ (11% × 75% equity)], as shown in Figure 11B-3.
The 9.5% rate calculated using WACC can be used as a hurdle rate for setting the
health plan’s financial policy. In our example, if the health plan establishes 9.5% as the
hurdle rate for capital investments, any investment that is expected to earn a return of
more than 9.5% should add value to the health plan. Ultimately, establishing a policy for
capital structure involves a tradeoff between increasing financial risk and decreasing the
cost of capital.
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Fast Definition
The hurdle rate (required return) is the minimum percentage rate of interest that a
company must earn to recoup its cost of capital.13
Review Question
The following information relates to the capital structure of the Laredo Health Plan:
After-Tax
Type of Capital Percent of Capital Cost Rate
Debt 0.40 0.07
Equity 0.60 0.13
This information indicates that Laredo’s weighted average cost of capital (WACC) is
equal to:
4.7%
5.3%
9.4%
10.6%
Incorrect. The formula is (Percent of Debt Capital X Debt After-Tax Cost Rate) +
(Percent of Equity Capital X Equity After-Tax Cost Rate.)
Correct. (.40 X .07) + (.60 X .13) = .106
Investment Policy
A typical company must generate working capital (current assets – current liabilities) to
operate. A typical health plan, however, collects its premium from its customers before
the month in which healthcare services are provided, while it often pays providers
several months after they have performed healthcare services for plan members.
Between the time a health plan collects its premium and pays all of the associated
claims or medical expenses, it holds cash, which is managed by the health plan’s
treasury function. For many health plans, investment income is significant in dollar
amount, even if it is not significant in percentage terms of the health plan’s total income.
In many cases, regulators provide some parameters on the type and amount of
investments a health plan can make, but a health plan also has some latitude in its
choice of investments. Stocks have historically yielded the highest returns, followed by
long-term bonds (those with maturities of 10 years or longer), with short-term bonds
(those with maturities of one year or less) yielding the lowest returns.
A health plan develops an investment policy that guides the health plan’s mix of debt
and equity investments. A health plan’s investment policy typically must be approved by
the health plan’s board of directors. Such a policy usually establishes guidelines for
matching the expected cash flows from investment income to the expected cash
outflows for provider reimbursement expenses, for example. A health plan’s investment
policy also establishes risk and return targets for the health plan’s investments.
Developing the Strategic Financial Plan
Once a health plan develops its financial policy, including the debt and equity targets it
needs to fund its business, and determines the policy it will follow in making investments,
the health plan can develop its strategic financial plan. The core of the strategic financial
plan is the development of the pro forma financial statements: income statement,
balance sheet, and cash flow statement.
Pro Forma Financial Statements
Pro forma financial statements are financial statements that project what a company’s
financial condition will be at the end of an accounting period, assuming that the company
achieves its objectives. Because the pro forma financial statements are a forecast
14
(projection), a company has to create, review, and revise pro forma statements several
times to make them useful in the strategic financial plan.
After developing a few iterations of pro forma financial statements, a health plan reviews
its strategic financial plan to see if the plan produces acceptable and reasonable
financial results. If it does, the health plan then conducts sensitivity analysis, discussed
later in this lesson, to determine if the assumptions made in the health plan’s strategic
plan are likely to occur.
A health plan also typically develops contingency plans for use in the event of changes
in the market environment or in the health plan’s underlying assumptions. After the
strategic financial plan is developed and reviewed, the health plan can begin
implementing its plan. As part of the implementation process, a health plan develops a
list of early indicators of success and failure. We discuss each of these steps in
developing, reviewing, implementing, and monitoring a health plan’s strategic financial
plan in the following sections. After the strategic financial plan is developed and
reviewed, the health plan can begin implementing its plan. As part of the implementation
process, a health plan develops a list of early indicators of success and failure.
It is critical that the same senior management that developed the overall strategic plan
actively participates with the finance function in developing and evaluating the pro forma
financial statements. Key assumptions that are used in developing a health plan’s pro
forma financial statements must be aligned with both the health plan’s SWOT analysis
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and its overall strategic plan. Minor, or more predictable, assumptions can be made by
the finance function with little or no outside help.
Before developing the pro forma financial statements, it is useful for a health plan’s
senior management to agree on some global assumptions. For example, in developing
the pro forma financial statements, a health plan must decide on what rates to assume
for
• Overall inflation
• Medical services inflation
• Utilization
• Interest
Upon determining these rates and any other necessary global assumptions, a health
plan can begin developing its pro forma financial statements. Typically, health plans
spend most of their time on the key assumptions that will drive the projected financial
results. The first pro forma financial statement that we examine is the pro forma income
statement.
Pro Forma Income Statement
Forecasting the income statement is the most critical of the three financial statements,
as it also drives the development of the balance sheet and cash flow statement. As a
result, errors in forecasting the income statement will flow through to the balance sheet
and cash flow statements. For this reason, forecasting the income statement typically
requires much participation from a health plan’s senior management.
In forecasting the income statement, a health plan starts with the key drivers of revenues
and expenses. Figure 11B-4 shows some high-level drivers and the impact strategic
decisions will have on making these forecasts. The health plan’s management forecasts
premium revenues and medical expenses by product type (for example: HMO, PPO,
POS, etc.), estimating price and unit costs (for example, PMPM) and then multiplying by
volume (membership).
It is critical that the assumptions used in developing the pro forma income statement be
consistently linked to the overall strategic plan. For example, if a health plan’s strategy
calls for a 15% annual increase in premium revenues, then the health plan’s prices and
membership assumptions must realistically support this. If the assumptions cannot
support this, the strategy must be revisited.
Health plans that have allowed the desired financial results to drive the
assumptions, instead of having the assumptions drive financial results, risk
developing unrealistic strategic financial plans. Therefore, a health plan’s senior
management attempts to resist any pressure to use unrealistic assumptions in
order to make the financial results acceptable.
One question that is often asked in the process of developing a pro forma income
statement is “How aggressive should the net income projection be?” There is no single
answer to this question, but many health plans use a 50% probability of achieving or
exceeding the forecasted net income level. Projections set too low do not cause the
organization to perform to its potential, while unrealistically aggressive forecasts tend to
frustrate and de-motivate the organization.
Pro Forma Balance Sheet
Much of the pro forma balance sheet is derived from the operating assumptions a health
plan made in developing the pro forma income statement. As a result, a realistic pro
forma income statement will usually result in a realistic pro forma balance sheet. Recall
that a health plan’s balance sheet lists the health plan’s assets, liabilities, and owners’
equity as of a specified date.
Figure 11B-5 describes some of the key drivers of assumptions used in developing the
assets and liabilities portions of a health plan’s balance sheet. This figure also provides
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examples of some strategic questions that a health plan must consider in developing its
pro forma balance sheet.
Pro Forma Balance Sheet
Note that changes in the product or payor mix can impact a health plan’s current assets
and current liabilities. For example, a health plan whose product mix contains an HMO,
rather than a PPO, may experience a lower IBNR liability if more providers are paid on a
capitated basis.
In creating a health plan’s pro forma balance sheet, financial assumptions, such as the
assumption that the health plan will issue debt or equity, must be supported by the
health plan’s overall strategic plan. Also, the health plan must ensure that it will have the
needed cash available to implement its strategic plan. We explore these types of
assumptions in the next lesson.
Review Question
Pro forma financial statements project what a company’s financial condition will be at the
end of an accounting period, assuming that the company achieves its objectives. Key
drivers of assumptions used to project a company’s assets include:
cash flows
accounts receivable as a percent of premium
space required for continuing operations
all of the above
Incorrect. While cash flow is one key driver, other answers are correct as well
Incorrect. While accounts receivable as a percent of premium is one driver, other
answers are correct as well.
Incorrect. While space required for continued operations is one driver, other
answers are correct as well
Correct. All are key drivers of assumptions used to project a company’s assets
Pro Forma Cash Flow Statement
Recall that the cash flow statement is derived from the income statement and the
balance sheet. Nonetheless, it is essential that a health plan review its pro forma cash
flow statement, because this review provides insight into whether the health plan can
achieve the forecasted income statement and balance sheet.
Another key use of the pro forma cash flow statement is that it can be used to calculate
the net present value of the health plan’s strategic plan. In other words, the pro forma
cash flow statement shows, in terms of cash inflows and cash outflows, the impact of a
health plan’s strategic plan on the health plan’s cash.
Fast Definition
Net present value (NPV) is the present value of a project’s earnings minus the present
value of its initial investment.15
Present value (PV) is the amount of money that, if invested now at a specified interest
rate, would grow to equal a specified future sum.16
Reviewing the Strategic Financial Plan
Because the development of a health plan’s pro forma financial statements is an iterative
process, it requires a number of revisions until the health plan has a set of workable
(reasonable) financial statements. In reviewing the pro forma financial statements, the
health plan may want to seek answers to the following questions in determining if
desired results are to be reflected in these financial statements:
If the forecasted financial results are still unacceptable, it is critical for the health plan to
revise its strategy. Changing the assumptions so that they produce the desired financial
outcome completely defeats the purpose of preparing both the strategic plan and the
strategic financial plan.
 Do results reflect a historical performance trend? Have predicted growth rates and
earnings ever been sustained in the health plan industry in this market? Although changes
in the market and changes in the health plan’s strategic plan will produce different results
from the past, it is especially important to look for forecasts that resemble hockey sticks
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—that is, flat in the beginning with steep improvements projected—without a reasonable
explanation for the performance improvement.
 If the forecasted results look outstanding, wouldn’t they invite a competitor response,
such as a new market entrant? Has this prospect been accounted for in the pro forma
financial statements?
 Are the forecasted operating ratios and financial ratios within the limits of the health
plan’s financial policy and investment policy? Do they meet the external requirements of
regulators and lenders? Are measures such as net income growth and return on equity
acceptable to the health plan and its owners? (We discuss financial ratios in Financial
Statement Analysis in health plans.)
Sensitivity Analysis
The strategic financial plan we have so far developed is based on a single set of
assumptions and results in a single outcome. The probability of that single set of
assumptions occurring is essentially zero because there is uncertainty concerning the
assumptions used in developing the strategic financial plan. Because of this uncertainty,
sensitivity analysis is recommended as part of the strategic financial planning process.
Sensitivity analysis is a process of taking the key assumptions made in the strategic
plan and estimating a range of uncertainty concerning these assumptions. In this way,
sensitivity analysis measures the downside risk and upside potential of the strategic
financial plan, and it allows for the development of contingency plans for use when the
plan’s implementation does not go as intended.
In performing sensitivity analysis, a health plan typically models only the key
assumptions that are likely to make a significant financial impact on the health plan.
These key assumptions might include market growth, pricing and cost assumptions, and
new market entrants. Predicting market trends and competitor actions is a necessary,
though imprecise, activity.
There are several recommended methods of performing a sensitivity analysis. A

common technique used in health plans is to perform a what-if analysis of a range of
values for key factors. For example, a health plan might conduct a what-if analysis for
medical inflation rates in a range of 0% to 10% to see how a percent change in the
assumed medical inflation rate would affect the potential outcome of its strategic
financial plan. In the following sections, we discuss the use of optimistic, most likely,
pessimistic scenario modeling and a Monte Carlo simulation. Figure 11B-6 compares the
results obtained under these two methods.
Optimistic, Most Likely, Pessimistic Scenario Modeling
As the name implies, optimistic, most likely, pessimistic scenario modeling involves
preparing two more sets of pro forma financial statements, in which key assumptions are
revised to project a set of optimistic outcomes and a set of pessimistic outcomes to
accompany the forecasted plan, which represents the most likely scenario.
A health plan defines what the optimistic scenario and pessimistic scenario mean in
terms of its probability (likelihood) of occurring. Some health plans use a 10% probability
that the outcomes will be optimistic and a 10% probability that the outcomes will be
pessimistic, with respect to the strategic financial plan, which represents the most likely
scenario. In this example, the health plan expects that its most likely scenario will occur
with an 80% probability. There is a 10% probability that the financial outcomes will be
lower than expected and a 10% probability that the financial outcomes will be higher
than expected.
Monte Carlo Simulation
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Although optimistic, most likely, pessimistic scenario modeling is useful, it yields only
three possible outcomes out of a distribution of infinite possibilities. To obtain a
distribution of possible outcomes, a health plan may conduct a Monte Carlo simulation.
A Monte Carlo simulation is a risk analysis technique in which probable future events
are simulated on a computer, using a random number generator, to produce a
distribution of possible outcomes. A Monte Carlo simulation defines the strategic
17
financial plan’s key assumptions—such as medical inflation rates and utilization rates—
in terms of mathematical formulas that can be correlated to each other or analyzed
independently. A health plan might use a Monte Carlo simulation to predict the
distribution of expected claims. This information would be useful in negotiating risk-
sharing arrangements with the health plan’s providers.
A Monte Carlo simulation results in more robust insights about the potential outcomes of
a health plan’s strategic financial plan, as illustrated in Figure 11B-6. In our example, the
Monte Carlo simulation shows that there is a 6.7% probability (calculated by adding all
the probabilities of net income below zero: 2.6% + 4.1%) that the health plan will have a
net loss in the year 2003. The optimistic, most likely, pessimistic scenario model cannot
address this possibility.
Contingency Planning
After performing a sensitivity analysis, a health plan then prepares contingency plans to
minimize the downside risk that changes in the market environment can exert on the
health plan. In addition, contingency plans enable the health plan to take advantage of
opportunities that such changes may present. Contingency plans contain alternative
actions that a health plan can take to respond to market changes. Examples of events
for which a health plan may develop contingency plans include
• Price wars
• New competitor entrants
• Low cost strategy failing
• Bad publicity
Admittedly, it is impossible to prepare plans for every contingency. However, it is

important for a health plan to have plans drafted and ready to implement when critical
assumptions do not go as planned.
Implementing and Monitoring the Strategic Financial Plan
After a health plan’s senior management has approved the strategic plan and the
strategic financial plan, management may present these plans to the board of directors
to obtain formal approval. In such cases, the health plan’s board of directors periodically
reviews management reports on the health plan’s progress toward achieving its strategic
objectives.
Parts of the approved strategic plan should be communicated throughout the health
plan. Everyone in a health plan should know the health plan’s mission and vision, as well
as the supporting goals and values. Communicating the health plan’s mission and vision
statements and its strategic goals to employees and other interested parties helps focus
the efforts of the health plan to achieve its mission. The strategic financial plan, however,
is a document that should be closely guarded, because the health plan would not want it
to end up in the hands of competitors.
A health plan’s strategic financial plan is a working document that the health plan uses to
manage its progress toward achieving strategic goals. This means that health plans
need to compare their actual performance with their forecasted performance to
determine the amount of any variance (difference). These variances, which include not
only financial performance, but also quality and service performance, must be analyzed
and corrective actions must be taken.
Early Indicators of Key Success Factors
The healthcare environment is changing far too quickly for a health plan to wait until the
end of an accounting period to determine whether or not its strategy is working.
Therefore, a health plan should develop a short list of early indicators of key success
factors and closely monitor the achievement of these factors. A health plan must
constantly monitor early indicators of key success factors and make the appropriate
adjustments to the strategic financial plan as changes occur. For this reason, the early
indicators of key success factors must be performance measures that a health plan can
use to track progress toward achieving its strategic goals.
Assume that a health plan’s strategic plan includes a goal to increase plan membership
by 30% next year. The health plan intends to achieve this objective by holding premium
rate increases to 4% in a market in which competitors typically increase their annual
premium rates by 12%. Suppose the health plan then learns that its competitors are
matching the health plan’s 4% premium rate increases.
If the health plan has already hired additional employees to accommodate its anticipated
30% increase in plan membership, then the health plan’s administrative expenses could
increase significantly without an accompanying increase in premium revenues. In this
case, the health plan would have to make the necessary adjustments in its strategic
financial plan, perhaps through developing alternative means of achieving the plan
membership increase or otherwise offsetting the increased administrative expenses that
would result from hiring additional employees.
Management Incentives and the Strategic Plan
A strategic plan can fail to obtain the desired financial results either because the plan
wasn’t followed or the strategy just didn’t work. Ideally, if the plan does work, all
employees should be rewarded financially, based on the value that each employee has
brought to the health plan with respect to achieving its strategic goals.
Again, the appropriate performance measures must be used to link employee actions
with a health plan’s strategic plan. Typically, linking a health plan’s strategic financial
plan to management incentives improves the likelihood that the health plan’s
management will develop realistic assumptions to be used in the strategic financial plan
and will focus on the successful implementation of the plan.
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For publicly held health plans, stock options provide a vehicle for linking incentives to
achieving the strategic financial plan, because better financial results ultimately lead to
higher stock prices. Stock options are an executive incentive whereby a company
offers to sell its stock to its executives at an identified price on a specified date. It is in
the executive’s interest for the company to do well, so the stock’s value will rise. If the
stock’s value does rise, the executive may, by exercising the stock options, be able to
buy the company’s stock at a price below the stock’s market value. 18
Privately held health plans can use management incentives such as long-term bonuses,
which are typically based on obtaining three-year results, or they can issue phantom
stock. A phantom stock is an incentive, issued to a privately held company’s
employees, that is similar to a publicly traded stock, but its price is set by a formula. The
formula is typically described in the company’s strategic plan, and the value of the
phantom stock is dependent on the company’s achievement of its strategic goals.
Chapter 11 C
Case Study: Lifelong Health, Inc.
• Apply the concepts discussed in The Strategic Plan and The Strategic
Financial Plan in a case study environment
In this lesson, we present a simplified case study to illustrate the development of a

strategic financial plan, including sensitivity analysis techniques and the development of
contingency plans.
The case study begins with a brief overview of the market and competitive situation
facing a fictitious health plan, Lifelong Health, Inc. (Lifelong). We examine the
development of Lifelong’s pro forma income statement, balance sheet, and cash flow
statement. Next, we see how assumptions made on Lifelong’s pro forma income
statement flow through to its pro forma balance sheet and cash flow statement. In
Financial Statement analysis in health plans, we will return to Lifelong in our discussion
of ratio analysis.
Although Lifelong’s pro forma financial statements are in the form of high-level
summaries, they contain enough information so that you may conduct an internal
analysis. Note that there are many other ways to present internal statements. For
example, many health plans do not include investment income as part of operating
income, but group it with other income or in a separate net of investment expenses
category.
Background Information
Lifelong is the largest provider of healthcare in Major City, a large, midwestern city.
Lifelong is a health plan that has two products: an HMO and a PPO. Lifelong, along with
its three key competitors—Global Health, Graymount HMO, and Sage Healthcare— has
a 75% share of the market in their city. Figure 11C-1 provides a Summary SWOT
analysis that includes a description of Lifelong and its competitors, as well as an analysis
of the competitive playing field.
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Lifelong’s Strategic Plan
Lifelong’s mission statement is “to provide superior healthcare at a reasonable cost to

employers and plan members.” Lifelong’s CEO, Dr. Susan Chandler, believes that
Lifelong can compete as the health plan leader in price, quality, and service. Dr.
Chandler notes that, “in this business, you can decrease costs by eliminating
unnecessary procedures. Doing so benefits the plan member, the provider, and the
payor, and ultimately results in more affordable premiums for healthcare benefits.”
Dr. Chandler believes that the practice of medicine must become more of a science,
particularly through using statistically proven medical protocols. Dr. Chandler has
identified the following key actions in Lifelong’s strategic plan.
Lifelong’s vision is to dominate health plans in Major City and to be recognized as one of
the most progressive health plans in the country. Lifelong has recently converted from a
not-for-profit company to a for-profit company and has aspirations of going public.
However, Dr. Chandler has asked that the assumption that Lifelong will issue common
stock be excluded from Lifelong’s pro forma financial statements. Because financial
markets can be unpredictable, Dr. Chandler does not want to rely on a public offering of
stock to raise funds for achieving Lifelong’s strategic goals.
 Renegotiate HMO provider contracts to lower costs by 5%, to reflect the results of
Lifelong’s analysis of per member per month (PMPM) reimbursement levels.
 Partner with Lifelong’s PPO providers to provide incentives—such as provider bonus
pools—to reduce unnecessary procedures by 10%, while being careful not to withhold
needed care.
 Install applications software to improve medical outcomes by 15% in Lifelong’s
disease management programs.
 Increase HMO plan membership by 8%, in part by migration from Lifelong’s PPO
product, where the previous two action items will have greater impact.
Current Financial Situation
Lifelong’s finance department has prepared financial statements to reflect Lifelong’s

historical financial performance in 1997 and 1998 and has prepared pro forma
statements (forecasts) for the next five years. (Note that, in practice, the transition
between the last year of a company’s historical performance and the first year of its
forecasted performance does not always neatly coincide with the end of an accounting
period. For example, forecasting 1999 results typically occurs before a company’s 1998
accounting period is over. As a result, the company’s 1998 year usually reflects eight or
nine months of actual results, combined with forecasted results for the rest of 1998. For
the purposes of this simplified case study, we assume that Lifelong had access to actual
results for the entire 1998 accounting period.)
Figure 11C-2 shows Lifelong’s 1997 and 1998 summary income statements and some
data on plan membership and the average prices for its products. In their review of
Lifelong’s financial performance for 1998, Dr. Chandler and senior management agree
that 1998 has been a disappointing year for Lifelong. Look at the “Net Income/Loss” line
in Figure 11C-2. For 1997, Lifelong experienced net income of more than $14 million,
but in 1998 Lifelong suffered a net loss of nearly $7 million—quite a change from the
previous year. This net loss is Lifelong’s first unprofitable year in more than a decade.
Note that, while Lifelong experienced a net loss, plan membership for both its products
increased. Look at the “Membership” line in Figure 11C-2. At the end of 1997, total plan
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membership was 507,500, but it increased to 530,100 by the end of 1998, representing
more than a 4% increase. This growth in membership occurred despite the fact that
Lifelong held its prices nearly flat in 1998, as can be seen in the “Average Price” and
“Average Price Increase” lines in Figure 11C-2.
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Recall that Lifelong’s fourth strategy action item was to increase HMO membership, in
part by migration from its PPO product. This strategy obviously did not occur as planned,
so Lifelong must examine the price relationship between its HMO and PPO products. Dr.
Chandler, in a meeting with Lifelong’s board of directors, pointed to the following areas
as contributing to Lifelong’s poor performance in 1998:
• Lifelong’s inability to control costs, particularly pharmacy costs, which were

growing at a much faster rate than forecasted
• Competitors Graymount, Global, and Sage Healthcare reduced their prices in
1998, leading to lower-than-planned membership growth for Lifelong. Dr.
Chandler noted that Lifelong’s key competitors also experienced losses in
1998.
• Anti-HMO sentiment sweeping the nation, combined with Lifelong’s low PPO
price increase, caused HMO membership to grow less than planned.
Dr. Chandler told Lifelong’s board of directors that “the good news is that the price war is
over. Lifelong’s competitor analysis points to average price increases in the 6% to 8%
range for HMO products and 10% to 15% range for PPO products.” Lifelong’s strategic
plan calls for greater price increases for its PPO product than for its HMO product, but
price increases are expected to be lower than those of its competitors.
Development and Review of Lifelong’s Pro Forma Financial Statements
As mentioned earlier, Lifelong’s finance department, working closely with its strategic
planning team and senior management, has produced a set of pro forma financial
statements for the years 1999–2003. The finance department is about to present these
pro forma financial statements to Dr. Chandler for her initial review. As with any pro
forma financial statement, Lifelong’s statements were prepared using certain
assumptions.
In the following sections, the finance department explains to Dr. Chandler the underlying
assumptions on which the pro forma financial statements were based. Also presented
are an analysis of Lifelong’s current financial situation and recommendations for
changes to Lifelong’s strategic plan to ensure favorable financial results over the next
five years.
Review of Assumptions
Figure 11C-3 includes the membership and pricing assumptions that Lifelong used in
developing its pro forma financial statements. Lifelong’s 1997 and 1998 historical
financial performance are repeated here for convenience.
Note that the assumptions were built around each of Lifelong’s products—the HMO and
the PPO. It is impossible to develop a pro forma income statement without looking at an
organization’s revenue drivers and cost (expense) drivers. Revenue drivers and cost
drivers can best be determined by estimating membership and price and costs per
member per month. As you can see from Figure 11C-3, Lifelong assumes very different
membership growth rates and prices for each product over the next five years. In the
more complex real world, the assumptions would have to be built around several
different products with different funding mechanisms in several different geographic
areas.
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Review of Assumptions
The Finance Department explained the following points concerning their assumptions to
Dr. Chandler:
• Pricing will be consistent with Lifelong’s strategy for PPO members to migrate to the
HMO.
• HMO membership is projected to pass PPO membership by 2001, and will represent
more than 60% of Lifelong’s total membership by 2003.
• Margin, as a percent of revenue, deteriorated most rapidly in the PPO product in
1998, and even with 12 % annual price increases will never reach 1997 levels. HMO
product margins will quickly approach 1997 levels.
• Costs are projected to rise much faster in the PPO product than in the HMO product,
mainly as a result of higher utilization rates.
• The HMO cases will have a higher medical intensity than the PPO cases, because
utilization rates are expected to decrease as a result of improvements in medical
management techniques. As a result, only the sickest HMO patients will be
hospitalized.
• Pharmacy cost increases will slow down, although they will still significantly outpace
inflation.
Lifelong has the following immediate concerns:
• Membership increases will not materialize because of premium rate increases that
are much higher than the previous year. Early indicators by Lifelong’s sales
department, however, suggest Lifelong will be well on its way to achieving its 1999
membership target upon completion of the January 1, 1999, open enrollment period.
• Medical costs will again increase faster than forecasted, rendering Lifelong’s price
increases inadequate to cover medical costs. For example, medical costs that rise
only 1.5% faster than Lifelong’s forecast will cause 1999 to be another year in which
lifelong records a net loss.
Lifelong’s key long-term risk is that public sentiment and regulations will continue to be
unfavorable to the HMO product. In response, Dr. Chandler requested that a
contingency plan be developed for possible mid-year price changes and that an early
indicator system be developed as well so that, if needed, the contingency plan could be
implemented on very short notice.
Dr. Chandler also asked the finance department to conduct an analysis, using
assumptions that address an unfavorable market, so that Lifelong can develop an
alternate pricing strategy to use in adverse market conditions. Finally, Dr. Chandler
recommended that the finance department, along with the sales department, explore the
possibility that Lifelong develop a POS product within a year.
Review of the Pro Forma Income Statement
In the pro forma income statement shown in Figure 11C-4, Lifelong’s premium revenue
(membership × price PMPM × 12 months per year) and its medical expenses flow from
the assumptions depicted in Figure 11C-3. Lifelong’s “Other Revenue,” shown in Figure
11C-4, consists mostly of investment income from its cash and marketable securities.
The finance department’s analysis of Lifelong’s pro forma income statement is as
follows.
(Note that Lifelong’s administrative cost percentages would be more realistic if each
year’s percentage were increased by 5%—for example: 15.4% of premium in 1998 and
11.7% of premium in 2003. Note also that Lifelong needs to address the work force
reduction, given its expected plan membership increases over the next five years.)
Dr. Chandler’s response was, “I’m committed to both holding 1999 administrative costs
flat and addressing our employee morale problem.” She pointed out that the strategic
financial plan allows a 4% average pay increase per year. In addition, Dr. Chandler
asked the finance department to run a scenario to include administrative costs that are
5% higher than the original projections. Dr. Chandler also reiterated the importance of
developing a contingency plan in the event of a mid-year price change.
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 Net income as a percent of revenue nearly doubles 1997 levels by the year 2003, in
spite of the fact that Lifelong’s gross margins (revenues minus expenses before interest
and taxes) as a percent of revenue are expected to be below 1997 levels.
 The projected net income increase is a result of administrative cost projections falling
from 10.4% of premium in 1998 to only 6.7% of premium in the year 2003. This
decrease is driven by (1) unusual severance costs at the end of 1998 due to a one-time
10% work force reduction and (2) productivity improvements due to implementing an
information technology system and achieving benchmarking levels.
Figure 11C-5 depicts Lifelong’s pro forma balance sheet. Lifelong’s assumptions and its
pro forma income statement indicate an optimistic five-year period for Lifelong. The
finance department, however, pointed out the following two concerns on the balance
sheet:
• Equity as a percentage of Lifelong’s annual premium is projected to fall from

more than 36% in 1997 to less than 29% in the year 2003. This decrease is
expected to occur, in spite of a record net income margin, because fast
membership growth outpaced the need for capital.
• Cash and investments as a percent of annual premium are projected to fall
from over 79% in 1997 to less than 47% in 2003, as shown in the Key
Statistics line in Figure 11C-5. In other words, Lifelong had cash on hand and
investments that total more than nine months’ worth of premium in 1997, but
by the year 2003, Lifelong’s cash and investments are projected to drop to
less than six months’ worth of premium.
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Review of the Pro Forma Balance Sheet
The projected decrease in the ratio of cash and investments to Lifelong’s premium is
being caused in part by the
• Repayment of $100 million bond in the year 2001, as shown in the Long-
Term Debt line of Figure 11C-5
• Decline in claims, including IBNR claims, from 30% (1997) to only 20%
(2003) of annual medical expenses
The decrease in the ratio of claims to annual medical expenses is a result of the higher
mix of HMO plan membership, for which Lifelong compensates a greater proportion of its
providers through capitation. Recall that, under capitation, a health plan pays its
providers at the beginning of the service period, before services are rendered.
Therefore, Lifelong has less cash on hand to invest from premiums received at the
beginning of the month if it also has to pay its providers at the beginning of the month.
Review of the Pro Forma Balance Sheet
Dr. Chandler is uncomfortable with the expected direction of these two ratios because
these ratios would begin to violate Lifelong’s existing financial policy, which specified a
minimum 70% ratio of cash to annual premium. In other words, Lifelong’s cash on hand
needs to be at least 70% of Lifelong’s annual premium. Dr. Chandler also expressed
concern that the direction of the relationship between Lifelong’s equity and its
percentage of annual premium eventually might approach regulator thresholds. She
requested the following scenarios be run:
• Assume that Lifelong refinances, rather than pays off, the $100 million in
bond debt that matures in the year 2000.
• Assume that Lifelong raises its premium, which in turn would slow Lifelong’s
growth in plan membership (Note that increasing the forecasted price without
decreasing plan membership would be letting the answer drive the
assumption.).
• Assume that Lifelong engages in an initial public offering of stock.
Review of the Pro Forma Cash Flow Statement
Recall from Assignment 10 that the cash flow statement ties the income statement and
balance sheet together, thus providing some interesting insights about a company’s
financial condition and performance. Figure 11C-6 depicts Lifelong’s pro forma cash flow
statement.
The finance department made the following points concerning the cash flow statement:
• Although 1998 will be a year of negative $6.9 million net income (a net loss),
cash flow from operations was projected to be a positive $6.5 million. The
$13.4 million difference primarily results from the increased claims, including
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IBNR claims. Establishing realistic targets for provider contract negotiations

will be critical.
• The trend of cash from operations being higher than net income is projected
to reverse itself by the end of the forecast period, because Lifelong will pay a
greater proportion of its providers in advance.
Review of the Pro Forma Cash Flow Statement
Dr. Chandler commented that she felt confident about being close to having a solid
forecast. She asked that the next review incorporate the changes discussed. She then
handed out copies of a page entitled “The Seven Keys to a Sound Strategic Financial
Plan,” shown in Figure 11C-7. Dr. Chandler noted that Lifelong’s strategic financial plan
has assumptions that are consistent with its strategic plan. She also acknowledged that
the projected results would stretch the team, but were achievable.
Dr. Chandler asked that more sensitivity analysis be performed and scheduled a
separate meeting to develop contingency plans. She noted that early indicators,
including PMPM targets, seemed like a good way to stay on top of achieving Lifelong’s
strategic goals. Dr. Chandler asked that Lifelong’s vice president of human resources be
invited to the next meeting so that he could start thinking about linking incentive
compensation to the plan. Dr. Chandler concluded her comments by stating that “the
strategic plan and the strategic financial plan are working documents and should
constantly be reviewed to determine what is working and what needs to be changed.”
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Chapter 12 A
Financial Statement Analysis
• Differentiate between a health plan’s external analysts and internal analysts and
describe the types of financial information each one seeks
• Distinguish between horizontal analysis and vertical analysis of an health plan’s
financial statements
• Analyze the trends a health plan exhibits using trend analysis
• List and apply the information contained in a common-size financial statement
• Explain how to use cash flows that are reported in the cash flow statement to
reveal financial information that is not immediately apparent from a health plan’s
balance sheet and income statement
Financial statements provide glimpses of a health plan’s past performance and current
condition, and they can be one of the tools used to predict its future success. Financial
statements are also a primary means for a health plan to communicate information to
various audiences, including internal managers, creditors, regulators, stockholders or
policyholders, employers and other plan sponsors, and plan members. But financial
statements require interpretation; otherwise, they are nothing more than columns of
numbers.
Financial analysis, also called financial statement analysis, is a process that assesses
a company’s financial performance and position and compares the company with other
companies within and outside its industry. The balance sheet, the income statement,
and the cash flow statement are the financial statements typically used in conducting a
health plan’s financial analysis.
External Analysis and Internal Analysis
Recall from Health Plan Financial Information that a variety of external and internal users
of financial information are interested in a health plan’s financial statements. Many of
these people and organizations analyze the health plan’s financial statements. Each
party has different goals and purposes for conducting financial analysis.
Just as we discussed users of financial information in the context of internal and external
users, we separate the people that are interested in financial analysis into external and
internal analysts. Both types of analysts use some or all of the following techniques:
horizontal analysis (including trend analysis), vertical analysis (including common-size
financial statement analysis), ratio analysis, and benchmarking.
External Analysis
External analysis is financial analysis performed by someone outside of the company

being analyzed. Most external users of a health plan’s financial information conduct
financial analysis themselves, but some also rely on analysis conducted by other
external parties. Examples of external parties that typically conduct their own analysis
include investment firms, public accounting firms, regulatory authorities, and
independent organizations such as the National Committee for Quality Assurance
(NCQA), A.M. Best, Standard & Poor’s, and Moody’s.
Employers and other plan sponsors, plan members, and individual stockholders usually
rely on published analytical materials. Note that most external analysts, whether they
conduct financial analysis themselves or rely on analyses conducted by others, want
comparative data—that is, they want to note a health plan’s financial condition and
performance in comparison with that of other health plans.
Internal Analysis
Internal analysis is financial analysis undertaken by employees of the company being

analyzed. Usually, a health plan’s managers conduct internal analysis (1) to maintain
awareness of the needs and interests of all external parties and (2) to determine where
to allocate health plan resources to support growth and ongoing business operations.
Although external analysts usually have available to them only published reports and
financial statements, internal analysts may access additional financial information that is
typically not released to the public. As a result, internal analysis can be more detailed
and more specific than external analysis.
Some types of internal analysis compare two or more accounting periods to determine
trends in financial performance. For example, in the case study in Case Study: Lifelong
Health, Inc., the senior management team at Lifelong Health, Inc. reviewed Lifelong’s
historical financial performance for strategic planning purposes. Other types of internal
analysis compare one health plan’s performance with the performances of other health
plans, or even other companies, to evaluate the performance of specific management
personnel and individual departments or functions within the health plan.
Comparative Financial Statements
A health plan’s financial statements are an important source of financial information for
both external analysis and internal analysis. However, numbers on a financial statement,
when viewed in isolation, usually do not tell a complete story about the health plan’s
financial condition or performance.
Suppose a health plan made $120 million in claims payments in 2003. The relative
importance of this amount would depend on the relationship between the amount of
claims payments and the amount of premium income the health plan earned in 2003, the
number of plan members in the health plan’s health plan, the amount of claims
payments made in other years, and so on.
Financial analysts obtain additional insight by relating one set of numbers to another set
of numbers or by analyzing the change in one or more numbers over a period of time.
For example, to determine the amount of cash needed to pay IBNR claims, an health
plan can analyze the historical relationship between the health plan’s premium revenues
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and IBNR claims. Then the health plan can determine an estimated percentage of
premiums that will be necessary to meet its IBNR claims liabilities.
One approach to addressing the limitations of analyzing a health plan’s financial

statements out of context is to use comparative financial statements. Comparative
financial statements are financial statements that present a company’s financial
information for two or more accounting periods side by side. In other words, comparative
financial statements enable a financial analyst to review any changes in a health plan’s
financial statement items from one year (or any other accounting period) to the next.
Both internal and external analysts use some or all of the following techniques:
horizontal analysis (including trend analysis), vertical analysis (including commonsize
financial statement analysis), ratio analysis, and benchmarking.
Horizontal Analysis
Comparative financial statements are useful in conducting horizontal analysis.

Horizontal analysis measures the numerical amount that corresponding items change
from one financial statement to another over consecutive accounting periods. Horizontal
analysis shows the absolute amount of the increase or decrease in an item, along with
the percentage increase or decrease. The earliest period being used in the analysis is
known as the base period, because all comparisons are made with the amounts and
percentage relationships of items in the base period.
Horizontal analysis is fairly straightforward. To compute the percentage change using

horizontal analysis, subtract the base period amount from the amount of the period being
studied. Next, divide that result by the base period amount. Finally, multiply the total by
100 to put the answer in percent form, as indicated in the following equation:
Figure 12A-1 shows Sheridan Health Networks (Sheridan’s) 1997 and 1998
consolidated balance sheets. We will use the information in this figure to conduct a
horizontal analysis of Sheridan’s balance sheet items.
Notice that Sheridan had total assets of $1,555,257 (in $000s) in 1997 and total assets
of $1,664,555 (in $000s) in 1998. Recall that the focus of horizontal analysis is the
percentage change between the two periods. In our example, assume that 1997 is the
base period and that 1998 is the period under study. The percentage change in total
assets from 1997 to 1998 is:
Thus, Sheridan experienced a 7.03% increase in total assets from 1997 to 1998. Figure
12A-2 illustrates Sheridan’s income statements from the same two years.
To perform a horizontal analysis of Sheridan’s selling expenses in 1997 and 1998, look
at the selling expense totals in Figure 12A-2 for each year. Next, notice that Sheridan
incurred $65,131 (in $000s) in selling expense in 1997 and $68,259 (in $000s) in selling
expense in 1998. Once again, the base period is 1997. The percentage change in selling
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expense is
This information indicates that Sheridan’s selling expense increased nearly 5% from
1997 to 1998. A health plan’s annual report may contain up to five years of financial
statements. A health plan’s Annual Statement—which is required if the health plan is
regulated under state insurance requirements—includes at least two years of financial
statements. Therefore, similar calculations can be made for every category on two or
more of a health plan’s financial statements, whether they were prepared under GAAP
or under SAP.
Trend Analysis
Although our example compares just two consecutive accounting periods, health plans
frequently prepare comparative balance sheets, income statements, and cash flow
statements across several accounting periods. One form of horizontal analysis used to
address changes across multiple accounting periods is trend analysis.
Recall from Pricing and Rating that trend analysis involves the calculation of percentage
changes in financial statement items over several consecutive accounting periods, they
were prepared under GAAP or under rather than over just two accounting periods. Trend
analysis is useful in developing a health plan’s premium rates to charge for a given level
of healthcare benefits. Trend analysis is also useful in constructing an health plan’s
strategic plan.
Both the direction and the velocity of trends are important factors that can be determined
from analyzing a health plan’s comparative financial statements. The term direction
refers to whether a trend displays an increase or decrease in account amounts. The
term velocity refers to whether the increase or decrease in an account is gradual or
rapid. Examining the direction and velocity of trends enables an analyst to compare
trends in relative items.
Analysts may describe the direction of a trend as positive (an increase in total revenues)
or negative (an increase in total expenses). Likewise, the velocity of a trend may be
described as gradual, stable, or rapid. For example, a financial analyst may describe the
velocity of Sheridan’s increasing premium income as
• Gradual : f the trend is increasing at a rate greater than 2%, but less than or
equal to 3%, per year
• Stable : if the trend is increasing at a rate less than or equal to 2% per year
• Rapid : if the trend is increasing at a rate greater than 3% per year
Trend Analysis
To conduct trend analysis across multiple accounting periods, first select a base period
and assign the base period an index number of 100. The use of an index number
provides a statistical method for measuring the change in a variable. The next step in
this process is to calculate a series of index numbers by reference to the base period.
If the amount of the period being studied is higher than that of the base period, then the
resulting index number will be greater than 100. If the amount of the period being studied
is lower than that of the base period, then the resulting index number will be lower than
100. For example, an index number of 120 indicates a 20% increase between the base
period and the period being studied. An index number of 80 indicates a 20% decrease
between the base period and the period being studied.
After determining the index number for the base period, apply the equation for
calculating percentage changes used in horizontal analysis to determine the percentage
increase or decrease for each period under study. Then, apply the percentage change to
the base period’s index number of 100. Finally, analyze the change in the period under
study to determine the trend.
Figure 12A-3 provides information we can use to perform a simplified trend analysis,
using the direction and velocity of trend, as applied to the Wholesome health plan’s
comparative income statements. Note that, for our simplified example, premium income
is Wholesome’s only cash inflow; claims payments and selling expenses are
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Wholesome’s only cash outflows. Also note that both premium income and claims
payment expenses increased during the three-year period under study, but selling
expenses remained stable for two years, then declined in 1998.
Let’s apply the equation from horizontal analysis for calculating the percentage changes
in income and expenses to the information in Figure 12A-3. Assume that 1996 is the
base period. Figure 12A-4 shows how trend analysis is performed for these income
statement items.
In this case, Wholesome’s net income decreased 50% in 1997 from the base year 1996
and 80% in 1998 from the base year 1996. Let’s focus on analyzing the changes in
these four income statement items—premium income, claims payment expenses, selling
expenses, and net income—for 1997 and 1998.
Figure 12A-4 , note that the percent increases in claims payment expenses (20% in
1997 and 40% in 1998) outpaced those of premium income (10% in 1997 and 20% in
1998), despite a decrease in selling expenses (0% in 1997 and 5% in 1998). The result
is a significant decrease in net income (50% in 1997 and 80% in 1998).
Keep in mind that, whenever the base period amount is greater than the amount of the
period under study, the resulting percentage change is a decrease. In our example, the
direction of trend for Wholesome’s net income is a decrease for both years (a 50%
decrease in 1997 and an 80% decrease in 1998). The velocity of trend for Wholesome’s
net income is rapid—a 50% decrease in 1997 and an 80% in 1998—given the same
criteria that were given for the Sheridan example earlier in this lesson. The disparity
between cash flows into and out of a health plan, which is indicated through an analysis
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of the health plan’s comparative financial statements, would trigger an investigation by

the health plan’s management.
Both the direction of trend and the velocity of trend in premium income are positive for
Wholesome because this represents an increase in cash inflows. Although the direction
of trend in selling expenses is positive for Wholesome, it is not enough to offset the
direction of trend in claim payments expenses. Also, the velocity of trend is worthy of
serious consideration because the flow of money out of Wholesome is increasing each
year. This example depicts an extreme trend in net income. In practice, Wholesome’s
management should have addressed this disturbing trend long before 1998.
Comparative financial statements often present the year-to-year (or other accounting
period-to-accounting period) changes in absolute amounts as well as percentages. An
analyst should consider both the amount and the percentage change. A large
percentage change, either in a negative or a positive direction, is significant only if the
item being analyzed is consequential. For example, a 50% decrease in a health plan’s
petty cash may be deemed insignificant, but a 50% decrease in the health plan’s
premium income is cause for alarm.
External financial analysts and health plan managers generally use trend analysis to
identify financial statement accounts or other items that appear unusual. However, trend
analysis cannot be used to express fluctuations between negative amounts and positive
amounts as index numbers. For example, index numbers cannot describe the change in
net income from -$1,000 (a net loss) in one period to $1,000 (net income) in the next
period. Also worth noting is that percentage changes are relevant only when compared
with the base period amount. To compare percentage changes between the amounts of
two other accounting periods, one of those periods must become the new base period.
Insight 12A-1 is an example of the use of trend analysis to note changes in HMO
enrollment, revenues, and net income from 1993 to 1997.
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Vertical Analysis
As we have seen, horizontal analysis highlights changes in a financial statement item

over time. Vertical analysis is a type of financial analysis that indicates the relationship
of each financial statement item to another financial statement item. Usually the item to
which all other items are compared is critical to a health plan’s financial performance.
For example, to conduct vertical analysis of a health plan’s balance sheet, an analyst
divides each asset item by total assets, and divides each liability or stockholders' equity
item by total liabilities and stockholders' equity (or total liabilities and capital and surplus
on a SAP-based balance sheet). The combined percentage totals of all asset accounts
or liabilities and stockholders' equity accounts should equal 100. On a health plan’s
income statement, each item is typically stated as a percentage of total revenues, which
equals 100%. In other words, an analyst divides each item by the health plan’s total
revenues.
Figure 12A-5 shows a vertical analysis of Sheridan’s consolidated balance sheets for
1997 and 1998. The analysis in Figure 12A-5 uses total assets for each respective year
as the denominator for performing a vertical analysis of Sheridan’s assets.
Sheridan’s balance sheets show that, for 1997, current assets represent 84.5% of
Sheridan’s total assets. Note also that investment securities represent a large
percentage of Sheridan’s total assets: 49.9% in 1997 and 48.7% in 1998. Sheridan’s
percentage of net receivables increased slightly in 1998 from 1997.
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On the liabilities and stockholders' equity side of the balance sheet, Sheridan’s current
liabilities were 47.4% in 1997 and 48% in 1998 of total liabilities and stockholders’
equity. Remember that the dollar amount of total assets must equal the dollar amount of
total liabilities and stockholders’ equity on the balance sheet. Sheridan's stockholders’
equity was 32.5% of total liabilities and stockholders’ equity for both years.
Care should be taken when determining the significance of vertical analysis percentages
of different years. Sometimes a percentage change may seem unimportant, but the
dollar amount of that change may be critical to a health plan. For example, although the
percentage increase in Sheridan’s net receivables was relatively small—from 15.1% in
1997 to 16.5% in 1998—the dollar amount ($40,573,000) was significant. Recall that net
receivables are primarily premium receivables that are amounts owed to a health plan
for services that have already been provided. In this case, Sheridan’s management
would most likely review its collections procedures and other factors to determine the
cause of an increase in net receivables, then take the appropriate action to reduce the
amount of receivables.
Review Question
Assets
Liabilities
An analyst at Rouge determined that current assets represented approximately 81% of

Rouge’s total assets. This type of analysis, which indicates the relationship of one
financial statement item to another financial statement item, is called:
vertical analysis
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horizontal analysis
trend analysis
benchmark analysis
Correct. Vertical analysis is a type of financial analysis that indicates the

relationship of each financial statement item to another financial statement item.
Incorrect. Horizontal analysis measures the numerical amount that corresponding

items change from one financial statement to another over consecutive
accounting periods.
Incorrect. A form of horizontal analysis used to address changes across multiple

accounting periods is trend analysis
Incorrect. Benchmarking is a process by which a company compares its own

performance, products, and services with those of other companies or
organizations that are recognized as the best in a particular category
Common-Size Financial Statement Analysis
Vertical analysis uses percentages to relate different financial statement items to a

specified, total amount on the statement. Vertical analysis can also be used to compile a
common-size financial statement, which is a financial statement that displays only
percentage relationships to a specified item; there are no dollar figures for each item.
Balance sheets and income statements are often exhibited as common-size statements.
Figure 12A-6 presents Sheridan's 1997 and 1998 common-size consolidated income
statements. Each line item is expressed as a percentage of Sheridan’s total revenues for
each respective year. In other words, total revenues is the common size to which all
other income statement items are compared.
Analysts use a common-size financial statement to compare the percentages associated
with a health plan’s current and previous accounting periods. In addition, common-size
statements allow a health plan to compare itself to another health plan or to published
industry averages. The use of common-size statements also somewhat facilitates the
comparison of companies in different industries, which is especially valuable to potential
investors.
Because all amounts are stated in relative terms rather than absolutes, common-size
financial statements facilitate the comparison of companies of different sizes in the same
industry. For example, a staff model HMO may compare its PMPM rates to those of
other staff model HMOs in its geographic area.
Assume that health plan A’s net income on its 1998 income statement was $450 million
and that health plan B's net income for 1998 was $150 million. It would be easy to
conclude that health plan A is more profitable because it had a greater net income that
health plan B. However, a review of each health plan’s 1998 common-size income
statement reveals additional information.
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Suppose health plan A’s common-size income statement indicates that health plan A’s
net income is 3% of its total revenues. Health plan B’s common-size income statement
shows that health plan B’s net income represents 5% of its total revenues. From another
perspective, expenses are 97% of health plan A’s total revenues, whereas expenses are
95% of health plan B’s total revenues. The information provided by common-size income
statements suggests that, although health plan B's net income is lower, all other factors
being equal, health plan B appears to be operating more efficiently tha health plan A.
In the above example, health plan A and health plan B obtain most of their revenues
from premium income. Suppose health plan C receives most of its revenues from
administrative services only (ASO) contracts for self funded plans. In this case, health
plan C will most likely have administrative expenses that are a higher percentage of its
premium income, and premium income that is a smaller percentage of its total revenues,
as compared with health plan A and health plan B, which have few or no ASO contracts.
In order to compare the efficiency of health plan C with that of health plan A and health
plan B, some analysts recognize “premium equivalents,” which include management fee
income from ASO contracts.
Benchmarking
Common-size statements are also a useful tool for benchmarking, which is a process
by which a company compares its own performance, products, and services with those
of other companies or organizations that are recognized as the best in a particular
category. Benchmarking measures a health plan’s performance and practices and helps
identify those practices that will lead to superior performance in a variety of financial and
non-financial areas.
Benchmarking also helps a health plan to assess which performance areas require
improvement. Setting specific goals for improvement within an established time frame is
a typical outcome of benchmarking. Some examples of healthcare practices or financial
performance measures that health plans typically benchmark with other health plans
include wait time in a doctor’s office, independent quality ratings, inpatient length of stay,
claims payment turnaround time, and key financial ratios.
Figure 12A-7 lists some additional examples of practices that health plans typically
benchmark in the health plan industry. Note that it is critical for a health plan to
benchmark against the same line of business. For example, when benchmarking its
employer group plan, a health plan would not typically compare its results with those of a
Medicare plan.
Suppose that, in our earlier example, health plan A’s management discovered that its
expenses were significantly higher than those of health plan B and most other health
plans. A next step for health plan A’s management probably would involve a review of
internal operations and related factors in an effort to decrease expenses so they are
within the industry range. This attention to expenses would ultimately enable health plan
A to increase the percentage relationship between net income and total revenues.
Health plans and providers can also benchmark against companies in other industries.
For example, to improve inpatient service, a hospital may benchmark against other
hospitals, but it may also want to benchmark against the hotel industry or the restaurant
industry. A health plan may benchmark the quality of its nurse advice line against “best
practices” available through customer service lines and call centers provided for
customers in the catalog sales industry or in the mutual funds industry. Alternatively, a
health plan may compare its call wait times and lost call percentages to those of the
airline industry. The ideal benchmarking candidates are those health plans or other
companies with a high level of performance in the area being studied, and with similar
asset size, business mix, market, and ownership structure.
A health plan’s benchmarking goals should be as explicit as possible. For example,

instead of setting the general goal of “reducing operating expenses,” a health plan would
typically select as a benchmark a similar-sized health plan that is known as an industry
leader in operating expense cost control. Using vertical analysis, the health plan could
then set the goal of equaling the benchmarked health plan’s percentage of operating
expenses to revenues by the end of the following accounting period. In this case, the
health plan could establish a goal of reducing operating expenses to less than 95% of
total revenues.
Cash Flow Statement Analysis
To this point, we have discussed financial analysis as it pertains to a health plan’s

balance sheet and income statement. However, a health plan should also analyze its
cash flow statement to gain a complete understanding of the health plan’s financial
condition. The cash flow statement can be a valuable aid in determining the health plan’s
future direction. Recall that the cash flow statement details the sources and uses of cash
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by segregating the statement into cash flows from operating activities, investing
activities, and financing activities.
Analyzing a health plan’s cash flow statement is important for both internal and external
analysis. For example, nearly all interested users of financial information prefer that a
health plan obtain cash from operating activities because this indicates that a health
plan’s core business operations are healthy and active. Consider the following three
circumstances in which a health plan can acquire a $250,000 net cash inflow:
• Higher, profitable sales volume (operating activity)

• The sale of a line of business (investing activity)
• A stock issue (financing activity)
If you were a potential plan sponsor, under which circumstance would you prefer to
contract with a health plan? You would probably prefer the health plan that obtained
most of its net cash inflow from operating activities, rather than from investing activities
or financing activities. High dollar amounts of net cash inflows from operating activities
usually indicate soundness in the health plan’s core business operations. This financial
strength in turn enables a health plan to finance and deliver healthcare services to
members of your sponsored group.
Similarly, if you were a potential creditor, under which circumstance would you prefer to
lend money to a health plan, all other factors remaining equal? As a creditor, you would
probably prefer that the health plan obtain most of its revenues from core business
operations, because this increases the likelihood that the health plan will be able to
repay any loans provided by the health plan’s current and future creditors. Selling a line
of business or issuing stock are one-time activities that are not likely to be repeated in
subsequent years. However, it is possible that a health plan could experience increasing
revenues on an annual basis.
As a potential investor, you would probably prefer to invest in a health plan that has
increasing sales revenues, again because it increases the likelihood that the health plan
will be profitable. You might be uneasy about investing in a health plan that just sold a
line of business, particularly one that might have been profitable, or a health plan that
has incurred additional debt or diluted the potential value of your stock by issuing
additional shares of stock.
All other factors being equal, the health plan that obtained $250,000 from an operating
activity would be more attractive to a plan sponsor, creditor, or investor than a health
plan that generated the majority of its net cash flows (that is, cash inflows minus cash
outflows) from financing or investing activities. Generally, the larger the cash inflows
from operating activities, the better able a company will be to pay its obligations and to
weather unfavorable changes in the economy. Given this information, a health plan’s
management could decide to sell an unprofitable line of business, then use the proceeds
from this sale to expand its relatively strong lines of business against competing health
plans.
This brief analysis is admittedly simplistic. The point of this illustration is to provide you
with a preview of how you might begin to use financial analysis to make rational
decisions about a health plan’s financial strength or performance. In this example, the
health plan’s interested parties would go beyond this one scenario to consider other
factors.
Suppose the health plan obtained higher sales volume, but at significantly higher
expenses. In this case, the operating activity could be interpreted as a negative factor.
What if the health plan obtained $250,000 from the sale of an unprofitable line of
business? In this case, the investing activity could be perceived as a positive factor.
Likewise, if the health plan issued stock to raise funds to finance a potentially profitable
expansion or acquisition, interested parties could interpret this factor as a positive one.
Figure 12A-8 summarizes a health plan’s typical operating activities, investing activities,
and financing activities.
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Chapter 12 B
Fundamentals of Ratio Analysis
• List and apply the financial ratios under U.S. generally accepted accounting
principles (GAAP) that fall into each of these four categories: liquidity, activity,
leverage, and profitability
• Recognize and apply the ratios that are most important to health plans
Managers use the information contained in a health plan’s financial statements and other
documents to measure the efficiency with which the health plan is achieving the strategic
financial plan. Recall that a health plan’s strategic financial plan typically includes goals
related not only to its current financial performance, but also to its growth rate. Financial
statement analysis is an objective technique for measuring a health plan’s performance
and its progress toward a sustainable rate of growth.
One of the most widely used methods of financial statement analysis is ratio analysis.
Ratio analysis consists of comparing various financial statement values for the purpose
of assessing a health plan’s financial performance or condition. A ratio is a comparison
of two or more numbers in fraction form. A ratio may be stated as a fraction; for example,
one-half may be written as either ½ or 1:2. The 1:2 is read as “one to two.”
Because any financial statement item can be related to any or all other financial
statement items, many potential ratios exist. But only a limited number of ratios are
meaningful, and not all ratios are applicable to all types of businesses. For example,
acceptable ratio results for a health plan are going to be quite different from the
acceptable ratio results for a clothing manufacturer or a public accounting firm.
Ratio analysis should also be conducted with a general understanding of the health plan
being studied and its environment. Because healthcare costs, benefits, demographics,
and forms of business typically differ regionally—and sometimes across health plans
within a specified region—it is important to compare a health plan’s ratios with similar
health plans in terms of these and other factors.
Published ratios are available for health plans to use in benchmarking specified
performance areas. Also, health plans that are subject to statutory solvency
requirements must comply with the established ranges of acceptable ratios for risk-
based capital (RBC) requirements, which we discussed in Risk Management in health
plans lesson.
Ratio analysis can answer a health plan’s direct (yes or no) questions, such as: “Can
short-term liabilities be paid on time?” or “Is the health plan efficiently using its assets to
generate profits?” However, ratio analysis does not address "why" questions such as:
“Why are current (short-term) liabilities exceeding current (short-term) assets?” or “Why
is the health plan unable to pay claims or reimburse providers within 30 days?”
Meaningful ratio analysis serves best only to point out changes or trends in operating
performance and help illuminate the hazards or opportunities associated with normal
business operations.
The relationships created by ratio analysis help to highlight a health plan's strengths and
weaknesses, thus revealing areas that need attention or additional research. For
example, a health plan’s current assets may seem adequate on the balance sheet, but
only when they are applied in the current ratio can their adequacy be confirmed or
contradicted. For this reason, ratio analysis is an important part of a SWOT analysis,
which we discussed in The Strategics Planning Process In health plans.
Before proceeding further, a few words of caution. First, other than regulatory mandates
for calculating specified ratios, there are few standards for calculating financial ratios.
For example, sometimes the formula for calculating a health plan’s return on assets ratio
and its return on investment ratio yield the same results; sometimes there is a slightly
different formula for each ratio. Consequently, this assignment cannot provide an exact
description for every financial ratio used in every analysis. Instead, we review some
commonly used ratios and indicate the type of information typically provided by these
ratios.
Keep in mind that the calculations in this lesson represent only one way of describing
each ratio. Also, because of the nature of the health plan industry, not all traditional
financial ratios are applicable to all health plans. For example, health plans do not
typically have inventories, make purchases or sales on an installment basis, or acquire
large amounts of fixed assets. Therefore, ratios involving inventories, most accounts
payable, most accounts receivable, and fixed assets, which are common in many
industries, are less critical or even lose meaning when applied to health plans.
As we noted in Accounting and Financial Reporting, health plans often prepare financial
statements under two different bases of accounting: generally accepted accounting
principles (GAAP) and statutory accounting practices (SAP). Recall that statutory
accounting is required for the Annual Statement, which must be submitted by any health
plan that must comply with state insurance requirements. Note, however, that ratio
analysis is also conducted for taxation purposes and that a health plan’s management
team may develop specific financial ratios to use in monitoring the health plan’s progress
toward achieving its strategic goals.
GAAP Ratios
This section describes traditional financial ratios that analysts use to study a health
plan’s GAAP-based financial statements. It is important for a health plan’s managers to
be familiar with these ratios because they should be able to analyze the health plan’s
financial statements, as well as those of other health plans.
In this section we categorize ratios as liquidity ratios, activity ratios, leverage ratios, and
profitability ratios. We apply each ratio to the 1998 balance sheet and income statement
from Lifelong Health, Inc. (Lifelong), which are presented in Figures 12B-1 and 12B-2.
Recall that we discussed Lifelong in a case study in The Strategic Planning Process In
Health Plans.
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Liquidity Ratios
Liquidity ratios measure a company’s ability to meet its current liabilities. Current
liabilities, also called short-term liabilities or short-term obligations, are those debts that
a company must pay within one year. For a health plan, liquidity is critical because a
sufficient amount of current assets—for example, cash and other liquid assets—must be
available when needed to pay medical expenses—particularly IBNR claims—and
general business expenses. Current assets, also called short-term assets, are those
assets that a company expects to use up or convert to cash during the current
accounting period, typically one year.
Because a health plan receives premium income in advance of the provision of

healthcare services, liquidity is typically not a problem, unless the health plan capitates
its providers. In such cases, at the beginning of each month, a health plan may receive
cash inflows (from premium income), which immediately become cash outflows (for
provider reimbursement). Having sufficient cash on hand is important to meet the
obligations to pay IBNR claims when a health plan becomes aware of them. For this
reason, liquidity is particularly important for health plans that capitate most or all of their
providers.
Current assets produce little, if any, return on investment. As a result, health plans try to
maintain as low a level of liquidity and as high a level of invested cash as possible, while
ensuring that their current liabilities can be met. Let’s look at some key liquidity ratios as
they apply to Lifelong’s balance sheet.
Current Ratios
The current ratio is the ratio of a health plan’s current assets to its current liabilities. We
calculate this ratio as current assets (the numerator) divided by current liabilities (the
denominator). In our example, Lifelong’s 1998 balance sheet has current assets of
$588,028,000 and current liabilities of $260,625, 000, so its current ratio is
A current ratio of 1.0 means that a company theoretically has enough current assets to
cover all of its current liabilities. Lifelong’s current ratio is 2.26; this means that Lifelong
has more than twice the amount of current assets necessary to fulfill its current
obligations. There is no standard current ratio result for all companies in all industries.
An average current ratio in the health plan industry is 1.2 to 1.4.
The higher a health plan’s current ratio, the greater its liquidity and the greater the ease
with which the health plan can cover its short-term obligations. A current ratio that falls
below 1.0 generally indicates that a health plan’s liquidity may be too low. In this case,
the health plan could be forced to sell long-term assets to cover current liabilities if an
unexpected event, such as several multiple births or an epidemic, occurred. On the other
hand, if a health plan experiences predictable cash flows, the health plan generally can
accept a lower current ratio.
Review Question
Assets
Liabilities
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Rouge’s current ratio at the end of 1998 was approximately equal to:
0.84
1.06
1.19
1.31
Incorrect. The formula is Current Assets/Current Liabilities
Correct. 950,000/800,000 = 1.19
The Quick Ratio and the Cash Ratio
The quick ratio and the cash ratio are more restricted variations of the current ratio. The
quick ratio is similar to the current ratio, but excludes the dollar amount of a health plan’s
inventory from the health plan’s current assets. A health plan calculates the quick ratio
by subtracting inventory from current assets and dividing the result by current liabilities.
For companies, like many health plans, that do not have inventories, the quick ratio
equals the current ratio. In our example, Lifelong has no inventory, so its quick ratio and
its current ratio are equal.
The Quick Ratio and the Cash Ratio

The cash ratio is the ratio of a health plan’s cash to its current liabilities. In other words,
the amount included in the numerator excludes all other current assets. In our example,
Lifelong’s cash ratio is
Lifelong’s cash ratio indicates that Cash is a relatively small percentage of Lifelong’s
current assets. In this case, it appears that Lifelong’s management has chosen to
maintain as little cash as possible and to invest the remainder.
Days in Accounts Receivables
The days in accounts receivable, also called the average collection period, is
calculated by dividing a health plan’s accounts receivable by its average daily revenues.
Suppose a health plan had $20 million in premiums receivable and $365 million in
annual revenues. In this example, the health plan would have an average collection
period of 20 days:
Because most of a health plan’s accounts receivable are premiums receivables, the
average collection period is the number of days that the health plan takes to collect
premium income from plan sponsors and others. In the event that healthcare benefit
services are rendered by a health plan before the health plan receives premiums for
those services, the average collection period will increase.
The longer it takes for a health plan to collect premium income, the higher the risk that a
health plan has a collection problem. Should premium income become uncollectable, the
health plan may have to write off the amount of uncollectable premium income as a bad
debt. In this case, the health plan would have to report lower premium income—and,
ultimately, lower net income—than it otherwise expected.
Again, because plan sponsors typically pay premiums a month in advance of receiving
healthcare benefits, a health plan usually has a sufficient amount of cash on hand to pay
its ongoing obligations, such as claims obligations and provider reimbursement. A typical
circumstance in which a health plan may not receive premium income prior to providing
healthcare benefits occurs when increases in the number of eligible plan members have
not been reported to the health plan in time for that month’s premium payment.
Net Working Capital
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Another common method of measuring a health

plan’s liquidity is to calculate its net working capital.
Net working capital is obtained by using the
elements of the current ratio, but in subtraction form:
Current Assets - Current Liabilities. The amount of a
health plan’s net working capital indicates the
amount of excess cash (sometimes called “free
cash available for long-term investments”) that the
health plan may consider using for investment
purposes. We discuss the investment of excess
liquid assets in Management Control. In our
example, Lifelong’s net working capital is:
Lifelong appears to have excess cash available for investment. Upon calculating the
liquidity ratios, we see that Lifelong’s liquidity is one of its strengths as a health plan.
Figure 12B-3 presents these liquidity ratios in summary form.
Activity Ratios
Activity ratios, also called operating efficiency ratios or operating ratios, measure how
quickly a health plan converts specified financial statement items into premium income
or cash. Activity ratios gauge a health plan’s productivity and efficiency. In other words,
activity ratios measure how well a health plan utilizes its assets to generate revenues.
Below is a discussion of several key activity ratios for health plans.
Total Asset Turnover Ratio

One activity ratio, asset turnover, is a standard
activity measure in most industries, including the
health plan industry. There are several versions of
the asset turnover ratio, each of which is found by
dividing a health plan’s total revenues by some
measure of assets, such as cash, invested assets,
or fixed (long-term) assets. An important asset
turnover ratio for health plans is the total asset
turnover ratio, which is a health plan’s total
revenues divided by its total assets. Below is the
calculation for the total asset turnover ratio and
Lifelong’s total asset turnover.
This information indicates that, for every $1.00 invested in assets, Lifelong was able to
generate $1.11 in revenues. Note that total asset turnover generally relates an item from
the income statement (total revenues) to an item on the balance sheet (total assets).
Some versions of this activity ratio use average total assets during a specified
accounting period as the denominator. For the purposes of our discussion, the
denominator is the amount of total assets on a health plan’s balance sheet. In the
numerator, we use total revenues because, for a health plan, generating investment
income is part of its core business operations.
Generally, the higher a health plan’s total asset turnover, the more efficiently it has used
its assets. For example, assume that the total asset turnover for health plan A is 1.0 and
the total asset turnover for health plan B is 2.0. This information indicates that health
plan B has generated $2 for each dollar invested in total assets, while health plan A has
generated only $1 for each dollar invested in total assets. Thus, we could infer that
health plan B has used its assets more efficiently. Note that health plans that own their
medical facilities may have a lower total asset turnover tha health plans that do not own
their own facilities. In this case, a health plan that owns its medical facilities is not
necessarily less efficient than a health plan that has leased its facilities.
Fixed-Charge Coverage Ratio
The fixed-charge coverage ratio is the ratio of earnings before interest and taxes
(EBIT) divided by all fixed-charge obligations, which include interest payments, taxes,
principal payments, and preferred stock dividends. Unlike dividends on common stock,
preferred stock dividends are a fixed obligation that must be paid to preferred
stockholders, regardless of a health plan’s earnings level. The fixed-charge coverage
ratio indicates a health plan’s ability to meet fixed payments, given its earnings during a
specified accounting period, as follows:
Fixed-Charge Coverage Ratio
A health plan incurs fixed-charge obligations if it owes taxes or if it decides to issue

bonds or preferred stock. The more fixed-charge obligations that a health plan has, the
higher the risk it has assumed, so the health plan will have a lower fixed-charge
coverage ratio. For example, a health plan with a fixed-charge coverage ratio of 2.4 has
EBIT that is more than twice its fixed-charge obligations. This health plan is not likely to
default on (be unable to pay) its obligations, assuming that the health plan has the cash
flows to pay its obligations on a timely basis. On the other hand, a health plan with a
fixed-charge coverage ratio of less than 1.0 does not have sufficient earnings to cover its
fixed payments.
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The fixed-charge coverage ratio includes all fixed payments that a health plan is
obligated to pay. Other activity ratios attempt to isolate specified components of a health
plan’s contractual fixed charges such as interest payments. Variations of the fixed-
charge coverage ratio include the times interest earned ratio and the debt-service
coverage ratio.
Times Interest Earned Ratio
The times interest earned ratio is calculated by dividing a health plan’s EBIT by its
contractual interest payments only. This ratio directly relates a health plan’s interest
payments to its EBIT, as follows:
Debt Service Coverage Ratio
The debt service coverage ratio relates a health plan’s EBIT, not only to all its inter-est
payment obligations, but also to all its principal and lease payment obligations, as
specified in the following equation:
Again, the higher the times interest earned ratio and the debt service coverage ratio, the
more likely that a health plan would be able to cover its fixed, contractual obligations.
Figure 12B-4 presents these activity ratios in summary form.
Financial Leverage Ratios

Leverage is an important concept in finance. Leverage, also called trading on the equity,
is a financial effect in which the use of fixed-cost funds magnifies both risks and returns
to a health plan’s owners.
A health plan’s total leverage consists of two types of leverage: operating leverage and
financial leverage. Operating leverage is the effect whereby incurring fixed operating
costs automatically magnifies a company’s risks and potential returns. We are most
2
interested in financial leverage, which involves financing company assets with debt or
other borrowed funds.
If the assets in which a health plan’s borrowed funds are invested earn a rate of return
greater than the fixed rate of return required by the health plan’s creditors (i.e., suppliers
of borrowed funds), the result is positive financial leverage. This positive difference
boosts overall returns for the health plan’s owners. On the other hand, if the assets in
which the borrowed funds are invested earn a rate of return lower than the fixed rate
required by lenders, the result is negative financial leverage.
Recall from Pricing and Rating our discussion of margins in the context of pricing a
managed healthcare product. In the context of financial leverage, the difference between
the cost of borrowing the funds and the return earned using these funds is called the
margin, also called the profit margin or the spread.
Suppose a health plan borrows money at a 9% interest rate. If the health plan earns an
11% return on those borrowed funds, it has realized positive financial leverage with a 2%
margin. On the other hand, if the health plan earned only 6% on those borrowed funds, it
would have realized negative financial leverage with a –3% margin.
The preceding examples illustrate the leverage effect, or the effect that fixed costs have
on magnifying a health plan’s risk and return. The leverage effect applies to all
companies. The more money a health plan borrows, the more debt the health plan has,
and the greater the fixed costs associated with making payments on the debt. Thus,
financial leverage exposes the health plan to risk. But financial leverage also provides
funds that the health plan can use to increase net income. Increasing financial leverage
by borrowing money simultaneously increases a health plan's risk and potential return."
The leverage effect is an illustration of the risk-return tradeoff that we discussed in Risk
Management in health plans.
Traditional leverage ratios compare some measure of a health plan’s liabilities to some
indicator of the firm's financial strength. For many non-health plans, liabilities on the
balance sheet consist largely of accounts payable and long-term debt (bonds payable or
notes payable). For health plans, most liabilities are for claims payments, including IBNR
claims, and other contractual obligations such as provider reimbursements.
Because financial leverage ratios measure a health plan’s debt burden in relation to the
assets it owns to cover its debts, these ratios are sometimes called solvency ratios. Two
important GAAP ratios that apply to all companies, including health plans, are the debt
ratio and the debt-to-equity ratio.
Health plans use the debt ratio to measure the proportion of total assets financed with
liabilities. Specifically for health plans, the debt ratio measures the proportion of total
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assets against which plan contractors and others have legal claims, such as healthcare
benefits, including IBNR claims. The higher the debt ratio, the greater the health plan’s
financial leverage. The debt ratio is a balance sheet ratio that is found by dividing a
health plan’s total liabilities by its total assets. Lifelong’s debt ratio is:
A debt ratio of about 85% is considered average for a health plan, so Lifelong’s debt
ratio is well below the industry average.
Error on page -- 29 of 44
Debt-to-Equity Ratio
For most non-health plans, the debt-to-equity ratio measures the relationship between
the amount of assets provided by the health plan’s creditors and the amount of assets
provided by its stockholders. For a stock health plan, the debt-to-equity ratio measures
the relationship between the amount of liabilities to plan sponsors, providers, and
creditors and the amount of equity provided by the health plan’s stockholders.
The higher a health plan’s debt-to-equity ratio, the

more the health plans relies on borrowed funds to
cover future and current benefit payments, to pay
for ongoing business operations, and to finance
growth. The debt-to-equity ratio is calculated as
total liabilities divided by stockholders' equity.
Lifelong’s debt-to-equity ratio is:
Debt-to-Equity Ratio
The healthcare industry average for this ratio is about 0.83, so Lifelong has a
significantly higher debt-to-equity ratio than does its peers. Health plans usually have
high debt-to-equity ratios because of pending claims payments. A health plan’s current
liabilities typically represent a large portion of its liabilities, which in turn must be
supported by the health plan’s assets.
Figure 12B-5 presents these financial leverage ratios in summary form.

Profitability Ratios
Companies are in business to earn a profit. Profitability ratios relate the returns of a
health plan to its sales, total revenues, assets, stockholders' equity, capital, surplus (if
applicable), or stock share price. Profitability ratios enable a health plan’s interested
parties to
• Determine if management has operated the health plan efficiently to cover its
costs
• Calculate the return that compensates the health plan’s owners for the risk of
their investment
• Measure the efficiency with which management has used the health plan’s
assets and stockholders' equity to generate revenues
For these reasons, both internal and external users of a health plan’s financial
information pay close attention to the health plan’s profitability ratios. Relating a health
plan’s net income to its revenues is one way to determine how efficiently health plan
costs are managed. Common-size financial statements, described in previous lesson,
are a handy tool for evaluating health plan profitability in relation to revenues. For
example, a frequently cited profitability ratio that can be found in the common-size
income statement is net profit margin, which is explained later.
Comparing a health plan’s net income to its assets or stockholders' equity used in
generating that income is one method of measuring the effective management of health
plan assets and equity. Two useful ratios for this task are (1)return on assets and (2)
return on equity. In the following sections, we also describe several other measures of
profitability: earnings per share, the price/earnings ratio, and the dividend payout ratio.
Net Profit Margin
Net profit margin, also called rate of return on net sales or return on sales, shows how
much after-tax profit is generated by each dollar of total revenue. This ratio is found by
dividing net income, sometimes called net gain from operations, by total revenues.
Lifelong’s net profit margin is:
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The average net profit margin for a health plan is 2.8%. Lifelong's net profit margin is
negative because Lifelong had a net loss in 1998. Lifelong’s management will likely take
steps to improve its operating efficiency in the next accounting period.
Return on (Total) Assets
The return on assets (ROA) ratio measures a health plan’s success in using its assets
to earn a profit. This ratio indicates the productive use of business resources and is often
used to rank companies within the same industry. A health plan’s ROA is a strong
indicator of management's efficiency and is one of the most widely used measures of a
health plan’s overall success. Generally, the higher a health plan’s ROA, the better.
There are several variations of the ROA ratio, such as return on total assets (ROTA) and
return on invested assets (ROIA). Alternatively, a health plan may use the average of the
current year’s total assets and the previous year’s total assets as the denominator to
obtain the return on average total assets ratio. Many health plans also calculate the ratio
using different assets to compare the efficiency of various asset categories. In addition,
different health plans may employ different valuations of assets to make these
calculations. For the purposes of our discussion, we calculate ROTA using the end-of-
period value for assets on the health plan’s balance sheet. Using these criteria,
Lifelong’s ROTA is
The managed healthcare industry average for return on assets is 2.1%. In this case,
Lifelong is lower than average because it suffered a net loss in 1998.
Return on Equity
The return on equity (ROE) ratio, also called the return on stockholders' equity ratio,
measures the rate of return on the book value of the stockholders' investment in the firm.
Alternatively, a health plan could calculate its ROE by using the average stockholders’
equity for the current and previous years in the denominator. For the purposes of our
discussion, we calculate ROE by dividing a health plan’s net income by its stockholders'
equity as of the end of the period.
Generally, the higher and health plan's ROE, the better for the health plan's stockholder.
Earning per Share
Investors purchase shares of a health plan’s stock to realize a return in the form of cash
dividends and capital gains (capital appreciation). In this context, a capital gain is the
amount by which the selling price of an asset exceeds its purchase price. A health plan’s
net income forms the basis for stockholder dividend payments and any future increases
in stock values that will provide for capital gains. Therefore, a health plan’s reported
earnings per share on stock is one of the most important ratios to investors.
Earnings per share (EPS), also called earnings per share of common stock, is the
amount of net income per share of a company’s common stock. To calculate EPS, divide
the amount of net income that is available to common stockholders by the number of
common shares outstanding (outstanding common stock). Note that preferred stock
dividends are subtracted from net income to determine the amount of income available
to common stockholders.
In our example, Lifelong’s equity consists of retained earnings, but no common stock, so
we will use another company to calculate EPS. If health plan A has a net income of $10
million, no preferred stock, and 6,000,000 shares of common stock outstanding, then
health plan A’s EPS is
Because health plans generally do not issue preferred stock, the numerator of this ratio
is the health plan’s net income. Earnings per share is the only ratio that all companies
that have common stock must include in their financial statements. Not-for-profit health
plans do not calculate EPS because they do not have common stock. This ratio appears
on the income statement in a health plan’s annual report. Most health plans strive to
increase EPS by 10% to 20% annually.
A health plan’s EPS can be affected by several factors, including extraordinary items.
For this reason, these factors must be considered when calculating a health plan’s EPS
or when comparing the EPS of several health plans. Recall from Assignment 10 that an
extraordinary item, also called an extraordinary gain (loss), is an item that is unusual or
infrequent, such as damage caused by fire at a health plan’s home office.
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A health plan that reports an extraordinary item on its income statement also reports two
EPS figures. The first EPS is calculated using earnings before the extraordinary item,
and the second is calculated using earnings after the extraordinary item. For example,
assume that a health plan had earnings after interest and taxes of $1,560,000, a
$600,000 (net) extraordinary gain, and 1,200,000 shares of common stock outstanding.
Figure 12B-6 demonstrates the way to report the earnings per share before and after the
extraordinary gain. By computing the EPS both ways, the company avoids artificially
inflating its EPS, which would have overstated its normal income-producing ability.
Price/Earnings (P/E) Ratio
An often-quoted relationship between a health plan’s earnings per share and the current
market price of its stock is the price/earnings ratio. The price-earnings (P/E) ratio, also
called the earnings multiple, represents the amount of money that investors are willing to
pay for each dollar of a health plan’s earnings. Recall that health plan A's EPS was
$1.67. If we assume that the market price of health plan A’s stock is $35 per share, then
health plan A’s P/E ratio is
There is a wide range of interpretations of the P/E ratio. Generally, the higher the P/E
ratio, the greater the investor confidence in a company. In our example, health plan A’s
common stock price per share is selling for about 21 times its current earnings per
share. Stated another way, investors are willing to pay $21.00 for each dollar of health
plan A’s earnings.
Investors use the P/E ratio as a guideline in evaluating whether to buy stock or acquire a
company. Price/earnings ratios vary widely among companies and industries and are
most meaningful when compared to selected industry groups or market averages so that
comparisons of relative performance can be made. An average P/E ratio for a health
plan is between 10 and 15. In our example, health plan A’s common stock is overvalued
with respect to the industry average.
Dividend Payout Ratio
Investors generally hold shares of stock for two reasons: (1) to realize current income in
the form of cash dividends and (2) to realize appreciation in stock market values. One
function of a stock health plan’s board of directors is to determine the portion of net
income, if any, to pay out in dividends to stockholders. To make this decision, the board
must balance stockholders' expectation of dividends with the health plan’s need for
capital.
The dividend payout ratio represents the proportion of earnings (net income) paid out
to stockholders in the form of cash dividends. This ratio, which is presented in
percentage terms, is calculated by dividing dividends per share by earnings per share.
Because the numerator and denominator are in per share terms, we can simplify the
dividend payout ratio to dividends divided by earnings (net income). The dividend payout
ratio is not applicable to stock health plans that do not pay dividends to their
stockholders.
Suppose health plan A had net income of

$10,000,000 and that health plan A’s board of
directors decided to pay $2,729,511 in dividends
to stockholders. Below is the general formula for
the dividend payout ratio, followed by health plan
A’s calculation of its dividend payment ratio.
Generally, investors who seek growth in a company want the dividend payout ratio to
remain small, because a low dividend payout ratio means that the company has retained
most of its earnings to fund future growth. Investors who seek current income prefer the
dividend payout ratio to be larger. The dividend payout ratio tends to be somewhat
similar for many firms within a particular industry.
Figure 12B-7 presents these profitability ratios in summary form.
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Chapter 12 C
Health Plan–Specific Ratio Analysis
• List and apply to the Annual Statement statutory ratios of liquidity, capital,
financial leverage, and profitability (for health plans that must comply with
state insurance regulations)
• Recognize and apply the ratios that are most important to health plans
Earlier in this assignment, we stated that health plans that must comply with state
insurance requirements must file the Annual Statement in every state in which they
conduct business. The financial statements contained in the Annual Statement include a
balance sheet, an income statement, and a cash flow statement. However, the
calculations for items listed in the financial statements contained in the Annual
Statement follow statutory formulas, rather than traditional GAAP-based formulas.
As a result, many traditional financial ratios cannot be applied directly to the statutory
financial statements that appear in the Annual Statement. The result has been a
modification of these traditional ratios for statutory purposes. In some cases, new ratios
were created specifically for analysis of statutory health plan statements. These
"statutory ratios" are commonly divided into four categories: liquidity ratios, capital and
surplus ratios, financial leverage ratios, and profitability ratios.
Liquidity Ratios
Two primary liquidity ratios for statutory purposes are (1)the quick liquidity ratio and
(2)the current liquidity ratio.
Quick Liquidity Ratio
The quick liquidity ratio compares a health plan’s liquid assets to the health plan’s
contractual reserves. Liquid assets include a health plan’s cash and other readily
marketable assets such as short-term investments. Recall from Fully Funded and Self-
Funded Health Plans that reserves are estimates of money that a health plan or insurer
sets aside to pay future business obligations. Contractual reserves typically include a
health plan’s claims liabilities and IBNR claims liabilities. To calculate a health plan’s
quick liquidity ratio, divide the health plan’s liquid assets by its contractual reserves:
The usual range for this ratio is between 10% and 20%. The quick liquidity ratio provides
regulators with information about a health plan’s solvency.
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Current Liquidity Ratio
The current liquidity ratio compares all of a health plan’s total assets not invested in its
affiliates to all the health plan’s total liabilities, not just its claim liabilities and IBNR
claims liabilities. The current liquidity ratio is calculated as follows:
The average range for this ratio is 95% to 120%. A ratio lower than 95% is considered
below the accepted norm.
Capital and Surplus Ratios
Health plans measure their financial strength using capital and surplus ratios, which are
sometimes referred to as capital ratios for stock companies. Both capital and surplus are
owners’ equity accounts on a health plan’s balance sheet. Capital accounts include
Common Stock, Additional Paid-in Capital, and Preferred Stock.
Recall from Fully Funded and Self-Funded Health Plans that, under statutory accounting
practices (SAP), surplus is the amount that remains when an insurer subtracts its
liabilities and capital from its assets. Recall from Accounting and Financial Reporting
1
that retained earnings is the cumulative amount of a company’s earnings that has been
kept (retained) in the company over time.
In this context, Surplus on a SAP-prepared balance sheet is similar to Retained Earnings

on a GAAP-prepared balance sheet. Not-for-profit health plans and certain insurers that
do not issue stock do not have capital accounts. As a result, their owners’ equity
accounts typically consist of Retained Earnings (GAAP) or Surplus (SAP).
Capital and Surplus Ratios

The basic capital and surplus ratio for a
health plan is calculated by dividing a health
plan’s capital and surplus by its total liabilities,
as follows:
Generally, the greater the value of this ratio, the stronger the health plan’s financial
position. The average industry range is between 4% and 12%. A health plan’s capital
and surplus position can weaken because of
• Poor profitability
• Payment of excessive dividends relative to the health plan’s actual profit
• Excessive capital losses from investments
• Reserve valuation changes that increase the health plan’s reserves
(Increases in a health plan’s reserve valuation may result from changes in
statutory requirements or from a decision by a health plan’s managers to
increase its reserves, including IBNR claims liabilities.)
One weakness of the basic capital and surplus ratio is that it is an unweighted ratio that
fails to recognize the factors that can cause significant changes to a health plan’s capital
position. To obtain a more accurate measure of a health plan’s solvency and financial
strength, many internal and external financial analysts use a specified set of capital
ratios.
These capital ratios, which are called risk-based capital (RBC) requirements, are weight-
adjusted to account for different levels and types of risk as well as different practices of
determining the appropriate amount of claims liabilities that are unique to each health
plan. The formula for determining a health plan’s RBC requirements considers five
different kinds of risk: affiliate risk, asset risk, underwriting risk, credit risk, and business
risk. We discussed RBC requirements in Risk Management in Health Plans.
Independent rating agencies also apply various capital ratios to determine a health
plan’s financial strength. Insight 12C-1 summarizes how one rating agency assigns a
value to the financial security of health plans.
Financial Leverage Ratios
As noted earlier, financial leverage ratios compare a health plan’s obligations to its ability
to meet those obligations. In the context of healthcare benefits, such obligations can be
measured in terms of claims liabilities or in terms of claims liabilities in combination with
other miscellaneous liabilities. Financial leverage ratios typically relate a health plan’s
liabilities to its capital. A key financial leverage ratio for health plan's is the insurance
leverage ratio.
Insurance Leverage Ratio
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The insurance leverage ratio, also called the gross leverage ratio, relates a health
plan’s contractual reserves (claims liabilities, including IBNR claims liabilities) to its
capital and surplus. This ratio is similar to the basic debt-to-equity ratio, which is the ratio
of total liabilities to total equity. A low result for this ratio is more desirable than a high
result, within a normal range. However, there is no absolute standard for determining
what is too low and what is too high for all health plans. The insurance leverage ratio is
found as follows:
Profitability Ratios
Specialized profitability ratios are available to meet the needs for diverse measures of a
health plan’s profitability. Some of these ratios evaluate a health plan’s overall results on
a gross basis (before deducting expenses and taxes) or a net basis (after deducting all
expenses and taxes). These ratios include the gross profit ratio and the return on capital
ratio. The following sections discuss these two ratios and the statutory return on assets
(ROA) ratio, the investment yield ratio, and the net gain to total income ratio.
Gross Profit Ratio
The gross profit ratio is a simple measure of the

growth of a health plan’s capital and surplus. The
gross profit ratio compares a health plan’s
gross gain from operations before interest
expenses and taxes with its beginning capital and
surplus for a specified accounting period. To
calculate the gross profit ratio, a health plan
divides its gross gain from operations by its
beginning capital and surplus amount for a
specified accounting period, as follows:
Return on Capital Ratio
To determine a health plan’s overall success in generating returns to stockholders, an

analyst calculates the health plan’s return on capital ratio. The return on capital ratio is
similar to the GAAP-based return on equity (ROE) ratio. Whereas ROE is stated as the
ratio of net income to stockholders' equity, the return on capital ratio is the ratio of net
gain from operations to beginning capital and surplus. A health plan calculates the
return on capital ratio by dividing its net gain from operations by its beginning capital
and surplus:
The beginning capital and surplus is the amount of capital and surplus that the health
plan had at the beginning of the specified accounting period. The result of the return on
capital ratio indicates how efficiently management is using a health plan’s capital and
surplus to earn a return for the health plan’s stockholders. The average industry range
for this ratio is 8% to 14%.
Statutory Return on Assets Ratio
The statutory return on assets (ROA) ratio is the ratio of a health plan’s net gain from
operations to its average invested assets. The statutory ROA ratio shows the efficiency
of a health plan’s managers in using the health plan’s investments to earn a return for
stockholders.
This ratio is similar to the GAAP-based ROTA,

which is the ratio of a health plan’s net income to
its total assets. However, statutory ROA
considers only gains from an health plan’s
normal business operations, like premium
income and investment income, rather than net
income, and only the health plan’s average
invested assets, rather than its total assets, as
follows:
To determine a health plan’s average invested assets, the health plan adds its
beginning-of-year invested assets balance to the end-of-year balance from the same
accounting period and divides the sum by two.
Investment Yield Ratio
The investment yield ratio, also called the net yield ratio, measures how effectively a
health plan can earn adequate or higher returns on the health plan’s investment
portfolio. The calculation for this ratio is a version of the traditional ROA ratio, as follows:
Note that the investment yield ratio uses a health plan’s investment income in the
numerator and invested assets in the denominator, rather than net income divided by
total assets, as does the basic ROTA ratio. The investment yield ratio is an important
indicator of a health plan’s potential returns.
Health plans prefer an investment yield that is neither too high nor too low, although a
definition of these extremes varies among health plans. How well a health plan manages
the cash it receives from plan sponsors is critical to the health plan’s solvency and
profitability. An unusually high investment yield could indicate excessively risky
investments, while a very low yield probably indicates inadequate returns.
Net Gain to Total Income Ratio
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Another performance indicator of interest to regulators is the net gain to total income
ratio. The net gain to total income ratio is calculated by dividing a health plan’s net
gain from operations by the sum of its total income, plus realized capital gains, minus
realized capital losses:
Net Gain to Total Income Ratio
In this context, net gain means net gain from operations, which is the net gain before any
dividends to stockholders and federal income taxes. This ratio also highlights the share
of the health plan’s income that is not used to cover expenses. A result of less than zero
for this ratio usually indicates that a health plan has experienced a net loss from
operations. The usual industry range is 1.5% to 6.0%.
Figure 12C-1 summarizes the GAAP-based financial statement ratios with the ratios
used to analyze SAP-prepared statements
Additional Financial Analysis
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Besides the financial ratios discussed above, health plans track other ratios and financial
data relating specifically to health business written. Among the most important ratios for
health plans are the medical loss ratio and the expense ratio, which are key components
of the combined ratio. The following sections discuss these ratios and the operating
expense ratio, months of surplus, months of claims reserve, the IBNR claims ratio, the
selling, general, and administrative expense ratio, the cash and investments to premium
income ratio, the cash to claims payable ratio, and the equity to premium income ratio.
Medical Loss Ratio
The medical loss ratio (MLR), also called the loss ratio, is the percentage of a health
plan’s incurred claims to its earned premiums. For the purposes of calculating the MLR,
incurred claims include those that have been paid as well as those that have not yet
been reported. A health plan’s earned premiums consist of both collected and
uncollected premiums.
The MLR is a measurement of a health plan’s overall claims levels. Monitoring the MLR
is critical to a health plan. Health plans use the MLR to determine if their healthcare
benefits are in line with the premiums charged. Because the denominator of the MLR is
earned premiums, MLR automatically adjusts for growth in a health plan’s business. The
industry average for the MLR is 83%.
To calculate the MLR, divide a health plan’s incurred claims by its earned premiums.
Assume that health plan Q had $82 million in incurred claims and $100 million in earned
premiums. The calculation of health plan Q’s MLR is as follows:
Review Question
The following information relates to the Hardcastle Health Plan for the month of June:
• Incurred claims (paid and IBNR) equal $100,000

• Earned premiums equal $120,000
• Paid claims, excluding IBNR, equal $80,000
• Total health plan expenses equal $300,000
This information indicates that Hardcastle’s medical loss ratio (MLR) for the month of
June was approximately equal to:
40%
67%
83%
120%
Incorrect
Incorrect
Yes!
Incorrect
Medical Loss Ratio
There are several variations of the MLR. One variation is the paid loss ratio, which is
based on paid claims rather than incurred claims. Keep in mind that a health plan’s MLR
should be based not only on the health plan’s paid claims, but also on the best estimate
of its IBNR claims for the accounting period being evaluated.
Calculating the paid loss ratio is easier because the data for paid claims are readily
available and do not have to be estimated. However, using the paid loss ratio instead of
the MLR can result in an inaccurate assessment of the magnitude and trend of a health
plan over time. Also, paid loss ratios can be unusually low for new or rapidly growing
blocks of business. It is therefore difficult to determine with certainty the profitable and
unprofitable blocks of business using only paid loss ratios.
Another variation of the MLR is the tolerable loss ratio (TLR), also called the acceptable
loss ratio. The TLR indicates the ratio of losses that a health plan can tolerate without
losing money on a particular block of business. If a health plan’s medical loss ratio
exceeds its tolerable loss ratio, then profits may disappear.
In addition, health plans that must comply with state insurance regulations are required
under certain circumstances to calculate the lifetime loss ratio, which measures the ratio
of losses for the entire lifetime of each product. Circumstances under which a health
plan must calculate the lifetime loss ratio occur when a health plan applies for a premium
rate increase on an existing product. State regulations stipulate the minimum percentage
requirement for a health plan’s lifetime loss ratio.
Expense Ratio
The second component of the combined ratio is

the expense ratio. The expense ratio measures
the percentage of health plan expenses, other
than medical expenses, paid for each dollar of
the health plan’s premium income. Suppose
Green HMO has health plan expenses of $15
million and earned premiums of $100 million. In
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our example, Green HMO’s expense ratio is

0.15:
This information indicates Green HMO's health plan expenses are 15% of its earned
premiums. The industry average is 14%. Note that a health plan’s expense ratio may be
somewhat misleading if the health plan has a new or growing block of business,
because expenses are generally higher in the first year of a sale. A health plan’s
expense ratio can also be misleading if the health plan has a lot of administrative
services only (ASO) business, small group business, or individual business. It is
therefore necessary to track the expense ratio over a number of years if the level of
earned premiums varies from year to year.
Combined Ratio
The combined ratio is used to determine whether a health plan is collecting enough
premiums to pay both its claims obligations and its operating expenses. The combined
ratio, which is a profitability ratio, is the sum of the medical loss ratio and the expense
ratio. Stated as a formula, the combined ratio, (0.97 for health plan Q in our example), is
the sum of its MLR (0.82 for health plan Q), and its expense ratio (0.15 for health plan
Q), as follows:
If a health plan’s combined ratio is less than 100%, then the health plan’s premium
income contains a margin for profit or for managing adverse conditions. In our example,
health plan Q has a 3% potential profit margin. To the extent that a health plan’s
combined ratio exceeds 100%, the health plan must rely on investment income to avoid
losses. In such cases, investment income is critical for a health plan to maintain
solvency.
Months of Surplus
A health plan may need to know how long it could meet its incurred obligations if it relied
solely on funds in its surplus account. To answer this question, a health plan calculates
its months of surplus. A health plan’s months of surplus is calculated by dividing the
health plan’s end-of-period surplus by the average underwriting deduction. The average
underwriting deduction is the sum of claims incurred and operating expenses incurred
divided by the number of months. The formula for calculating a health plan’s months of
surplus is
The more months of surplus that a health plan has, the lower the risk that the health plan
cannot meet the obligations that it has incurred. The average months of surplus for a
health plan is 2.3 months.
Months of Claims Reserve
When a health plan establishes a claims reserve, it does so under the assumption that
there are enough assets available to match claims liabilities. If applicable, statutory
requirements may also mandate the amount of a health plan’s claims reserve.
The months of claims reserve is obtained by dividing the sum of a health plan’s
adjusted, unpaid claims liabilities by its average claims expense. A health plan adjusts
its unpaid claims liabilities to reflect changes in its business and in inflation. The average
claims expense is the sum of claims and the adjustment for claims expenses incurred,
divided by the number of months in the period being evaluated. The formula to calculate
a health plan’s months of claims reserve is as follows:
The more months of claims reserve that a health plan has, the stronger its financial
position. The industry average for the months of claims reserve is 1.67 months.
IBNR Claims Ratio
Knowing the ratio of a health plan’s IBNR claims to total claims is useful in estimating
future claims obligations. The IBNR claims ratio is obtained by dividing the estimate of
IBNR claims by total claims liabilities:
Selling, General, and Administrative

Expense Ratios
Earlier we discussed the expense ratio with

respect to a health plan’s combined ratio. To
control operating expenses, a health plan’s
managers often find it useful to break down the
expense ratio into its components according to
selling expenses, general expenses, and
administrative expenses. In this way, a health
plan can identify what percent of the overall
expense ratio comprises selling expenses,
general expenses, and administrative expenses.
To isolate a particular type of expense, a health
plan divides that expense by the health plan’s
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earned premiums
Cash and Investments to Premium Income Ratio
A health plan is also interested in the relationship between the amount of cash and
investments it has and its premium income, in part because the health plan needs to
manage its cash inflows and cash outflows carefully. Premium income results in a cash
inflow for a health plan and investment purchases result in a cash outflow for the health
plan.
Remember that premium income consists of earned premiums, which include both
collected premiums and uncollected premiums. The investments in this case are
primarily marketable securities that can be readily sold if necessary.
Cash and Investments to Premium Income Ratio

Suppose health plan Q has $42 million in cash,
$500 million in investments, and $700 million in
premium income. The formula for the cash and
investments to premium income ratio, and health
plan Q’s ratio calculation, is:
The amount of health plan Q’s cash and

investments is about 77% of the amount of health
plan Q’s premium income. This information
indicates that health plan Q has the equivalent of
77% of its premium income in current assets—
that is cash and readily marketable investments.
The industry average for this ratio is 75%.
Cash to Claims Payable Ratio
Another liquidity ratio that is of interest to health plans is the cash-to-claims payable
ratio, which indicates the relationship between a health plan’s cash and its claims
payable. Assume that health plan Q has $42 million in cash and $192 million in claims
payable. The formula for this ratio, along with health plan Q’s ratio calculation, is as
follows:
A health plan’s claims payable includes both IBNR claims and reported claims. In our
example, health plan Q has enough cash to cover approximately 22% of its outstanding
claims liabilities. The average ratio of cash to claims payable is 20%.
Review Question
the Rouge health plan as of December 31, 1998:
Assets
Liabilities
When calculating its cash-to-claims payable ratio, Rouge would correctly divide its:
cash by its reported claims only

cash by its reported claims and its incurred but not reported claims (IBNR)
reported claims by its cash
reported claims and its incurred but not reported claims (IBNR) by its cash
Incorrect. The formula is cash divided by payable claims.
Correct. The formula is cash divided by payable claims.
Equity to Premium Income Ratio
A health plan is also interested in learning the ratio of equity to premium income. The
higher the health plan’s premium income, the more likely the health plan will have a
higher net income, assuming the health plan can manage its expenses effectively.
Higher net income in turn becomes part of the health plan’s retained earnings or surplus,
which ultimately increases the health plan’s equity.
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The equity to premium income ratio is obtained by dividing a health plan’s equity by
its premium income. Suppose health plan Q has $250 million in owners’ equity and $700
million in premium income. This ratio, and health plan Q’s calculation, is
This information indicates that the amount of health plan Q’s equity is approximately
36% of the amount of its premium income. The industry average is 30%.
Chapter 13 A
Management Accounting
• Explain the purpose of management accounting

• Identify the distinguishing features of a cost center, profit center, and
investment center
• Discuss volume-related variances, cost-related variances, and revenue-
related variances in a health plan setting
The Role of Management Accounting
With respect to management, we can identify four core functions: (1) planning, (2)
organizing, (3) leading, and (4) controlling. Although the four functions of management
have distinct characteristics, they are interrelated and often difficult to distinguish in
practice. Implicit within the four management functions is decision making, in which a
company’s management selects a course of action.
To make effective decisions about a company, a manager needs financial information.

For example, a health plan manager might need to know how much money the health
plan paid in provider reimbursement last year or the economic effects of installing a new
computer system. Management accounting, also called managerial accounting, is the
process of identifying, measuring, analyzing, and communicating financial information to
assist managers in making decisions. With the information provided through
management accounting, a health plan’s managers can
• Hire an appropriate number of employees

• Price products and services to cover costs and produce a desired profit
• Forecast premium income and investment income accurately
• Pay claims as they come due
Accurate and timely feedback is essential for effective management. Providing feedback
is one of the most important purposes of management accounting. Feedback allows
managers to locate the sources of its financially successful and unsuccessful operations
and to analyze why certain areas of the company perform well while others do not.
Management accounting information is most useful in the management functions of
planning, organizing, and controlling.
Planning
Planning occurs at all levels of a company. Typical financial planning activities in a

health plan include the study of costs, budgeting for short-term and long-term
expenditures, and evaluating potential acquisitions or divestitures.
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Generally, we can divide a company's planning activities into two major segments:
strategic planning and tactical planning. Recall from The Strategic Planning Process in
health plans that strategic planning is the process of identifying an organization’s long-
term objectives and the broad, overall courses of action that the company will take to
achieve those objectives. Strategic planning forces a company to look beyond tomorrow
or next year and establish a long-term plan. Most health plans today develop a strategic
plan for at least the next three to five years as well as a short-term tactical plan (with
measurable objectives) for the first one or two years of the strategic plan.
Tactical planning, also called operational planning, is the process of determining

how to accomplish specific tasks with available resources. Tactical planning is
primarily concerned with the short-term, day-to-day activities of a company. In
tactical planning, each functional area within the health plan develops specific plans
based on the health plan’s overall strategic goals and business objectives. Figure 13A-1
lists some areas that are often associated with strategic planning and tactical planning in
a health plan.
Note that overlap can exist between the topics covered by the two types of planning. For
example, forecasting premium income (strategic planning) directly affects a health plan’s
cash flow planning (tactical planning). Also, both types of planning involve the
preparation of budgets. Approaches to budgeting are numerous and diverse, as we
discuss in The Budgeting Process lesson.
Organizing
During the organizing function, a health plan’s management takes explicit actions to
ensure that the necessary resources are available to achieve the health plan’s strategic
plan. Suppose a health plan’s management has projected what it will cost the health
plan to enter a new market with its HMO product. In this case, management can use the
cost projection to decide which employees and how many employees will be involved,
and the role that each employee will take if the health plan enters a new market.
Controlling
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The control function of management involves ensuring that a company’s performance

results in the achievement of the company’s strategic plan. Management control
activities involve the (1) establishment of standards of performance, (2) measurement
and evaluation of actual performance against the standards, (3) detection of deviations
from the standards, and (4) the determination of appropriate action to correct deviations.
The most complete managerial control would consist of close physical supervision of
each employee. However, this type of control is not usually practical or desirable.
Therefore, managers rely on the concept of management by exception, which states
that managers should focus on operational results or activities that differ from expected
norms by a certain amount or percentage. Such information comes from management
accounting reports that indicate deviations or exceptions. A manager can then
investigate these exceptions to learn the causes behind them.
For example, one management accounting report could show the projected costs and
actual costs for a health plan’s claims department. Instances where the actual costs
differ from the projected costs are known as variances. One way to gauge the
performance of the health plan’s claims department is to examine these variances. A
report of variances is an example of feedback that informs management how well the
organization is achieving its plan. We discuss variance analysis later in this lesson.
Decision Making
To make sound decisions, a manager needs financial information that is relevant,

reliable, and comparable across accounting periods and departments. Management
accounting provides this information, as well as analytical techniques that help
managers understand the implications of a decision.
Suppose a health plan decides to launch a new product. In this case, management
accounting analysis can indicate the number of members that must be enrolled, at a
specified PMPM rate, to generate enough premium income to achieve the health plan’s
strategic plan.
Management accounting analysis can also indicate the cost savings and useful life
required of a new piece of equipment for a health plan to recover the cost of the
equipment. Although the information provided by management accounting does not itself
solve the problems that a health plan faces, the use of management accounting reports
enables the health plan’s managers to weigh the consequences of various actions so
that the managers can make well-informed decisions.
Responsibility Accounting
Responsibility accounting is a form of management accounting that is used primarily to

prepare and monitor a company’s budgets and to analyze the company’s performance.
Responsibility accounting, sometimes called profitability accounting, is a people-
oriented system of policies and procedures that assigns revenues and costs to individual
employees or to the organizational units that are accountable for these revenues and
costs.
Responsibility accounting focuses on the status of a company’s internal operations and
on specific areas of managerial responsibility. In responsibility accounting, the person
who has the most influence over an area—the manager of a department, function,
activity, or product—is held accountable for the operations and financial outcomes of
that area. This means that only those items, such as investments, revenues, and costs
that can be directly attributable to a particular area are the responsibility of that area’s
manager.
A direct cost, also known as a traceable cost, is a cost incurred for or traceable to one
specific product, line of business, or department or function. A cost that is not incurred
for or cannot be traced to one specific product, line of business, or department or
function is called an indirect cost, also called a common cost or a shared cost. For
example, the salary of the manager of a health plan’s accounting function is a direct cost
of that function. However, the salary of the health plan’s president is an indirect cost of
the accounting function.
Responsibility Centers
When a manager has control of, and thus responsibility for, an organizational unit of the
company's business, the area or unit is commonly known as a responsibility center. A
responsibility center defines the sphere of its manager's responsibility. In other words,
only those items, such as investments, revenues, and costs, that can be directly
attributable to a responsibility center are the responsibility of that center's manager. A
responsibility center can be a department, division, line of business, or any other
business segment. Responsibility centers typically are divided into three types: cost
centers, profit centers, and investment centers, which are listed in Figure 13A-2.
One way we can differentiate these centers is based on the extent of overall operational
control accorded to the manager. The degree of control ranges from lowest (cost center)
to highest (investment center). Note that, in many companies, the distinction between a
profit center and an investment center is blurred. Therefore, some companies use the
term profit center to refer to both investment centers and profit centers. In this course,
we maintain the distinction between the two.
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The manager of a responsibility center, called a responsibility manager, is evaluated

according to the responsibility center's performance. The responsibility manager should
have (1) objectives that are consistent with the company's objectives, (2) a clear
understanding of the responsibility center's objectives, and (3) the necessary authority to
establish formal reporting and budgeting control over the resources required to meet
those objectives.
By assigning responsibility to specific individuals, a health plan’s senior management

has a tool for controlling revenues and costs and an objective means of evaluating its
managers and supervisors. The basic tenet of responsibility accounting is that
responsibility managers should be held accountable for only the costs and revenues
over which they have direct control.
A critical component of responsibility accounting is goal congruence, which we discuss

in the next section. Then we describe methods of measuring and evaluating the
performance of responsibility centers and responsibility managers. Last, we discuss
various factors that can impact performance evaluation.
Goal Congruence
Successful health plans are those that create an operational condition called goal
congruence, in which the goals of a company and the goals of its managers are
mutually supportive. When the business goals of a company are congruent with the
personal goals of the company's managers, the managers are motivated to make
decisions that are in the best interest of the company. The managers can achieve their
own goals by helping the company achieve its goals.
Goal incongruence occurs when management goals and the company's goals are in
conflict; in other words, the goals are not mutually achievable. Suppose a health plan’s
strategic plan includes a goal of rapid growth in market share, even at the expense of
short-term profitability. At the same time, the health plan’s underwriting department
manager decides to establish more conservative (that is, more stringent) underwriting
guidelines. In this case, the more conservative the health plan’s underwriting guidelines,
the less likely that the health plan will achieve its strategic goal for market share growth.
The ultimate effect is goal incongruence.
Management by Objectives
Responsibility managers manage with the intention of achieving stated goals, a process
known as management by objectives (MBO). A typical goal for a responsibility
manager is to meet a budget. Management by objectives also includes the
establishment and achievement of nonfinancial goals, such as improved customer
service or more favorable responses on an opinion survey of the responsibility center's
employees.
In successful MBO programs, senior management and responsibility managers

collaborate on developing objectives, and these objectives support the company's
overall objectives. Typically, objectives that are devised by a third party and then
imposed on the responsibility manager are less likely to be attained. Note, however, that
in recent years, health plans have devoted a significant amount of their resources to
attaining quality standards established by external organizations.
When the objectives of responsibility center managers conflict, goal incongruence may
result. A health plan’s senior management would typically review such conflicts and
resolve them. Suppose a health plan’s product development manager establishes a goal
to reach a certain level of new product sales. The health plan’s actuarial department
manager may argue that the new product objective conflicts with the health plan's profit
objectives because of the high first-year expenses that a new product typically incurs. In
this case, the health plan’s senior management would have to analyze the effects of
increased sales on profit and recommend a course of action.
Effectiveness vs. Efficiency
All responsibility centers should share a common goal: to be both effective and efficient.
Effectiveness (doing the right things) is the extent to which a responsibility center is
able to establish and achieve the appropriate objectives. Efficiency (doing things right)
is the extent to which a responsibility center is able to achieve objectives with a minimum
of waste. While effectiveness generally fosters goal congruence, efficiency, on its own,
1
does not. In other words, it is possible for a company to have an efficient responsibility
center whose goals do not support the company's goals.
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For example, a health plan’s investment department that executes investment

transactions on time and at a low cost is efficient. But if the investments that the
department makes result in a lower investment returns or significantly higher risks for the
health plan, then the investments department has not met its goal of maximizing
investment return and is therefore not effective.
A company’s responsibility accounting system should incorporate methods of

simultaneously measuring both effectiveness and efficiency. The first step in
implementing such a responsibility accounting system is to establish responsibility
centers, which we discussed above.
Review Question
The goal of the investment department at the Wayfarer Health Plan is to maximize
investment return. The investment department executes investments on time and at a
low cost. However, these transactions often result in low returns or risks that are
deemed too high for Wayfarer. With regard to effectiveness and efficiency, it is correct to
say that Wayfarer’s investment department is:
both effective and efficient

efficient, but not effective
effective, but not efficient
neither effective nor efficient
Incorrect. The transactions resulting in low returns or risks too high for the health
plan, can be called ineffective
Correct. The Wayfarer investment department executes investments efficiently,

but the investments themselves are not effective in achieving desired objectives
Incorrect. The transactions resulting in low returns or risks too high for the health
plan, can be called ineffective
Incorrect. The Wayfarer investment department executes investments efficiently,

but the investments themselves are not effective in achieving desired objectives
Performance Measurement and Evaluation
Responsibility managers know what aspects of a company's operations they are

responsible for and understand how their performance is judged. In theory, the
characterization of success and failure is a two-step process: (1) measuring
performance and (2) evaluating performance. Measuring performance involves
quantifying the responsibility center's results. Evaluating performance involves assessing
those results. Together, measuring and evaluating performance answer two questions:
“What did the responsibility manager achieve?” and “What do the achievements mean?”
Responsibility accounting requires the establishment of procedures for fairly and
accurately measuring and evaluating the performance of responsibility centers and
responsibility managers. Distinguishing between performance measurement and
performance evaluation can be difficult. Specific tools for performance measurement and
evaluation differ for each type of responsibility center. However, one basic technique
applicable to any responsibility center is variance analysis.
Variance Analysis
A basic concept in management accounting is the use of a company’s expected

(projected, forecasted) results as a benchmark against which the company’s actual
performance is compared. Whenever an actual result differs from the expected result,
the difference is called a variance.
Variance analysis is the study of the difference between expected results and actual
results. Variances for each responsibility center are usually shown in a responsibility
center report, sometimes called a responsibility report, which itemizes projected and
actual amounts and the corresponding variance for each item. Variance analysis is
helpful for monitoring and evaluating performance because variances quantify the
unexpected results under the control of a responsibility manager. The concept of
management by exception, which we introduced earlier in this lesson, encompasses
variance analysis.
Budgets are often used to pinpoint variances. A budget is a financial plan of action,
expressed in monetary terms, that covers a specified time period, such as one year. 2
Typical budgets that lend themselves to variance analysis are sales budgets, expense
budgets, and investment budgets. When using budgets to study variances, some degree
of variance is not unusual because budgeted amounts and actual amounts are rarely
equal. For example, if an amount budgeted for an expense item is $10,000, and the
actual result for this item is $12,000, the budget variance is $2,000. We discuss budgets
in The Budgeting Process.
Variance analysis normally studies budgeted and actual results, but managers can also
use it to compare other data. Managers can analyze variances between numbers from
different areas or reporting periods by comparing a responsibility center's operating
results from a current accounting period with those from a prior period. Another version
of variance analysis compares actual costs with standard costs. Standard costs are
predetermined costs that a company expects to incur during normal business
operations.
Generally, positive variances—variances in which actual amounts exceed expected

amounts—are unfavorable for expenses, because the responsibility center incurred
more expenses than it had anticipated. In contrast, positive variances are considered
favorable for revenues because the responsibility center earned more revenues than it
had anticipated. Similarly, negative variances, in which actual amounts are less than
expected amounts, are usually considered favorable for expense items and unfavorable
for revenue items.
An effective variance system focuses on matters that require management's attention.

Variance analysis allows a manager to isolate the problem areas, but it does not suggest
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solutions to problems. Most companies conduct monthly or quarterly reviews of their

operating expenses and compare actual expenses to budgeted expenses.
Review Question
Variance analysis is the study of the difference between expected results and actual
results. Variances can be positive or negative. A positive variance is typically
considered:
favorable for both expenses and revenues

favorable for expenses, but unfavorable for revenues
favorable for revenues, but unfavorable for expenses
unfavorable for both expenses and revenues
Incorrect
Incorrect
Yes!
Incorrect
Variance Analysis
Large variances are a matter of concern, or at least interest, to a health plan’s senior
management because they can lead to revised budgets or changes in the health plan’s
operations. An important aspect of responsibility accounting is that managers should be
able to explain budget variances that are under their control.
We can categorize variances as either price variances or volume variances. The sum of
the two equals the total variance. The price variance, also known as the rate variance
or cost-related variance, is the difference between a product's actual rate (or unit cost or
price) and its budgeted rate, multiplied by the number of units sold or processed. The
volume variance, also known as the usage variance or the volume-related variance, is
the difference between the budgeted quantities to be sold or processed and the actual
quantities sold or processed, multiplied by the budgeted amount.
Figure 13A-3 highlights health plan A’s price variance and volume variance with respect
to health plan A’s expected PMPM rates. This variance analysis indicates that the health
plan A experienced lower membership than expected, which, in turn led to lower-than-
expected revenues. The result is both an unfavorable price variance ($916,700) and an
unfavorable volume variance ($83,500), which lead to an unfavorable total variance of
$1,000,200.
A responsibility center report often contains segmented information about a high
organizational level responsibility center and the lower-level centers contained within it.
The performance reports for the lower managerial levels become a part of the
performance reports for levels above. We discuss responsibility center reports for profit
centers and investment centers in the following sections.
Segment Reporting in Cost Centers and Profit Centers
The evaluation of a profit center is based on the profits earned by the center. One way to
monitor profit centers is to prepare a document that functions as an internal income
statement. Preparing statements of this type is sometimes referred to as segment
reporting.
A segment report for a cost center details the direct costs—those costs that are directly
under the control of the cost center’s responsibility manager. A segment report for a
profit center includes the information contained in a cost center report, but it also
includes revenues. Further, a segment report for a profit center divides these direct costs
into fixed costs and variable costs.
Fixed costs are costs that remain constant for all levels of operating activity or products.
One example of fixed costs are lease payments for a health plan’s office space because
these payments stay the same regardless of the health plan’s volume of business or
support activity. Variable costs are costs that fluctuate in direct proportion to changes in
the level of operating activity. Claims processing costs are an example of variable costs.
The more claims a health plan processes, the greater the overall cost of providing claims
services.
The segment report begins with total revenues (premium income plus investment
income) attributable to each level of profit center, then subtracts, in order, the variable
costs and fixed costs incurred by each segment. After all variable costs have been
assigned to the proper segments, we can calculate a contribution margin.
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The contribution margin for a product is the difference between its selling price and its
variable costs. Similarly, the contribution margin for a segment is the difference between
total revenues and total variable costs. We discuss the contribution margin in the context
of cost-volume-profit analysis in the next lesson.
Fixed costs are categorized as either direct costs or indirect costs to allow for the
calculation of a segment margin for each segment of the company. A segment margin
is the portion of the contribution margin that remains after a segment has covered its
direct fixed costs. The segment margin is found by subtracting the segment's direct fixed
costs from its contribution margin.
In segment reporting of profit centers, managers pay close attention to the segment
margin, which is an indicator of a segment's profitability. A segment margin incorporates
only those costs and revenues attributable to the segment. If the segment cannot cover
its own costs, it is not profitable and should be investigated. Segment margins and
contribution margins are also useful for performance evaluation when put in ratio form.
The segment margin ratio is the segment margin divided by the segment's total
revenues:
The segment margin ratio measures a segment's efficiency of operating performance.

The contribution margin ratio is the contribution margin divided by the segment's total
revenues. This ratio is also a measure of segment performance:
Both ratios allow for the comparison of segments of different sizes.
Measuring Investment Center Performance
Unlike cost centers and profit centers, investment centers are also evaluated on the
effective use of assets employed to earn a profit. The simplest measure of an investment
center's performance is the amount of net income listed on the investment center's
income statement. Traditional thinking indicates that the best-run segment of the
company is the one with the highest net income, but this is not necessarily true.
Recall that a company’s net income includes the effects of income taxes. Therefore, the
use of net income violates the maxim of responsibility accounting, because taxes are
beyond the control of an investment center manager. Also, a small, well-managed
investment center may have lower net income than a large, poorly managed investment
center.
For these reasons, we should not compare two responsibility centers only by net income
because such a comparison does not adequately interpret their respective
performances. Comparing investment centers by the amount of income they generate
should not be completely dismissed, however. Two common measures of investment
center performance, return on investment (ROI) and residual income (RI), both
incorporate income in the context of responsibility accounting.
Return on Investment
Recall that return on assets and return on equity measure the financial performance of
an entire company. To measure the performance of an investment center, many
companies use return on investment (ROI), which is the ratio of operating income to
controllable investment. The ROI ratio is calculated as follows:
Operating income, which can also be called net gain from operations before taxes, is
income before subtracting income taxes. Controllable investment includes all balance
sheet items controlled by the manager of the investment center. Controllable investment
is found by subtracting controllable liabilities from controllable assets. Sometimes health
plans substitute controllable surplus for controllable investment in the denominator of the
ROI ratio. All other factors being equal, the higher the ROI, the better the performance of
the investment center.
Return on investment is a better performance measure than net income because ROI
overcomes the problem of comparing investment centers of different sizes. Like the
segment margin ratio and the contribution margin ratio, ROI presents a result in
percentage terms rather than in absolute terms. This is not to suggest that absolutes are
unimportant. Absolute size is still a consideration in determining an investment center's
contribution to the company as a whole. However, a large absolute can unintentionally
prejudice an evaluator against a smaller investment center. Calculating ROI for each
investment center helps level the playing field.
Suppose Health Plan Q has two investment centers: Investment Center A and
Investment Center B. Assume that Investment Center A earns $10,000,000 in operating
income on controllable investments of $60,000,000. Investment Center A’s ROI is 16.7%
($10,000,000 ? $60,000,000).
Assume also that Investment Center B earns $1,000,000 in operating income on

$4,000,000 on controllable investments. The ROI for Investment Center B is 25%
($1,000,000 ? $4,000,000). In absolute terms, Investment Center B's operating income
is only one-tenth that of Investment Center A ($1,000,000 versus $10,000,000), yet
Investment Center B achieves a much higher return on its available resources (25%
versus 16.7%).
Besides being valuable as an evaluation tool, ROI can assist company executives in
searching for ways to improve an investment center's performance. Such assistance
arises when the ROI formula is broken down into a return on revenue component and an
investment turnover component. Return on revenue measures management's ability to
control operating income in relation to total revenues, which includes premium income
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and investment income. Return on revenue is found by dividing operating income by

total revenues:
Investment turnover is a measure of the revenue that can be generated for each dollar
invested by the responsibility manager. We calculate investment turnover by dividing
total revenues by controllable investment:
The ROI formula is the product of return on revenue and investment turnover:
It is important to note that an increase in total revenues alone will not increase an
investment center’s ROI. Figure 13A-4, which helps to clarify ROI, presents data for the
East and West regions of a health plan.
Each region is considered to be an investment center. Total revenues for the West
region are nearly twice those of the East region, yet West's ROI is much lower than
East's. Why? Notice that East earned a much better return on revenue than West. East
also had a significantly higher investment turnover. These two factors led to a much
more impressive ROI which, all other factors being equal, could earn East's manager a
better performance evaluation than West's manager.
How can the West region attain an ROI similar to that of the East region? As stated
earlier, an increase in total revenues alone is not the answer. Generally, ROI increases
in one or more of the following ways: (1) by reducing expenses to increase operating
income, (2) by reducing controllable investment, or (3) by increasing total revenues,
accompanied by a proportionate increase in operating income.
Figure 13A-5 details these possibilities. Column 1 restates the current data for the West
region. The goal is to increase ROI from the current 14.9% to the 23.5% achieved by the
East region. In Column 1, we reduce the West region’s administrative expenses from
$3,900,000 to $3,140,000. This reduction in expenses increases operating income,
which increases return on revenue and ultimately increases ROI to the target 23.5%.
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In Column 2, we retain the current levels of total revenue and operating income and
reduce the investment from $8,850,000 to $5,620,000 to generate an ROI of 23.5%. And
in Column 3, an increase in total revenue from $10,395,000 to $11,155,000, along with a
corresponding increase in operating income, increases ROI to 23.5%.
Notice that the increase in operating income (the differences between Column 0 and
Columns 1 and 3) required to raise ROI to 23.5% is only $760,000. But the decrease in
controllable investment (between Column 0 and Column 2) necessary to achieve the
same ROI is $3,230,000.
Because either of these changes results in the same improvement in ROI, it would seem
to be much easier for the West region to improve its ROI by either decreasing expenses
or increasing revenues (and operating income) by a relatively small amount than it would
be to operate at the current level using far fewer invested assets. In fact, a current trend
in all industries is to cut expenses to improve operating results.
Some health plans require that their investment centers earn a specified ROI. Incentive
programs often encourage responsibility managers to strive for higher returns on
investment. Managers of these investment centers consider a variety of actions that
could increase ROI, such as expansion, capital improvements, and even the sale or
discontinuance of a lagging business.
Review Question
Ways in which a company can increase its return on investment (ROI) include:
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1. Reducing expenses to increase operating income

2. Increasing controllable investment
Both 1 and 2
1 only
2 only
Neither 1 nor 2
Incorrect. While a company can increase ROI by reducing expenses to increase

operating income, increasing controllable investment will not net an ROI
Correct. A company can increase its ROI by reducing expenses to increase

operating income
Incorrect. Decreasing controllable investment will net an ROI
Incorrect. A company can increase ROI by reducing expenses to increase

operating income.
Residual Income
Some companies measure the performance of investment centers using residual

income. Residual income (RI) is the amount of income an investment center earns
above a certain minimum required rate of return on investment. The minimum required
rate of return reflects the company's cost of capital, which we discussed in The Strategic
Planning Process in health plans.
To earn a positive ROI and to

foster growth, companies establish
a required rate of return that is
higher than their cost of capital.
Residual income is found by
subtracting the product of (1) an
investment center's minimum
required rate of return and (2) its
controllable investment from the
center's operating income. The
minimum required rate of return
times controllable investment is
sometimes called the capital
charge. The entire residual income
calculation is as follows:
Assume that an investment center's operating income is $450,000, its controllable

investment is $2,000,000, and its minimum required rate of return is 15%. We calculate
the center's residual income as follows:
The $150,000 in residual income represents the amount of income that the investment
center manager is able to earn in excess of the company’s minimum required rate of
return. When using residual income to compare two or more investment centers, the
investment center with the largest amount of residual income generally has the best
financial performance.
Return on Investment and Residual Income Compared
Goal congruence is a key consideration when a company implements a performance

measurement system for its investment centers. Performance measurement systems
can affect the behavior of managers and thereby affect whether the decisions they make
are the right ones for the company. Ideally, the performance measurement system
draws managers toward goal congruence.
The RI method of evaluation demands greater goal congruence from managers than
does ROI. Evaluation by ROI requires only that investment center managers achieve an
acceptable return on investment, but residual income encourages managers to accept
investment opportunities that have rates of return greater than the cost of capital. One
drawback of ROI is that managers being evaluated by ROI may be reluctant to accept
new investments that might lower their center's current ROI, even though the investment
would be in the best interest of the entire company. This practice defies goal
congruence.
Figure 13A-6 reveals these behavioral characteristics of ROI and RI. Assume that health
plan Q requires its investment centers to achieve an ROI of 20%. The actual results of
one investment center, as seen in the top portion of Figure 13A-6, are $610,000 of
operating income on $3,000,000 of controllable investment. As you can see, the ROI of
20.3% indicates that the investment center's manager has met health plan Q’s target
ROI.
Suppose this manager has the opportunity to invest $500,000 in a project that will
provide a 17% annual return or $85,000 (17% ? $500,000). The minimum required rate
of return for this investment is 15%. (Note that the minimum required return will be
different for different projects to reflect the level of risk presented by each project.) It is in
health plan Q’s best interest for the manager to invest in this project because the
project's return exceeds the health plan’s minimum required rate of return and the
project will generate an additional $85,000 of operating income per year.
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However, this manager, whose performance evaluation is based on achieving an ROI of

20%, might be reluctant to make the investment because it would lower the investment
center's ROI from 20.3% to 19.9%, as is exhibited in the middle section of Figure 13A-6.
This goal incongruence is induced by the use of ROI.
What if the investment center is evaluated by residual income? The bottom portion of
Figure 13A-6 demonstrates an acceptance of the project. As you can see, because the
project's 17% return exceeds the company's 15% minimum required rate of return, the
project will increase residual income from $160,000 to $170,000. This additional residual
income will not only improve the investment center manager's evaluation, it is also in the
best interest of health plan Q. Thus, the use of residual income as a performance
evaluation method fosters goal congruence.
The major disadvantage of residual income is that it is an absolute figure and tends to
favor larger investment centers. A disadvantage of both ROI and RI is that, if
emphasized too greatly, they can lead to decisions that improve short-term profits at the
expense of long-term objectives. As shown in Figure 13A-5, residual income and ROI
can be improved by reducing expenses. It is possible that a manager may forgo some
important expenditures for the sake of a higher ROI or residual income.
For example, a health plan’s member services division may need additional staff, but the
division manager might not receive approval to hire the necessary employees because
the extra salary expense would decrease the division's ROI or RI. However, overworked
employees could make mistakes and cause delays in service, dissatisfying members
and resulting in a high lapse rate at renewal. In the long run, this would be more costly to
the health plan than hiring additional employees in the first place. Figure 13A-7
summarizes the main advantages and disadvantages of ROI and RI.
Issues Associated with Performance Evaluation
In the previous section, we examined the ways in which a company’s senior

management measures and monitors the performance of its various responsibility
centers. In practice, however, achieving an accurate summary of performance is rarely
so straightforward as preparing one report or calculating a simple ratio.
As we discussed earlier, a premise of responsibility accounting is that responsibility

managers should be accountable for only the costs that they directly control. But few
costs are clearly the responsibility of only one individual. Most costs have varying
degrees of controllability. The purpose of responsibility management is to identify the
individual most directly responsible for incurring each cost.
Several related issues must also be considered before giving a final “grade” to a
responsibility center or its manager. Some of these issues are problems inherent in the
evaluation process. Other issues may affect a responsibility center’s performance, and, if
not considered, may lead to an inaccurate appraisal of the center. In the following
sections, we discuss potential problems surrounding performance evaluation criteria.
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The underlying motive behind responsibility accounting is measuring and evaluating the
performance of responsibility centers and responsibility managers. These evaluations
guide a health plan’s senior management in allocating future resources to each business
segment, making decisions about segments, and compensating and promoting
responsibility managers.
But the evaluation criteria can be as important to the final evaluation as the actual
performance that is being evaluated. Potential problem areas include (1) relying too
heavily on variance analysis, (2) using only one evaluation criterion, (3) using
inappropriate evaluation criteria, (4) setting unattainable goals, and (5) judging a
responsibility manager’s performance solely on the basis of the responsibility center’s
performance.
Overemphasis on Variance Analysis
Isolating budget variances is a simple and common method for evaluating performance.
Variances, however, can be misleading. For example, when analyzing budget variances,
management has a tendency to pay attention only to unfavorable variances. However,
seemingly favorable variances should also receive close scrutiny to determine whether
they are indeed favorable to the company.
For example, a responsibility center may have been budgeted $38,000 for a given
activity but spent only $29,000. On the surface, this variance appears to be favorable.
Upon reviewing the figures, however, management attempts to determine the reason for
the seemingly superior performance. The favorable variance may have resulted from
overly pessimistic (or “padded”) projections, indicating that what at first appeared to be
performance that exceeded expectations was actually an indication of the responsibility
manager’s poor judgment in making budget estimates.
Favorable variances can also occur as a result of overzealous or shortsighted actions

that include lowering quality standards, disregarding training, or altering operating
procedures to reduce expenses in ways that diminish a product’s or service’s quality or
competitiveness. For example, a dramatic increase in new business that might appear to
be a favorable budgetary variance could actually be the result of using more relaxed
underwriting standards. Ultimately, the health plan could experience extensive losses
from that new business.
Variance analysis can also mislead when evaluators consider budget variances that are
beyond the control of a responsibility manager. Such uncontrollability often arises when
one variance causes a second variance. In the following example, an unfavorable
variance (a significant increase in the volume of phone calls) in one area causes another
unfavorable variance (a significant increase in departmental salary costs).
Suppose a health plan’s budget for its member services department forecasts call
volume similar to that of the previous year. However, this year, the health plan’s
marketing department introduces a new product that generates a significant increase in
phone calls to the member services department, which in turn has to hire several new
employees to answer phones.
In this scenario, the member services department experiences an unfavorable variance
—even if the cost per phone call has actually decreased—because of the increase in
wages paid to new employees who were hired to accommodate the increase in phone
volume from the previous year. This circumstance should not be overlooked during the
final evaluation of the member services department or its manager.
Use of a Single Evaluation Criterion
Another evaluation problem occurs when evaluators reduce a responsibility manager’s

performance evaluation to a single, all-encompassing measure. This practice usually
emphasizes only one goal and ignores all others. For example, if the member services
manager in the preceding example were evaluated almost exclusively on budget
variances, then this manager would be motivated to understaff the department to keep
expenses low.
If the manager acted in this way, the result would be a lower member service quality for
the health plan’s new product. To avoid this problem, responsibility managers are
typically evaluated on a number of criteria. For example, the member services manager
might also be evaluated on average call hold-times, call abandonment rates, and plan
member survey results on the quality of member services for the new product.
Use of Inappropriate Criteria
A related evaluation criteria problem is using performance measures that fail to reflect a
health plan’s objectives or its employees’ responsibilities. Again, emphasizing profits in
the short run without consideration of long-term consequences can negatively affect a
company’s financial performance.
Nonetheless, some companies base management evaluations only on short-term

results, such as a quarterly target ROI. Therefore, managers can be tempted to forsake
long-term goals and overuse resources to maximize short-term returns if it is the only
way to earn a satisfactory performance evaluation. Such companies may find
themselves with insufficient resources in the future.
Unattainable Goals
Evaluation problems can arise when performance standards are not attainable by
responsibility managers. For example, a responsibility manager may be evaluated
unfavorably for failing to achieve goals that are unrealistic. Evaluators can avoid this
problem by becoming aware of how the budgets and other standards are determined
and to what extent controllability is considered in the comparison of budgeted to actual
amounts. A company can reduce the problem of unattainable goals by involving
responsibility managers in the preparation of their centers’ budgets. Managers tend to
react more favorably toward budgets that they helped prepare.
Responsibility Managers vs. Responsibility Centers
Senior management evaluates responsibility managers apart from their responsibility

centers. A manager may be doing an acceptable job even though the results of the
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center are unsatisfactory. This situation can happen to the manager of a responsibility
center or other business segment in a declining market.
Conversely, a business segment in a growing market may be thriving through no special

accomplishment of the manager. In either case, senior management determines whether
the performance of the manager has affected the performance of the segment, or
whether the results are a function of the segment’s environment.
Transfer Pricing
Evaluating the performance of a company’s profit centers and investment centers can be
difficult when transfer pricing is involved. A transfer price is the price of a good or
service that one segment of a company charges another segment of the same company.
Unlike intercompany transactions in which prices are determined by supply and demand
factors, transfer pricing arrangements are established by a company’s management.
Transfer pricing is especially important for health plans with subsidiaries or health plans
that are themselves subsidiaries.
Several methods are used to set transfer prices. The transfer pricing method a company
selects is critical because transfer prices directly influence the profits for which
managers of profit or investment centers are held responsible. An inappropriate transfer
price might provide a misleading picture of a responsibility center’s true performance,
and, even worse, might motivate the responsibility manager to initiate actions that are
not in the best interest of the company. Figure 13A-8 summarizes three methods of
setting transfer prices: cost, market price, and negotiated price.
Chapter 13 B
Cost Accounting
• Explain the primary uses of cost accounting in health plans

• Discuss various ways that costs can be accumulated
• Compare the three methods of analyzing costs: change analysis, functional
cost analysis, and activity-based costing
Nearly every decision that a health plan makes about product benefit design, provider
reimbursement, products, and advertising carries a cost. Before a health plan can
determine what products it can offer, how many plan members it can serve, and what it
can charge for its products and services, the health plan must know its cost of doing
business.
For example, a health plan determines the minimum premium (price) that it can charge
for a given level of healthcare benefits by examining the costs it incurs in developing,
distributing, and administering those benefits now and in the future. Generally, the
selling price of a company’s product must be at least high enough to cover all of the
product's costs and provide a profit for the company. The gathering and interpretation of
cost information is therefore critical for determining an appropriate premium rate.
Cost Accounting
A cost is an expenditure incurred to obtain an economic benefit or to extinguish an

obligation. Cost accounting is a system that defines, describes, accumulates, records,
and assigns all the costs incurred by a company. Cost accounting enables a health
plan’s managers to plan operations, organize employee work loads, develop provider
networks, and evaluate current financial performance so that the health plan is best
prepared to make decisions.
Most health plans have an automated cost accounting system. To satisfy unique needs,
a cost accounting system may vary among individual health plans, and, sometimes,
even between different divisions of the same health plan. Whether a health plan
prepares its financial statements for management reporting purposes or to comply with
regulatory requirements, the health plan can design its cost accounting system to
provide cost information in a variety of different formats or to allocate expenses to a
specified division, segment, product, or plan sponsor. Figure 13B-1 lists some of the
uses of cost accounting for health plans.
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One essential element of an effective cost accounting system is accurate and complete
accounting data. Before a health plan can develop an effective cost accounting system,
it must already have in place an accounting system that produces reliable financial data
at the appropriate level of detail. The information provided by cost accounting is only as
reliable as the historical and current data on which the cost accounting system is based.
Another necessary element is the identification of costs by product line, line of business,
division, and function. Examples of a health plan’s product line include its HMO, PPO,
and POS products. A health plan’s lines of business may include its group and non-
group business.
A health plan may also need to analyze costs by department or function, such as
marketing, sales, claims, member services, provider relations, and underwriting.
Typically, the more specified the cost information, the greater a health plan’s overall
effectiveness in analyzing costs. The rest of this lesson discusses how a health plan
classifies and analyzes its costs.
A health plan tries to obtain precise, specified descriptions of all costs that it incurs in the
course of conducting business. The process of classifying a health plan’s costs produces
useful information for the health plan’s managers to make objective decisions based on
cost. Costs can be classified by description, behavior, and measurement. Note that
many costs fit into more than one classification. Where appropriate, we identify the
classification of a cost in more than one category.
Costs Classified by Description
The most basic way to classify costs is by their descriptive characteristics. Because
many cost classifications have an opposing classification—for example, direct costs and
indirect costs—costs classified by description may be thought of in pairs. Figure 13B-2
summarizes the most common classifications for pairing costs by description.
In the context of cost accounting, a cost object is any purpose for which a company
measures its costs. One way to determine whether a cost is a direct cost of a particular
cost object is to decide if the cost would disappear if the cost object disappeared. For
example, the salary (cost) of a health plan’s marketing manager for its managed dental
product (cost object) is a direct cost of the managed dental product because the salary
cost disappears if the health plan no longer markets that product.
To establish and evaluate distinct responsibility centers, a company must be able to

distinguish controllable costs from noncontrollable costs and direct costs from indirect
costs. For example, the salary of a responsibility center manager is a direct cost of that
center. However, depreciation on a health plan’s home office facility is an indirect cost,
so this same responsibility manager should not be held accountable for it.
The most basic way to classify costs is by their descriptive characteristics. Because
many cost classifications have an opposing classification—for example, direct costs and
indirect costs—costs classified by description may be thought of in pairs. Figure 13B-2
summarizes the most common classifications for pairing costs by description.
In the context of cost accounting, a cost object is any purpose for which a company
measures its costs. One way to determine whether a cost is a direct cost of a particular
cost object is to decide if the cost would disappear if the cost object disappeared. For
example, the salary (cost) of a health plan’s marketing manager for its managed dental
product (cost object) is a direct cost of the managed dental product because the salary
cost disappears if the health plan no longer markets that product.
To establish and evaluate distinct responsibility centers, a company must be able to

distinguish controllable costs from noncontrollable costs and direct costs from indirect
costs. For example, the salary of a responsibility center manager is a direct cost of that
center. However, depreciation on a health plan’s home office facility is an indirect cost,
so this same responsibility manager should not be held accountable for it.
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Review Question
In order to achieve its goal of improved customer service, the Evergreen Health Plan will
add three new customer service representatives to its existing staff, install a new
switching station, and install additional phone lines. In this situation, the cost that would
be classified as a sunk cost, rather than a differential cost, is the expense associated
with:
adding new customer service representatives

maintaining the existing staff
installing a new switching station
installing additional phone lines
Incorrect. Adding new customer service representatives may be described as a

discrentionary cost
Correct. A Sunk cost is a past cost that does not change as the result of a future
decision
Incorrect. Installing a new switching line can be considered a committed cost
Incorrect. Installing new phone lines can be considered a committed cost
Differential costs and sunk costs usually are a direct result of management decisions.
Suppose a health plan plans to design and implement a new automated system to track
provider reimbursement and utilization of healthcare services. To complete this project,
the health plan must add new computer equipment and software to existing equipment
and it must hire consultants to design the system's software and train the health plan’s
employees.
In this case, all costs that are incurred as a result of deciding to proceed with this project
are both direct costs and differential costs. All costs that are already committed costs,
but that were not originally committed to this project, are direct costs and sunk costs.
Thus, the costs of the new computer equipment and software and the costs of the
consultants are differential costs. The costs associated with the health plan’s existing
equipment will not change as a result of the decision to go ahead with the project, so
these costs are sunk costs.
Costs Classified by Behavior
Time and volume are the defining factors when classifying cost by behavior. Some costs
change as the amount of time needed to complete an activity changes. Other costs
change as the volume of an activity changes. Many costs change with both time and
volume, and some costs are not affected by time or volume at all.
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Costs that can be defined by behavior are most commonly classified as fixed costs,
variable costs, and semi-variable costs. We introduced fixed and variable costs in our
discussion of segment reporting in the previous lesson. Figure 13B-3 lists costs that are
classified by behavior.
Review Question
Costs that can be defined by behavior are most commonly classified as fixed costs,
variable costs and semi-variable costs. Examples of fixed costs include:
rent, insurance expense, and depreciation on computer equipment

rent, claims processing costs, and selling expenses
claims processing costs, telephone expense, and depreciation on computer
equipment
premium processing, rent, and selling expenses
Correct. Rent, insurance expense and depreciation on computer equipment are all
fixed costs
Incorrect. Claims processing and selling expenses are examples of variable costs
Incorrect. Claims processing costs and telephone expense are examples of

variable, and semi-variable costs
Incorrect. Premium processing and selling expenses are variable costs
Costs Classified by Measurement
The third cost classification considers a cost's measurement attributes. These costs are
especially helpful for management reports and for cost-volume-profit analysis, which we
describe later in this lesson. Costs classified by measurement include unit costs,
marginal costs, and opportunity costs, which are depicted in Figure 13B-4 and discussed
in the following sections.
Unit Costs
Unit costs in health plans are often described on a per member basis. Examples of unit
costs include the
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• Cost per policy or contract issued

• Cost per $100 of broker commissions paid
• Cost per new plan member
• Cost per existing plan member
• Cost per paid claim
• Cost per account or group
• Cost per $1,000 of investment income
Unit Costs
Knowing the per member unit cost of products sold can guide a health plan’s managers
in
• Predicting future costs

• Evaluating the efficiency of personnel, operations, and equipment
• Setting premium and dividend rates
• Benchmarking the health plan’s operations with those of other health plans
Fixed costs and variable costs can be expressed in terms of unit costs. Normally, as
production volume or the amount of activity increases, fixed unit costs decrease. As
volume decreases, fixed unit costs increase.
Suppose a health plan had 150,000 existing plan members in 2003 and 160,000 existing
plan members in 2004. Assume that the health plan’s total fixed costs in each year were
$2,500,000. In 2003, the fixed unit cost per member was $16.67 ($2,500,000 ÷ 150,000).
In 1998, the fixed unit cost per member was $15.63 ($2,500,000 ÷ 160,000). This simple
example demonstrates that fixed unit costs decrease as volume increases.
Unit costs are often used to express standard costs. Recall from the previous lesson that
standard costs are predetermined costs that a health plan expects to incur for particular
items during normal business operations. Many health plans establish a standard cost
for each item against which they later compare the actual cost.
For example, an important standard unit cost for PPOs is the unit cost of processing one
claim. A PPO establishes a standard unit cost for processing one claim and then
conducts variance analysis; in other words, the PPO compares that standard cost with
the actual unit cost of processing the claim. We discussed variance analysis in
Management Accounting.
Marginal Costs
Marginal cost information is essential for making production decisions because it helps
managers to determine the monetary effect of a specific action, and, in certain cases,
whether an action should or should not be taken. Once a certain sales volume has been
reached, the decision whether to produce or sell additional units involves different cost
considerations than the earlier decision to produce or sell the initial amount. Some of the
costs involved in processing the initial amount may not apply to the additional
production.
Suppose a health plan receives 50 new individual policy applications per year at a total
cost of $40,000. The total cost of processing 51 new individual applications is $40,500.
The marginal cost of the 51st policy is $500 ($40,500 - $40,000). A similar marginal cost
study could be performed on the costs of processing the 52nd and 53rd policy
application, and so on.
The health plan’s receipt of the 51st application would probably not cost as much as
1/50th of $40,000, because most of the health plan’s total expenses—such as
advertising, office supplies, and office space rent—are committed costs or sunk costs.
Therefore, these expenses are unaffected by the processing of one additional
application.
In other words, the marginal cost of each additional unit is different from the unit cost of
the initial amount produced. To help make production decisions, managers consider the
marginal unit cost, which is the increase or decrease in the unit cost as a result of an
additional unit of a good or service. As you may have guessed, marginal cost information
is useful to managers when determining the optimal level of production relative to the
resources available.
For example, a health plan often compares sales per member costs by group size.
Larger groups tend to be less expensive to sell on a per member basis, in part because
it is possible to spread the plan’s fixed costs over a larger number of plan members. In
this case, the health plan would allocate proportionately more resources to individual or
small group product sales than to large group sales.
Opportunity Costs
In making decisions about expenditures, a health plan must consider both its out-of-
pocket costs and its opportunity costs. Suppose a health plan is considering the
introduction of a new POS product. The health plan estimates that its out-of-pocket cost
of this project will be $1 million for research, actuarial work, automated systems,
marketing, and compliance with statutory reporting requirements. What are the health
plan’s opportunity costs associated with this project?
Instead of introducing the POS product, the health plan could use the $1 million to
enhance its current information system. Alternatively, the health plan could use the $1
million to purchase assets to generate investment income. Efficiencies realized from an
improved information system or from additional investment income may provide the
health plan a return that equals or exceeds the return offered by the new POS product.
Note that the health plan could also use the $1 million for a variety of other purposes.
The difficulty with considering opportunity costs is that there is no definitive way to
capture them in a health plan’s accounting system because there is no transaction
involved—no exchange of money or value of service to record. A health plan’s managers
should therefore analyze various business scenarios to determine the cost of making
each business decision.
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In the above example, before deciding whether to develop the POS product, the health
plan would consider not only the out-of-pocket costs of undertaking this project, but also
the opportunity costs associated with
• Undertaking the new POS product

• Enhancing the existing information system
• Investing in assets to generate additional investment income
When deciding whether to introduce the POS product, the health plan would also
consider the marginal unit costs associated with other alternatives.
Review Question
A cost for which a benefit is forfeited in choosing one decision alternative over another is
known as:
a marginal cost
a unit cost
an incremental cost
an opportunity cost
Incorrect. A marginal cost, also called an incremental cost, is the additional total
expense incurred as a result of producing one additional unit of a product or
service.
Incorrect. A unit cost is the incurred expense attributable to a single measured

amount of work
Incorrect. An incremental cost, also called a marginal cost, is the additonal total
expense incurred as a result of producing one additional unit of a product or
service.
Correct. An opportunity cost is a cost for which a benefit is forfeited in chosing

one decision alternative over another.
Cost Perspective
From the above discussion, we may conclude that there are many varieties of costs and
that a single cost can be classified in several different ways. Cost classification depends
on the point of view of the individual analyzing the cost and the point of view of the
individual or department incurring the cost. For example, the salary of a health plan's
vice president of group marketing is
• A direct cost of the marketing division as a whole
• An indirect cost with respect to the individual and small group marketing
areas within the marketing division
• A fixed cost that remains unchanged regardless of the activity of the division
• A controllable cost to the health plan’s president and board of directors
• A committed cost that resulted from a prior management decision regarding
the operation of the health plan
• A sunk cost that has already been incurred and cannot be avoided
Similar multiple characterizations can be made for virtually every other cost incurred by a
health plan. A function of management accounting is classifying costs in different ways
to better analyze company operations. Useful cost classification also promotes proper
cost accumulation and cost allocation, which we discuss in the following sections.
Cost Accumulation
Ideally, a cost accounting system should provide each manager with sufficient
information to make informed decisions about the operations for which he or she is
accountable. But the information generated from the cost accounting system is only as
useful as the information originally input. To be a valuable management tool, the cost
accounting system should accumulate costs and allocate costs accurately and fairly.
Cost accumulation is the process of capturing all of a company’s costs and

categorizing them in meaningful ways. Once the company accumulates the total amount
of costs, it can allocate them to departments, products, and lines of business relative to
management needs. Specifically, a health plan’s cost accounting system should ensure
that each cost is charged to the area of the health plan that is responsible for generating
the cost.
Four methods of accumulating cost data are by (1) type of cost, (2) line of business, (3)
department or cost center, and (4) function. Many health plans accumulate costs by
more than one of these methods to learn whether the costs associated with one
classification, line of business, department, or function are greater or less than expected.
Accumulating Costs by Type
The most basic level of cost accumulation is by type of cost, such as salaries,
advertising, marketing, medical services, and so on. On this level, costs are
accumulated without regard to the specified area of the health plan that incurs the
expense. For example, all health plan costs relating to salaries can be accumulated in
one "Salaries" classification instead of being associated with a particular department,
function, product, or service.
Accumulating costs by type enables health plans to satisfy financial reporting

requirements for compiling financial statements and corporate tax returns. Also,
accumulating costs by type assists a health plan’s managers in studying which types of
costs are rising and falling over time. However, accumulating costs by type does not
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explain which areas of the health plan incur each cost and, therefore, who or what is
responsible for changes in cost levels.
Accumulating Costs by Line of Business
When accumulating costs by line of business, all costs that are associated with the sale
and administration of a particular line are charged to that line. A line of business (LOB)
is a segment that differs from other segments with respect to sales approach or with
respect to client or member service; in the context of cost accounting, a line of business
is a segment of products that has a cost pattern distinct from that of other product
segments.
The product segment’s methods of sales and service usually determine its cost patterns.
Examples of a health plan’s lines of business include individual, small group, large
group, Medicare, and Medicaid. After entering a cost in the accounting system, such as
under "Salaries," the health plan also assigns the cost to an LOB, such as small group.
Cost accumulation by LOB may include all the costs associated with a particular line or
with individual products within a line. This method of cost accumulation helps
management to
• Make pricing decisions

• Analyze the profitability of products and lines of business
• Comply with financial reporting requirements
Suppose a certain product requires significantly more of a health plan’s resources than
the health plan’s other similar products. When it accumulates costs by line of business,
the health plan’s management is better able to identify the problem and take appropriate
action. Actions that the health plan may consider to address this problem include a
product rate increase, product redesign, re-engineering of product processes to reduce
costs, or, in a worst-case scenario, withdrawal of the product from the market.
Accumulating Costs by Department or Cost Center
The third level of cost accumulation is by department or cost center. A cost center, as we
saw in Management Accounting, is a department or other business segment—for
example, accounting, legal, or claims—to which costs can be charged. To provide
accurate cost information, cost centers should accumulate their costs according to the
various levels of accumulation, such as type and function.
A health plan accumulates costs by cost centers to facilitate the budgeting process and
to identify the total cost of operating various areas. When accumulating costs by cost
center, the costs of departments at each level of a health plan can be "rolled into" the
cost reports for departments at higher levels in the health plan. This type of
accumulation enables management to judge the performance of individual cost centers.
Accumulating Costs by Function

When costs are accumulated by function, they are directed to the health plan operation
that generates the costs. In the context of cost accumulation, a function consists of a
series of tasks that serve a specific purpose. The accumulated costs of the activities
involved within a certain function, without regard to departmental lines, are known as
functional costs. Within each function are the costs of salaries, supplies, equipment,
and so on.
For example, a health plan can determine the cost of collecting renewal premiums by
gathering cost data from all departments or areas that are involved in the collection
process, not just from the cashiers' area that receives and records premiums. Other
costs incurred in receiving premiums include printing and postage expense, machine
costs for preparing and mailing premium notices, and the indirect costs of other
departments involved in premium collection. The costs of all these operations are
included in a functional cost analysis of the renewal premium collection process. We
discuss functional cost analysis later in this lesson.
Accumulating costs by function is more complicated than accumulating costs by type or

cost center. Functional cost accumulation involves identifying and measuring all the
activities involved in a given function. If an activity is involved in more than one function,
a health plan allots the correct portion of an activity's cost to each function that uses the
activity.
Suppose one of a health plan’s functions is to maintain current information on plan

members in the health plan’s information system. In this case, all the costs associated
with maintaining these records—including costs associated with obtaining plan member
information, inputting the information into the health plan’s information system, and
obtaining and inputting updated plan member information—would be charged to this
function.
Assume that the health plan’s employees in the claims department spend 10% of their
time updating plan member records. In this case, the health plan would allot 10% of total
salaries in the claims department to the function of maintaining current information on
plan members.
Cost Perspectives
Again, we can classify a single cost in different ways. For instance, the cost of
underwriting applications for a new individual HMO product could be classified as
• A salary cost when accumulated by type

• An individual product cost when accumulated by line of business
• An underwriting department cost when accumulated by cost center
• A plan member record cost when accumulated by function
Cost Allocation
Once a health plan accumulates all costs, it assigns the costs to the department,
function, and line of business that was responsible for generating them. It is usually
straightforward to charge direct costs to the appropriate cost object. For example, if the
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marketing department spends $300 for dedicated telephone lines for its department's fax
machines, the cost of the lines is charged to the marketing department.
Assigning indirect costs to the appropriate responsibility center is less straightforward.

To address the problem of assigning indirect costs, health plans use cost allocation.
Cost allocation is the accounting process of assigning or distributing an indirect cost or
expense according to a method or formula. Examples of indirect costs that can be
allocated include service department costs and the salaries of managers in charge of
more than one responsibility center.
Cost Accumulation
Note that cost allocation is arbitrary to some degree. Therefore, a health plan’s
management considers whether indirect costs are allocated and by what method they
are allocated in evaluating a responsibility manager. Sometimes responsibility managers
believe they are being allocated costs that do not apply to their centers. Problems with
improper or unfair cost allocation can occur because of internal influences (company
politics), insufficient data to properly allocate costs, or a flawed cost allocation system.
Suppose a health plan serves markets in several metropolitan areas, with separate profit
centers for each market. Each of these profit centers receives support—such as
underwriting, contract issue, and claims processing—from a regional home office. The
health plan must determine an effective way to allocate the expenses for the support
services to each profit center.
Assume that Profit Center A’s market consists predominantly of large employer groups
and that Profit Center B sells primarily to individuals. In this case, Profit Center A would
expect to pay less per plan member for its underwriting, contract issue, and claims
processing services than Profit Center B.
Cost Allocation Bases
To help ensure an equitable allocation of indirect costs, health plans seek an allocation
base, or measure of use, that exhibits a proportional relationship between the indirect
cost and the cost center being allocated a portion of that cost. Common allocation bases
are the amount of square footage, number of employees, and percentage of direct costs,
as described in Figure 13B-5. In addition to these allocation bases, health plans also use
number of plan members as an allocation base.
Cost Allocation Methods
Keep in mind that different allocation methods and allocation bases are typically
appropriate for various types of costs. There are several general methods for allocating
a health plan’s indirect salary costs and nonsalary expenses. In addition to these
methods, health plans that have government business, including Medicare and Medicaid
contracts, must comply with regulatory requirements concerning cost allocation.
Most health plans allocate indirect salary costs by using time analysis, which
determines the percentage of time a manager spends with different departments or
activities. Three common methods of time analysis are estimated time, actual time, and
standard time. A discussion of these methods is beyond the scope of this course.
Indirect expenses other than salaries include rent and utilities, institutional advertising,
association dues, medical fees, and data processing services. A decision whether to
distribute nonsalary expenses among cost centers depends on a health plan's size, cost
control program, and the level of information that its management requires.
Nevertheless, methods of allocating indirect expenses other than salaries are somewhat
arbitrary and differ from company to company.
Cost Analysis
Originally, most cost accounting systems for insurance companies and health plans
were established to meet statutory reporting requirements, rather than the information
needs of internal management. In recent years, however, changing factors—including
new and complex products, declining profit margins, increased competition, and more
knowledgeable and demanding purchasers—have led to refinements in cost accounting
systems.
As a result, health plans have become more aware of the need for accurate cost data
and analysis. In the following sections, we describe three methods used to analyze costs
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for internal management purposes: change analysis, functional costing, and activity-
based costing.
Change Analysis
Health plans analyze the way costs change over time to spot trends in costs. Change
analysis involves the comparison of costs in one period to the same costs in a different
period, such as comparing this month's costs to last month's costs or this month's costs
to the same costs six months ago, one year ago, or several years ago. Figure 13B-6
shows an example of a health plan's change analysis. This example compares operating
costs for the current period with the same period in the previous year.
Analyzing cost trends helps management spot fluctuations, peaks, and valleys in the
health plan’s operations. It also helps predict future costs. However, change analysis
does not indicate what causes the fluctuations. For example, if a health plan’s research
and development costs increased by 130% in one year, resources may or may not have
changed proportionately. Change analysis would not consider this alteration in product
mix. Thus, change analysis is useful for identifying what costs have changed but not why
they changed.
Functional Cost Analysis
We discussed functional costs earlier in this lesson. Functional cost analysis enables
a health plan's top management to analyze costs as they apply to workflow rather than
to organizational structures. Through functional cost analysis, a health plan’s
management can identify inefficient or unnecessary functions within a department and
cut costs accordingly, without harming the more efficient, useful functions within the
department.
Developing an effective functional cost accounting system with an appropriate level of
detail requires identifying and defining each business function within the health plan—
marketing, claims processing, data processing, underwriting, and so on—as well as
each line of business or product offered. These functions, lines, or products may or may
not coincide with the departmental units of the health plan.
Functional cost analysis is especially helpful when health plans make pricing and staffing
decisions. Using functional cost analysis, a health plan’s management can analyze
relatively small functions (for example, file maintenance) by product line, all the way up
to complex functions (for example, total selling costs). Having functional cost data in
addition to departmental data helps a health plan to
One of the most useful ways to analyze functional costs is through unit costs. A
functional unit cost is found by dividing the total functional cost by an appropriate base
unit, such as number of plan members, number of claims, or amount of premiums
collected. The ratio of expenses to premiums is an example of unit cost information in
which a health plan’s management is keenly interested.
• Price products
• Monitor and control current operational procedures
• Identify trends that are not recognizable with conventional analyses
• Project more accurate plans and budgets for future operations
• Benchmark operations against other health plans
Analysis-Based Costing
Activity-based costing (ABC), a type of functional cost accounting, links costs to

products according to the activities consumed in producing the products or services. In
other words, ABC identifies units of activity, calculates the costs of performing each unit
of activity, and then assigns the cost of each unit of activity to products or lines of
business.
An activity is any procedure that generates work. Activities within a health plan include
issuing a group policy, sending a premium due notice, and investigating a claim. An
activity driver is the output of an activity being performed. For example, if the activity is
the preparation of member booklet-certificates, the activity driver would be the mailing of
the printed booklet-certificates.
Analysis-Based Costing
Establishing an ABC system for a health plan is essentially a four-step process:
1. Identify the activity

2. Identify the activity drivers
3. Match costs to each activity
4. Trace activity costs to products or lines of business
Under traditional costing systems, the assumption is that products generate costs. Under
ABC, the assumption is that activities generate costs. To provide products and services
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for its purchasers, payors, and strategic partners, a health plan engages in a variety of
activities. These activities consume resources—such as labor, supplies, and computer
time—and produce outputs—such as checks for network providers or contracts for
purchasers and payors.
By using ABC, a health plan's managers are able to identify which activities add value to
its products and services and which do not. A value-added activity is one that makes a
product or service more valuable to the customer. A non-value-added activity is an
activity that does not make a product or service more valuable to the customer.
Generally, non-value-added activities are wasteful and should be minimized. Figure 13B-
7 presents a simple comparison of costs accumulated in a traditional way and costs
accumulated by activity. Note that the total costs incurred do not change.
Cost-Volume-Profit Analysis
Cost is a major area influencing the pricing of products and services. For each health
plan’s product, the product's cost sets the lower limit for the product's price. In the long
run, no health plan can expect to survive if it sells products below what it costs to
produce and sell them. The pricing of health plan products is much more complicated
than the pricing of most other products because the price has to be established before
the costs are known.
A health plan carefully establishes the assumptions on which it bases a product's

estimated costs. Understanding the behavior of costs is essential to estimating a
product's costs. Some costs may decrease over time. Other costs may escalate,
particularly in times of high inflation. Unmanaged costs can quickly reduce or even
eliminate a health plan’s expected profit on a particular product or service.
Cost accumulation data helps a health plan’s managers to project the costs associated
with a product as the health plan gains experience in developing, marketing, and
servicing the product. The health plan can apply this knowledge when pricing similar
new products or when adjusting pricing factors, such as morbidity charges, on current
products. One tool that health plan managers use to help analyze the appropriateness of
pricing decisions is cost-volume-profit analysis.
Three important elements in business decisions are cost, volume, and profit. Analysis of
these elements is a powerful management accounting tool. Cost-volume-profit (CVP)
analysis, sometimes called break-even analysis or profit-volume analysis, is the study of
the effects of changes in product prices, sales volume, fixed costs, variable costs, and
the mix of products.
The use of CVP analysis assists managers in budgeting and planning and it helps
answer such questions as, "Which products and services should we sell?" "What price
should we charge?" and "What level of sales should we strive for?" In the following
sections, we discuss two key components of CVP analysis: contribution margin and the
break-even point.
Contribution Margin
Cost-volume-profit analysis makes use of costs that are classified by behavior—fixed

costs, variable costs, and semi-variable costs—and unit costs. Fundamental to CVP
analysis is the concept of contribution margin, which, as we saw in Management
Accounting, is the difference between a product's selling price and its variable costs. The
contribution margin is important to CVP analysis because it indicates the impact of
changes in net gain caused by changes in costs, selling price, volume, or a combination
of the three.
The term contribution is used because this amount is available to (1) cover fixed costs
and (2) contribute to profit. If a product's contribution margin is less than its fixed costs,
the health plan suffers a loss on the product. Otherwise, the health plan breaks even or
experiences a gain (profit). Two ways to express contribution margin are as a total, and
on a per-unit basis. We calculate these two variations
Determining unit price figures for health plan products is complicated and outside the
scope of this text. In this discussion, we assume that the health plan has already
calculated its unit price figures.
Break-Even Point
The break-even point is the point at which total revenues equal total costs, and fixed
costs equal the contribution margin. If a health plan sells just enough units of a product
to experience neither a net gain nor a net loss—in other words, net income equals $0—it
will break even. Once it reaches the break-even level of sales, the health plan will begin
to experience a net gain equal to the contribution margin for each additional unit of
product sold.
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A product’s break-even point could be found by

trial and error. However, it is much simpler to use a
break-even formula, in which fixed costs are
divided by the unit contribution margin:
Figure 13B-8 calculates the break-even point for a

health plan's product.
Review Question
For a given healthcare product, the Magnolia Health Plan has a premium of $80 PMPM
and a unit variable cost of $30 PMPM. Fixed costs for this product are $30,000 per
month. Magnolia can correctly calculate the break-even point for this product to be:
274 members
375 members
600 members
1,000 members
Incorrect. The formula is: Fixed costs/(unit price - unit variable cost)
Incorrect.The formula is: Fixed costs/(unit price - unit variable cost)
Correct. $30,000/(80-30) = 600
Incorrect. The formula is: Fixed costs/(unit price - unit variable cost)
Cost-Volume-Profit Graph
A cost-volume-profit (CVP) graph, sometimes called a break-even chart, highlights

cost-volume-profit relationships over a wide range of sales levels. A CVP graph gives a
health plan’s managers another way to see the point at which a product’s net gain
begins.
Figure 13B-9 shows the CVP graph for the product discussed in our previous example.
Note that the total cost line and the sales revenue line intersect at the break-even point
—that is, when the volume of sales (enrolled plan members) is 1,000. This is the same
break-even point that we calculated using the break-even formula.
From Figure 13B-9, we see that, at each volume of sales to the right of the break-even
point, the vertical distance between the sales revenue line and the total cost line is the
amount of net gain realized at that volume. Likewise, to the left of the break-even point,
the vertical distance between the total cost line and the sales revenue line is the amount
of net loss realized at that volume.
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Uses of Cost-Volume-Profit Information
There are many applications of CVP analysis for management accounting. The use of
CVP analysis enables a health plan’s managers to test scenarios using different cost,
volume, and price assumptions for each product so they can see what different inputs
result in net gains for the health plan.
Suppose a health plan currently has a membership of 2,000 and its management is
looking for ways to increase its net gain from operations. One suggestion might be to
change the product benefit design so that more members will enroll each month.
The health plan’s management predicts that a change in benefit design worth an
additional $2 in benefits—in other words, a $2 increase in the variable unit cost on a
PMPM basis—will increase membership by 100. The expectation is that the increase in
membership will increase the health plan’s net gain. Before instituting this change,
however, the health plan’s management decides to use CVP analysis to confirm its
estimates.
Currently, the unit contribution margin on this product is $40 ($100 unit sales price
(PMPM) - $60 variable unit cost). After increasing the variable unit cost by $2, the
product’s contribution margin decreases to $38 ($100 unit sales price (PMPM) - $62
variable unit cost). Given that the increase in variable cost will increase sales volume
from 2,000 to 2,100, the change in total contribution margin is found as follows:
As you can see, proceeding with the change in product benefit design would result in a
$200 decrease in the product’s contribution margin. Because fixed costs remain
unchanged, this change in contribution margin will decrease the health plan’s net gain by
$200. The health plan should therefore not institute this new benefit design.
The previous example is one of many possible applications of CVP analysis, in which a
health plan seeks the most profitable combination of fixed cost, variable cost, sales
volume, and product price. A health plan’s managers study changes in any or all of
these variables to maximize the performance of the health plan’s products and product
lines. Sometimes, a health plan can improve its overall net gain by reducing the
contribution margin on a product, but only if it reduces its fixed costs by a greater
amount. Otherwise, an increase in net gain comes through an increase in contribution
margin.
There are many ways to increase contribution margin, such as reducing selling price to
increase sales volume, increasing fixed costs to increase sales volume, or trading off
fixed and variable costs to achieve appropriate changes in volume. The process is more
complex when health plans sell many products. In that case, improving net gain comes
from finding the right mix and right amount of each product to sell.
Chapter 13 C
The Budgeting Process
• Distinguish among top-down budgeting, bottom-up budgeting, and zero-

based budgeting
• Distinguish among static budgets and flexible budgets, short-term budgets
and long-term budgets, and rolling budgets and period budgets
• Itemize the various components of a master budget
Recall from Management Accounting lesson that a budget is a financial plan of action,
expressed in monetary terms, that covers a specified period of time, such as one year. A
budget can be used to plan for something as minor as the office supplies the
underwriting department will use in a given month, or as major as the premium income
and medical expenses that a health plan expects for the entire year. Through budgeting,
a health plan affirms its goals and establishes expected performance levels for its
management team. Once a budget is in place, the health plan uses it to monitor
performance and ensure behavior that is consistent with its goals.
As you read the following sections, keep in mind that a budget is an estimate. It reflects
management's expectations of performance and provides a plan that a health plan uses
to guide it into the future. Although a budget cannot anticipate future conditions
precisely, it does provide a health plan with a point of reference. By comparing its actual
results to its budgeted expectations, a health plan can evaluate and control its overall
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performance and the performance of individual departments and employees. Through

such comparisons, a health plan gains insights that help it plan new courses of action.
In this lesson, we present an overview of the budgeting environment for health plans.
First, we describe the benefits and the drawbacks of budgeting, followed by a discussion
of the budgeting process. We separate budgeting into operational budgeting, financial
budgeting, and capital budgeting. (We discuss capital budgeting in the next lesson.)
Then we discuss how a health plan combines these individual budgets into a master
budget, which becomes the basis for the health plan’s pro forma financial statements.
(Recall that we discussed pro forma financial statements in The Strategic Planning
Process in Health Plans.)
Why Budget?
Through strategic planning, most health plans determine their mission, their long-term
objectives, and the broad overall courses of action they will follow to achieve those
objectives. To determine whether or not the health plan is achieving its mission, the
health plan develops and applies means of measuring where it stands in relation to its
objectives. Budgeting plays a key role in this process.
Through budgeting, a health plan projects financial targets for a defined future period—
typically one year—and creates a financial plan of action that it believes will help it
achieve its goals. In the cyclical management functions of planning, organizing, and
controlling, budgeting is one of the central planning activities, and budgets are an
important instrument in the controlling process.
Budgeting assists a health plan in defining the financial costs and benefits of achieving
its objectives. In defining costs, the budget not only sets goals for management, but also
provides a map of the types of expenses that will be incurred in meeting these goals.
Thus, the budgeting process integrates the costs of the health plan’s business with the
benefits.
For this reason, all companies use budgets, however informally. A budget outlines a
health plan's plans for the acquisition and allocation of financial and other resources.
Further, a budget is one of many management accounting reports that a health plan
uses to make decisions about its product lines, target markets, and future expectations.
Budgets are most often used to:
• Monitor and evaluate financial operations

• Evaluate managerial performance
• Assist in financial planning
• Control and reduce expenses
• Communicate information throughout the various levels of a health plan
• Motivate personnel
Regardless of its ultimate uses or its sophistication and complexity, a budget's primary
objective should be to systematically project for a given department, division, or line of
business the anticipated expenses and income for a given period of time. Budgets
indicate whether managers are meeting the financial goals set for the health plan.
Managers are evaluated on the basis of their ability to control the costs, revenues, or
investments that are under their supervision. For this reason, most managers review
computer-generated reports on a regular basis to compare monthly and year-to-date
actual operating expenses and compare them with the budgeted operating expenses.
If an area's actual expenses vary significantly from its budgeted amounts, then the
area's manager will meet with senior management or with the analysis unit's personnel
to discuss the variance. Once the cause of the variance is determined, management
uses the findings to develop an action plan.
Typically, budget variances in which (1) expenses are higher than projected, or (2)
revenues are lower than expected result from one or more of the following causes:
• Failure to monitor and control expenses

• Failure to retain or increase business sufficiently to meet revenue objectives
• Unrealistic budget projections
• Changes in a health plan’s objectives between the time the budget was
developed and the time the evaluation was made (for example, the health
plan decides to enter a new market, to withdraw from an existing market, to
develop a new product, to withdraw an existing product, or to increase
spending on operating systems or training)
• Unanticipated changes in the external environment, such as changes in state
laws regarding mandatory healthcare benefits.
Although the drawbacks of budgeting are not important enough to keep companies from
using budgets, you should be aware of what those drawbacks are. First, the budgeting
process can be very time-consuming and can involve everyone from entry-level
personnel to senior management. During the budgeting process, a health plan forecasts
—by line of business or product—a variety of items, including the
 Number of new plan sponsors that the health plan anticipates contracting with in the
coming year and the number of existing plan sponsors that the health plan anticipates it
will retain
 Total number of new and existing plan members the health plan expects will be
enrolled in the coming year
 Anticipated cost of providing medical benefits for all plan members covered under
non-administrative services only plans
 Staffing levels needed to fulfill the health plan’s objectives based on the projected
number of plan sponsors and members
 Amount of money to be spent in salaries, overtime, and benefits for the health plan’s
employees
 Level of resources the health plan should spend on technology, training, and
compliance with regulatory requirements during the coming year
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The time that a health plan takes to make these estimates is time spent away from doing
the actual work that generates the revenues needed to keep the health plan in business.
Another drawback is that if the health plan makes a material change in its plan for the
year, or if expected market conditions change considerably, the health plan has to revise
its budget, which may involve considerable additional work. However, budgeting is work
that must be done, because it imposes discipline in controlling costs and because it
improves the health plan’s probability of achieving its revenue goals.
The budgeting process also has a behavioral drawback: Managers may try to
manipulate the budgeting process to improve or protect their status. For example,
because many companies evaluate managers by comparing results to objectives,
managers may develop budgets too conservatively. Such a budget might project lower
revenues or higher expenses than those actually expected. Thus, a manager makes it
easier to achieve revenue or expense goals by manipulating the budget rather than by
improving performance.
These budgeting techniques can hurt a health plan in a number of ways. Managers may
receive better-than-deserved evaluations, salary treatment, or advancement within the
company. In addition, the health plan may not be in position to make the most informed
judgments regarding investments as well as allocation of resources among the various
departments. Further, the health plan’s net gain may be reduced because of
uncontrolled spending.
The extent to which a health plan suffers from these drawbacks reflects the health plan’s
own corporate culture. If the budgeting process is well monitored and if managers are
not rewarded for underestimating revenues or for padding expense budgets, then these
behaviors are less likely to occur. As reflected in Figure 13C-1, which summarizes the
benefits and drawbacks associated with budgeting, the benefits of budgeting outweigh
the drawbacks.
Producing a thorough, accurate budget requires considerable cooperation among

company managers and other employees. This cooperation between different
departments and functional areas allows a health plan to prepare a comprehensive
planning document known as a master budget.
The Master Budget
Large companies usually draw up a network of separate budgets and schedules, each
reflecting operating and financial plans for specific segments of the health plan. When
integrated, this group of budgets becomes the master budget, which shows the overall
operating and financing plans for the health plan during a specified period, often one
year. Different companies refer to the master budget by many different names, such as
operating budget, comprehensive budget, corporate budget, performance plan, or simply
the budget. In this text, we use the term master budget.
The master budget begins with a health plan’s revenue forecast, then shows the health
plan’s budgeted expenses, cash flows, and investment activities. The master budget can
be thought of as a profit plan, because the achievement of the health plan’s goals
outlined in the budget typically will result in a profit for the health plan. Most companies
compile the master budget annually and update it via "re-projections" semiannually.
The master budget culminates in a set of pro forma financial statements. Recall from
Assignment 11 that pro forma statements project what a health plan's financial condition
will be at the end of a budgeting period, assuming that the health plan achieves all of its
budgetary objectives. At the close of the budget cycle, most health plans draft a pro
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forma income statement, cash flow statement, and balance sheet. Figure 13C-2 shows
the relationships among the various components of the master budget, including the pro
forma statements for a typical health plan. Notice that supporting budgets interweave to
complete the master budget.
At the end of the accounting period, the health plan compares its actual financial
statements to its pro forma financial statements to determine whether it has met its
goals. Top management and the board of directors use the variances between the pro
forma statements and the actual statements to evaluate the performance of the health
plan and its management team.
Approaches to Budgeting
In many health plans, a budget committee formed by top executives and managers from
the health plan’s functional areas oversees the budgeting and financial planning
process. The budget committee reviews proposed plans for reasonableness and works
toward integrating all supporting budgets into the master budget. Ultimately, the budget
committee provides the overall guidance necessary to coordinate a health plan-wide
budgeting process.
Technically speaking, we can identify three distinct approaches to budgeting: (1) top-
down budgeting, (2) bottom-up budgeting, and (3) zero-based budgeting. In practice,
most health plans use a combination of these approaches in a manner that best suits the
health plan’s culture and needs.
Top-Down Budgeting and Bottom-Up Budgeting
As the names imply, top-down budgeting is generated on the corporate level by upper
management and is passed down to lower management, while bottom-up budgeting is
generated at the department level by lower management and is presented in the form of
recommendations to upper management. In both types of budgeting, a health plan
typically uses the previous year's budget as a starting point and then makes adjustments
for the current year's projections.
The amounts found in top-down budgets are based on a health plan’s strategic vision
and objectives for the coming year and financial data from the health plan’s activities in
prior years. The health plan’s top executives typically develop top-down budgets.
Bottom-up budgeting, on the other hand, includes a much larger number of employees
from all departments within the health plan.
These characteristics give top-down budgeting the advantage of being less time
consuming and less labor intensive than bottom-up budgeting. Also, because top-down
budgeting is generated at the corporate level, it is more likely than bottom-up budgeting
to reflect top management's intentions for the health plan. Further, top-down budgeting
enables a health plan to incorporate key changes in regulatory requirements or the
health plan’s strategic plan on a timely basis.
On the other hand, because budgets developed from the bottom up usually reflect the
input and participation of the employees who will be responsible for achieving the
budgetary goals, bottom-up budgeting is more likely to reflect the realities of day-to-day
operations. In addition, bottom-up budgeting often has more grassroots support among
company employees than does top-down budgeting.
Zero-based budgeting (ZBB) differs from other budgeting approaches in that, for every
accounting period, each line of business within the health plan must justify its continued
operation. Zero-based budgeting generally applies only to expense budgets.
(Companies can apply top-down and bottom-up budgeting approaches to both income
and expense budgets.) Medical expenses generally are the largest expense for health
plans.
With zero-based budgeting, a health plan begins with the premise that no resources will
be allocated for the following period unless and until each dollar to be spent is justified
and is shown to be in accord with departmental plans and corporate goals and
objectives. Thus, ZBB treats each activity as though it is a new project under
consideration and does not automatically assume that the current levels of spending are
reasonable starting points for developing next year's budget.
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Many of the positive results of zero-based budgeting come from the financial analysis
and planning required at all levels of management in carrying out this budgeting process.
Management must evaluate every operation in terms of efficiency and need. Lower-level
employees play a key role in ZBB because they often provide necessary details to
accurately assess the importance and financial requirements of each activity. Other
benefits of ZBB are the breadth and quality of information contained in the budgets and
the training and education employees receive as part of their contribution to the process.
The main drawback of ZBB is that it is costly and time consuming. A great deal of the
work associated with ZBB involves collecting and analyzing data to justify each item and
prepare contingency budgets. Thus, many companies do not really have pure ZBB, but
instead use a modified ZBB. With a modified ZBB approach, either the budgetary
approach is only partially zero-based, or the zero-based process is performed irregularly
and not at each accounting period. Figure 13C-3 summarizes the three approaches to
budgeting.
Review Question
The Amethyst Health Plan uses a budgeting approach that requires each line of
business within Amethyst’s operation to justify its continued operation. Amethyst begins
with the premise that no resources will be allocated for the following period unless each
dollar to be spent is justified and is shown to be within departmental plans and corporate
goals and objectives. The budgeting approach used by Amethyst is known as:
bottom-up budgeting
top-down budgeting
zero-based budgeting
master budgeting
Incorrect. This type of budgeting is presented by lower management and

presented as a recommendation to upper management, using the previous year's
budget as a starting point
Incorrect. This type of budgeting is generated at the corporate level by upper

management and is passed to lower management, using the previous year's
budget as a starting point
Correct. In zero-based budgeting, for every accounting period, each line of

business in the health plan must justify its continued operation.
Incorrect. The master budget is the overall operating and financing plan for a
health plan in a specific period.
Budget Classifications
Each of these budgeting approaches can be classified in three ways: (1) as a static
budget or flexible budget, (2) as a short-term budget or long-term budget, and (3) as a
rolling budget or period budget.
Static Budgets and Flexible Budgets
When budgets are classified by the degree of variability inherent in them, they are often
referred to either as static budgets or flexible budgets. A static budget, also known as a
fixed budget or a fixed-amount budget, generally does not change unless management
has approved the changes. As a result, static budgets are of limited managerial
usefulness if projected amounts of revenues and expenses are uncertain. Static budgets
provide no alternative financial predictions when actual experience differs from the
assumptions underlying the budgeted figures.
Static budgets are most useful when a budget's objective is to reduce or limit expenses.
For example, if a health plan allocates $10,000,000 for expenses for the coming month,
the health plan generally cannot spend more than this fixed amount on existing revenue-
generating activities. Further, the health plan would probably not pursue new revenue-
generating activities that would require it to incur additional expenses. The health plan,
of course, could spend less than the budgeted amount. Figure 13C-4 presents an
example of a monthly static expense budget for each functional area of the health plan.
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In contrast, a flexible budget, also known as a flexible-amount budget, a dynamic

budget, or a variable budget, provides alternative sets of figures to use under the
different circumstances that may arise during a budgeting period. Managers use flexible
budgets to test assumptions.
A health plan typically would develop a flexible budget to show the budgetary impact of
obtaining a new large account or as part of a new product introduction. For example,
before the introduction of a new product or line of business, a health plan might prepare
separate budgets for levels of activity that approximate different projected dollar
amounts of business sold.
One approach is for the health plan to develop a flexible budget that shows three
columns of possible first-year selling expenses based on (1) a pessimistic sales figure of
$22,000,000, (2) a most likely figure of $25,000,000, and (3) an optimistic figure of
$28,000,000, of new premium income. In each case, the amount budgeted for selling
expenses differs accordingly.
Figure 13C-5 is an example of this health plan’s flexible budget. Recall that we
discussed optimistic, pessimistic, most likely scenario modeling in The Strategic
Planning Process in Health Plans in the context of pro forma financial statements
Short-Term Budgets and Long-Term Budgets
Budgets can cover almost any time frame. A short-term budget generally addresses a
period of one year or less and relates mainly to a health plan's operations during that
period. Often, the budget is further divided into quarterly, monthly, or weekly budgets. A
long-term budget addresses periods of more than one year. Many companies produce
long-term budgets in their strategic financial plans.
Budgets projecting far into the future allow for income and expenses that correspond to
a health plan’s strategic planning objectives. For example, long-term budgets are often
used to plan for the large capital purchases that will be necessary for the future
operations of the health plan.
Long-term budgets have less detail than short-term budgets because budgetary
predictions are less accurate over multiple years. The most current year of a health
plan’s long-term budget is the short-term budget for the current accounting period. Thus,
a long-term budget incorporates a health plan's short-term budgets.
Rolling Budgets and Period Budgets
A rolling budget, also known as a continuous budget, allows a company to continually

maintain projections for a certain time period into the future. For example, a health plan
with a six-month rolling budget updates the budget at the end of each month so that the
projections always apply to the coming six-month period. A rolling budget forces the
health plan’s management to constantly consider the upcoming six months regardless of
the current point in the fiscal year.
In contrast, a period budget covers a specific time frame, such as one month or one
year. The numbers in a period budget do not change during the time frame covered by
the budget. Because it is updated regularly based on the results of the most recent
period, a rolling budget can maintain a higher measure of accuracy than a period
budget. However, maintaining a rolling budget generally requires more resources than a
period budget.
Suppose a health plan creates a rolling budget for the six-month period from January 1
through June 30. If the health plan updates the budget monthly, then it presents a new
budget on February 1 to reflect the six-month period from February 1 through July 31.
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The health plan repeats this procedure for the six-month period from March 1 through
August 31, April 1 through September 30, and so on. Each new budget reflects revised
projections for the coming six-month period. Figure 13C-6 depicts a rolling sales revenue
budget based on this scenario.
Operational Budgets
Companies typically produce three types of budgets: operational budgets, cash budgets,
and capital budgets. In the following sections, we discuss operational budgets. We
discuss cash budgets and capital budgets in Cash Management and Capital Budgeting
lesson.
An operational budget sets forth the income and/or expenses that a company expects
over a definite period of time. Operational budgets provide detail for the projections and
objectives found in a health plan's master budget. Operational budgets can show
information by department, line of business, functional area, or any other classification
that might accommodate management's decision-making needs. The operational budget
reflects the financial steps the health plan will take during the coming year to achieve its
profitability objectives.
Operational Budgets
Examples of a health plan’s operational budgets, which are generally classified by

subject matter, include the
• Revenue budget or sales budget to project first-year and renewal premium

income
• Expense budget to project medical expenses and selling and administrative
expenses
• Investment budget to project the types of investments to be made and the
amounts of expected investment-related income
• Cash receipts and cash disbursements budget to estimate the cash flows
during the period (discussed in the next lesson)
In the following sections, we discuss two basic types of operational budgets: revenue
budgets and expense budgets.
Revenue Budgets
A revenue budget indicates the amount of income from operations—new business,

renewal business, and investments—that a company expects in the coming budget
period. The revenue budget determines the limits of the other budgets and must be
prepared before them. Some health plans divide the revenue budget into the sales
budget and the investment budget. A sales budget projects premium income from both
new business and renewal business. The health plan bases its estimates on historical
data, reviews of the marketplace, and premium rates charged by competitors, among
other factors.
An investment budget projects the types of investments the health plan will make and
the expected amount of investment-related income for each type. Because cash flow
can have a significant impact on investment strategy, the health plan does not complete
the investment budget until after it completes its cash budget.
All operational budgets begin with a forecast of sales revenue and investment income
because a health plan cannot establish appropriate spending levels until it determines
the funds it will have available. The sales forecast estimates new business and renewal
business premiums for a particular period. The investment forecast estimates earnings
based on the performance of bonds, stocks, mortgages, and other invested assets a
health plan owns.
For large health plans, developing sales and investment forecasts is complex and time
consuming. Sales forecasts require analysis of all internal and external variables that
can affect sales. Internal variables include changes in the product portfolio, product
prices, provider reimbursements, staffing, systems, and advertising outlays. External
variables include changes in the economy, the regulatory climate, and the preferences of
purchasers and consumers.
Investment forecasts also require analysis of specific types of investment vehicles and
analysis of market conditions. Methods of projecting sales and investment performance
can range from relatively simple estimates based on prior experience to more complex
forecasts based on computer simulations. A few of the forecasting techniques that health
plans use include qualitative methods, trend analysis, and regression analysis.
• Qualitative methods rely on the judgment of managers, who use their own
experience and understanding of current economic conditions to make
predictions.
• Trend analysis, which we discussed in Financial Statement Analysis in health
plans, relies on historical data to reveal sales and investment trends, and
then uses these trends to predict future performance.
• Regression analysis relies on the knowledge of how the fluctuations of a
known, dependent variable, such as number of plan members, impacts an
unknown variable, such as claims costs.
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Some health plans make several different forecasts that reflect different assumptions,
such as fluctuations in interest rates, then use the different tentative sales or investment
forecasts to devise a single composite forecast. Personnel in a health plan's sales and
actuarial areas provide management with estimates of the amount of premium income
the health plan can expect. Sales managers in the home office usually check the sales
forecasts for reasonableness. The investment department estimates the amount of
investment income the health plan expects to earn during the next period.
The sales budget is often broken down by product type (such as individual or non-group,
small group, large group, Medicare, and Medicaid). The investments budget is often
broken down by investment vehicle (such as bonds, mortgage loans, stocks, and so
forth).
Suppose a health plan sells an HMO and a managed dental product. Figure 13C-7
shows the health plan’s annual revenue budget, divided into its sales and investment
components, and broken down by quarter.
Expense Budgets
Following the revenue budget, the next step in completing the operational budget is
preparing expense budgets. An expense budget is a schedule of expenses expected
during the given period. An expense budget helps to (1) control expenses, (2) increase
cost awareness among managers, (3) measure management performance, and (4)
assign responsibility for expenses.
Three types of health plan expense budgets are (1)the medical expense budget, (2)the
selling expense budget, and (3)the administrative expense budget. Some health plans
have two expense budgets: a medical expense budget and a selling and administrative
expense budget.
The medical expense budget indicates the amount of money a health plan expects to pay
for medical benefits during the next period. Actuaries and medical management
personnel are typically responsible for developing the medical expense budget.
The selling expense budget is based primarily on the costs incurred in selling health plan
coverage. In addition to commission costs, these selling expenses may include the direct
costs associated with advertising, promotion, travel, sales office operations, and salaries
for sales and marketing personnel. The marketing and sales departments typically are
responsible for developing the sales expense budget.
The administrative expense budget includes the other expenses needed to operate a
company. Usually, this budget is the sum of all departmental expense budgets. The
administrative expense budget also includes such companywide expenses as depreciation
on buildings, computer equipment costs, and administrative salaries. Each functional area
of the health plan usually prepares its own expense budget.
Expense Budgets
Expense budgets can describe variable as well as fixed expenses. Both the medical
expense budget and the selling expense budget describe variable expenses because
the amounts budgeted depend on the figures contained in the sales budget. Typically,
the more plan contracts a health plan sells, the more selling expenses it incurs and the
more medical expenses it incurs due to increased plan membership.
The administrative expense budget contains most of the health plan’s fixed expenses,
such as home office salaries, rent, and depreciation. However, the administrative
expense budget also contains variable expenses because the services provided by
administrative departments are often based on the number of plan members.
Figure 13C-8 shows a health plan’s annual expense budget by quarter. This budget
includes elements of the medical expense budget, the selling expense budget, and the
administrative expense budget.
Having prepared its revenue and expense budgets, a health plan can then draft its pro
forma income statement, which estimates the net income for the entire health plan. If a
health plan’s master budget is for a period of one year, the health plan’s pro forma
income statement may show only the end-of-period data. However, some pro forma
income statements can also be divided into quarterly or monthly columns to show the
end-of-quarter or end-of-month totals.
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Chapter 14 A
Cash Management
• Discuss the fundamentals of cash inflows and cash outflows for a health plan
• Analyze a health plan’s cash budget using the health plan’s cash receipts and
cash disbursements
Cash management, also called treasury management or working capital management,

is the management of a company’s short-term cash needs. In the near term, a health
1
plan either has excess cash or a cash shortage. Excess cash can easily become idle
cash if it is not invested to earn a return. On the other hand, a cash shortage may delay
provider payments and other payments that must be made to satisfy a health plan’s
current obligations. Further, a health plan may incur additional liabilities if it has to
borrow short-term funds to meet these obligations. To manage its cash effectively, a
health plan typically constructs a cash budget.
Recall that a health plan’s working capital is the difference between the health plan’s
current assets and its current liabilities. Although the amount of working capital is
typically positive, sometimes a health plan experiences negative working capital. In other
words, the health plan’s current liabilities may be greater than its current assets.
Negative working capital tends to occur whenever healthcare expenses generated by

plan members exceed the premium income that the health plan receives. This situation
can develop in the short run simply because healthcare expenses generated by plan
members vary from month to month, but premium income tends to be a more stable
cash flow.
Earlier we discussed how health plans manage the volatility in claims payments through
estimating its IBNR claims. In addition, some forms of provider reimbursement—notably
capitation contracts—tend to stabilize a health plan’s expenses, because a provider will
be paid the same PMPM rate every month of the contract period, even if the cost of
providing medical care to plan members varies.
Review Question
A health plan may experience negative working capital whenever healthcare expenses
generated by plan members exceed the premium income the health plan receives. Ways
in which a health plan can manage the volatility in claims payments, and therefore
reduce the risk of negative working capital, include:
1. Accurately estimating incurred but not reported (IBNR) claims

2. Using capitation contracts for provider reimbursement
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Both 1 and 2
1 only
2 only
Neither 1 nor 2
Correct. Both estimating IBNR and use of capitation are ways a health plan can
stabilize expenses
Incorrect. Using capitation contracts for provider reimbursement is also a way to

stabilize expenses.
Incorrect. Accurately estimating IBNR is also a way to stabilize expenses
Incorrect. Both estimating IBNR and use of capitation are ways a health plan can
stabilize expenses.
Developing the Cash Budget
Typical sources of cash for health plans include premium income, investment income,
management fee income obtained from administrative services only arrangements, and
subsidiary income. A health plan uses cash to make many types of payments for
healthcare benefits, provider reimbursement, employee salaries and other operating
expenses, and so on.
Most health plans plan to have on hand just enough cash to make these payments as
they come due. A shortage of cash means that the health plan could be delinquent on
some of its payments, leading to problems with providers, stockholders, or employees.
The health plan may also have to sell its investments at an inopportune time and incur a
loss or perhaps borrow money at a higher interest rate to meet its obligations.
But holding too much cash on hand presents another set of problems. Although it
provides the health plan a sense of security, excess cash is unproductive because it sits
idly and earns little or no return. A large amount of excess cash therefore has a high
opportunity cost because the health plan could, by using that money elsewhere, earn
additional income and improve its profitability.
Budgeting for cash helps a health plan avoid cash shortages and cash excesses. Cash
budgeting anticipates the flows of cash into and out of a health plan during a given
period. A cash budget shows all expected cash inflows, cash outflows, and ending cash
during a period. Many health plans prepare an annual cash budget that is broken down
into quarterly, monthly, weekly, and, sometimes daily budgets to monitor its cash flow
more closely.
Through monitoring its cash budget over a long period, a health plan may discover how
cyclical events and seasonality affect its estimated cash inflows and cash outflows.
Suppose a health plan learns that its IBNR claims liabilities typically become cash
disbursements within 45 days of their occurrence. In this case, the health plan’s cash
disbursements budget and cash budget would indicate a 45-day payment cycle for IBNR
claims.
In another example, a health plan may discover that its provider reimbursement
payments peak around a specified time each year. The underwriting cycle is one
example of the impact of a cyclical effect on health plans. Recall from The Relationship
Between Rating and Underwriting that the underwriting cycle occurs when a health plan
experiences a pattern of three years of underwriting profits, followed by three years of
underwriting losses.
In conjunction with, and sometimes instead of, a formal cash budget, some health plans
have their internal accounting function submit a daily cash report to the health plan’s
investment function. In turn, the investment function uses the daily cash report to
determine the amount of excess cash available to invest each day. The daily cash report
is used primarily for operational purposes.
Although specific cash inflows and cash outflows are unique to each health plan, some
general assumptions can be made about cash flows in the health plan industry. A health
plan forecasts its expected cash receipts and cash disbursements using qualitative
methods, trend analysis, and regression analysis. We discussed trend analysis in
Financial Statement Analysis in Health Plans. A discussion of regression analysis is
beyond the scope of this course.
The Cash Receipts Budget
Typical cash receipts (inflows) for a health plan result from premium income and
investment income. Most group health premiums are due on a quarterly or monthly basis
according to due dates specified in each contract. The majority of plan sponsors remit
their premiums by the due date to avoid losing coverage, so a health plan’s cash inflows
from premiums are relatively stable.
Somewhat less predictable is a health plan’s investment income. However, even if some
of a health plan’s investments are volatile by nature, most of a health plans investments
are in relatively low-risk assets that provide a guaranteed, steady income stream. One
example of such an investment is a U.S. Treasury bill that pays semiannual interest.
Nevertheless, when forecasting for investments, health plans must consider the overall
economic outlook, statutory requirements, tax factors, and the health plan’s investment
strategy.
A company plans for its cash inflows through a cash receipts budget, which is a
schedule of cash receipts that the company expects to receive during the period. To
predict both the timing and the amount of its cash receipts, a health plan constructs the
cash receipts budget using data from its sales forecast and investment forecasts. Many
cash inflows are received on or around the first day of each month because many
premiums and investment income payments have due dates at the beginning of the
month.
Figure 14A-1 shows a sample health plan’s annual cash receipts budget broken down by
quarter. Note that the sample health plan divides its cash receipts budget into receipts
from the sales of health plans and healthcare products and receipts from investments.
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For simplicity, Figure 14A-1 assumes that there is no timing difference between income
and cash receipts. In other words, the revenue forecast equals cash.
The Cash Disbursements Budget
A company attempts to estimate the timing and amount of all of its cash disbursements
in a cash disbursements budget. Unlike a health plan’s cash receipts, the health plan's
cash disbursements take a variety of forms. Common disbursements that most health
plans make include
• Healthcare benefit payments

• Provider reimbursement payments
• Employee salary payments
• Investment purchase payments
• Stop-loss insurance premium payments
• Tax payments to government agencies
• Operating expense payments
Besides the ongoing cash disbursements listed above, a health plan also incurs some
nonrecurring cash disbursements, many of which result from its capital budgeting
decisions. Also, a health plan must estimate its liability for IBNR claims as accurately as
possible to manage cash effectively. If an health plan significantly underestimates the
IBNR claims liabilities, the amount of these liabilities will be understated on the health
plan’s balance sheet—that is, the dollar amount of IBNR claims liabilities would be lower
than it should be.
The health plan’s income statement would similarly understate the amount of its
healthcare benefit expenses, thereby making the health plan look more profitable than it
really is, all other factors remaining equal. If a health plan significantly overestimates its
IBNR claims liabilities during a period, then the health plan would most likely have little
or no excess cash to invest—essentially the health plan would be holding cash to pay for
claims that do not exist. A high opportunity cost would result.
Again, a health plan generally experiences heavy cash outflows in the first few working
days of each month because most monthly payments are due on the first of the month.
These payments include provider reimbursements and utility payments. The cash
disbursements for fixed expenses such as salaries are made with relative ease and
accuracy. However, estimating the cash disbursements for variable expenses such as
claims payments and variable provider reimbursement contracts such as FFS contracts
is less predictable. The accuracy of these predictions depends in large part on the
accuracy of a health plan’s sales forecast.
Figure 14A-2 shows a sample health plan cash disbursements budget. This figure shows
that a sample health plan first divides its cash disbursements budget into two categories:
healthcare-related disbursements—such as claims payments and provider
reimbursement—and investment-related disbursements.
Note that a sample health plan subdivides its healthcare-related cash disbursements into
a fixed component and a variable component and its investment-related cash
disbursements into short-term purchases and long-term purchases. Also, note that a
sample health plan made a one-time purchase of computer equipment during the third
quarter.
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The Cash Budget
Once a health plan has prepared its cash receipts budget and cash disbursements
budget, the health plan prepares its cash budget. Important pieces of information that
are contained in a health plan’s cash budget include the health plan’s
 Beginning-of-period cash balance (equals end-of-period cash balance from previous

period)
 Available cash for the period (beginning cash plus cash receipts during the period)
 Minimum cash balance (the amount of cash that a health plan determines is necessary
to pay all obligations in a given budgeting period without needlessly tying up excess
cash)
 Cash needed for the period (cash disbursements during the period plus the minimum
cash balance)
 Excess cash or cash shortage (cash available for the period minus the cash needed;
excess cash results if this amount is positive; a cash shortage results if this amount is
negative)
 Effects of financing activities (initial borrowing or repayment of borrowed funds)
 End-of-period cash balance (excess cash or cash shortage plus any financing activity)
The minimum cash balance is of great importance in cash budgeting. Determining the
amount of a health plan’s minimum cash balance requires a great deal of research and
estimation from a health plan's managers. Setting this figure too low raises the risk of
running out of cash. Setting this figure too high carries a high opportunity cost.
The Cash Budget
A health plan that sets a lower minimum cash balance in an effort to keep as much cash
"at work" in the health plan’s productive assets usually arranges for a line of credit from
a bank. A line of credit, also called a bank line, is a pre-arranged agreement that allows
a company to borrow money on demand up to a specified amount. This short-term
borrowing becomes necessary whenever a health plan encounters a cash shortage.
Some health plans make arrangements with banks that allow a health plan to keep funds
in interest-bearing accounts and the bank automatically transfers money to the health
plan’s checking (or other cash disbursements) account as needed.
A health plan can use many methods to derive its minimum cash balance. For example,
a health plan may set its minimum balance equal to that of its budgeted cash
disbursements for a month. The health plan’s IBNR calculations, as well as planned-for
capital improvements, may also figure into the determination of an appropriate cash
balance for any given period. More sophisticated techniques involve computer
spreadsheet simulations. Regardless of the method used to determine the minimum
cash balance, this decision is a significant one with respect to a health plan’s solvency
and profitability.
By examining its cash budget, a health plan’s management can estimate the timing and
amount of a cash shortage, which will require additional financing, or excess cash, which
will allow for investment in relatively liquid assets. Recall that an asset’s liquidity is the
ease with which an asset can be converted into cash for an approximation of its true
value. Generally, the more liquid an asset, the more easily it can be converted into cash
if the need for that cash arises.
Typically, health plans invest excess cash assets in money market mutual funds,
government securities money funds, certificates of deposit (CDs), commercial paper,
and U.S. Treasury bills, so that, when necessary, they can retrieve cash quickly. Figure
14A-3 shows health plan XYZ’s cash budget. Note that health plan XYZ has set its
quarterly minimum cash balance at $3,250,000.
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Note also that health plan XYZ anticipates that, by the end of the first quarter, it will
encounter a cash shortage of $2,021,000. To address the expected cash shortage,
health plan XYZ has planned for a short-term loan in the amount of $2,500,000.
(Alternatively, health plan XYZ could sell some of its investments to cover the cash
shortage.) The health plan also expects to be able to repay the loan plus interest in the
fourth quarter, and the effect of this financing activity is noted in its cash budget.
After completing its cash budget, a health plan then prepares its pro forma financial
statements. First, the health plan develops its pro forma income statement. Next, data
from a health plan’s cash receipts and cash disbursements budgets, the cash budget,
and the pro forma income statement are transferred to the health plan’s pro forma cash
flow statement. Then, the health plan prepares its pro forma balance sheet.
Chapter 14 B
Capital Budgeting
• Describe the purpose of capital budgeting

• Identify the characteristics of the payback method, the discounted payback
method, the net present value method, and the internal rate of return method with
respect to a health plan’s capital budgeting decisions
• Describe factors that affect a health plan’s capital budgeting decisions
• Explain the function of sensitivity analysis in capital budgeting
A health plan’s managers focus on ways to make the health plan grow or otherwise
become more profitable. In many cases, growth or increased productivity requires
investing in new assets, which sometimes means a large outlay of funds. To prepare for
such large cash outlays, a company undertakes capital budgeting, which is the
analysis of decisions about investing in long-term assets. The capital expenditures made
to obtain a health plan’s long-term assets are expected to produce income or other
benefits for more than one year.
Buildings and computer equipment are examples of long-term assets that a health plan
plans to hold for 3 to 20 years or more. Long-term assets are sometimes referred to as
long-lived assets, capital assets, plant assets, or fixed assets. For health plans, a new
product launch may be a major capital project if the new product requires a large amount
of up-front capital for development and marketing.
The Capital Budgeting Process
Because a capital budget is long-term in nature, it is used extensively in a health plan’s

strategic planning. As a result, the health plan’s top management is closely involved in
developing the health plan’s capital budget. A capital budget is a budget in which a
company estimates its need for capital. Capital budgets generally incorporate new
projects, major repairs to or remodeling of already-owned long-term assets, acquisitions
of other companies, legislatively mandated safety and environmental improvements,
cost reduction projects, and revenue expansion projects.
The capital budgeting process often includes many steps. In this lesson, we identify four
important steps: (1) generating capital budgeting ideas, (2) classifying each capital
project proposal, (3) estimating cash flows for each proposal, and (4) evaluating and
selecting proposals.
Generating Ideas
All capital projects begin as ideas. For example, a health plan’s marketing function or
actuarial function may suggest a new product idea for development. The claims
administration function may recommend upgrading outdated equipment to enable more
effective claims processing. A health plan’s investment function may request a new
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decision support system to generate a higher return on the health plan’s investments. Or
the health plan’s president may decide that the organization plan is outgrowing its office
space and propose investing in additional space or extensive remodeling.
Classifying Each Proposal
In compiling the master budget, a health plan determines the resources—money, staff
time, equipment, and so on—that it can devote to proposed capital projects. Because
there are often multiple functional areas requesting capital resources, it is helpful to
classify each capital project proposal so that a health plan’s managers can better
analyze each one and gauge its potential usefulness to the health plan. Although
specific classifications vary among health plans, some typical classifications include
New Projects : such as new assets or new uses for existing assets. Examples of this
category are new healthcare products or the purchase of another health plan or one or
more of its product lines.
Replacements : such as new assets that will be used to replace old or defective assets.
An example is the replacement of an outdated mainframe computer with a new
computer system.
Cost reduction programs : such as assets that reduce the cost of a health plan’s
operations. An example is the purchase of a printer to handle in-house print jobs that
previously had been outsourced.
Safety and regulatory expenditure programs : such as those that address employee
safety concerns or are required by legal regulations. An example is the purchase of a
new fire alarm and sprinkler system for a health plan’s home office building.
Estimating Cash Flows
Once a health plan has generated and classified its capital project ideas, the health plan
then estimates the cash flows associated with each project. Estimating each project’s
cash flows quantifies both its benefits and drawbacks and facilitates the evaluation of
each project. Capital projects have both cash inflows and cash outflows. A health plan’s
management should consider only each project’s incremental cash flows, which are
the additional costs or revenues that result from a capital project. We discussed
incremental (differential, marginal) costs in Management Contol.
Suppose a health plan’s salary expenses are $1,000,000 before undertaking a new
capital project. The health plan estimates that its salary expenses will be $1,200,000
after undertaking the project. In this case, the incremental cash outflow associated with
this project is $200,000. In other words, the health plan would incur the $1,000,000 of
salary expenses, all other factors remaining equal, even if it did not undertake this
particular project. The new project would result in a $200,000 increase in salary
expenses only if the health plan accepted the project.
Almost all capital projects begin with an initial investment in equipment or other assets.
In subsequent years, some capital projects will require cash outflows for repairs and
maintenance. These ongoing cash outflows are referred to as incremental operating
costs. The cash inflows of a capital project are usually in the form of incremental
revenues or a reduction in costs.
Typically, a health plan would consider accepting a capital project if the health plan
expects that the project will increase revenues, decrease costs, or both. A project’s cash
inflows may be predictable in amount and timing; that is, the same cash inflow may be
expected during each year of the asset’s useful life. Often a project’s cash inflows are
uneven, in which case the amount or the timing of the inflow varies each year.
For capital budgeting purposes, a reduction in costs is equivalent to an increase in

revenues because either results in an increase in a health plan’s net income. In the case
of a replacement proposal, such as a computer system, the salvage value of the old
computer system is treated as a cash inflow. Salvage value is the residual value or
selling price of a tangible (physical) asset at the end of its useful life.
The time value of money concept is critical to capital budgeting decisions because such
decisions require a health plan to invest money in the present so it can generate more
money in the future. Generally, the value of one dollar earned today differs from that of
one dollar earned three years ago or five years in the future. Calculating the present
value or future value associated with each capital project is therefore critical to the
decision-making process. Although a complete discussion of the time value of money is
beyond the scope of this course, Figure 14B-1 provides a summary of this concept.
Review Question
An investor deposited $1,000 in an interest-bearing account today. That sum will

accumulate to $1,200 two years from now. One true statement about this transaction is
that:
the process by which the original $1,000 deposit grows to $1,200 is known as
compounding
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$1,200 is the present value of the $1,000 deposit

the $200 increase in the deposit’s value is its incremental cash flow
the $200 difference between the original deposit and the accumulated value of the
deposit is known as the deposit’s discount
Correct. Compounding is the process of converting the present value of an

amount of money to it's future value
Incorrect. The present value is how much the money is worth today.
Incorrect. An incremental cash flow is the additional cost or revenue that result
from a capital project
Incorrect. Discounting involves calculating the present value of future money.
Estimating Cash Flows
Besides considering the time value of money, a health plan’s managers need to consider
the opportunity costs associated with its capital budgeting decisions. In other words, by
committing money today for a specified capital project, the health plan is giving up the
opportunity to invest in other capital projects. Before we review a few of the evaluative
methods that health plans use in making capital budgeting decisions, we first review the
selection of the appropriate discount rate to use in calculating a capital project’s
estimated cash flows.
Because of the importance of the time value of money, some capital budgeting methods
involve the calculation of discounted or compounded cash flows. It is therefore vital that
the health plan choose an appropriate rate to discount these cash flows to their present
value and apply that rate consistently to each project being evaluated. The discount rate
used in capital budgeting usually represents a health plan’s weighted-average cost of
capital (WACC).
A health plan’s cost of capital is the "price" that a health plan pays collectively for its
various sources of financing. One way to determine a health plan’s cost of capital is to
find the weighted average cost of all sources of debt capital (primarily bank loans and
bond issues) and equity capital (common stock, preferred stock, and retained earnings).
Each component’s costs are measured in terms of interest payments, bond
amortizations, stockholder dividend payments, and the opportunity cost of retained
earnings (or surplus). Recall our discussion of the weighted average cost of capital
(WACC) in The Strategic Planing Process in Health Plans.
A complete analysis of the way a health plan derives its WACC is beyond the scope of
this text, but a simple example using the Mainline health plan, a publicly owned
company, should help illustrate the concept. The WACC simply means that Mainline will
factor into its calculation the amount of money financed at each discount rate. Suppose
that 60% of Mainline’s total capital comes from retained earnings and 40% comes from a
new issue of common stock. Assume that the financial managers of Mainline have
calculated the cost of retained earnings to be 13% and the cost of the common stock
issue to be 18%. Mainline’s cost of capital is the weighted average of these two sources
of financing, calculated as shown in Figure 14B-2.
Mainline’s weighted average cost of capital is 15%. Therefore, an appropriate discount

rate for Mainline to use when applying each capital budgeting method could be 15%.
Evaluating and Selecting Proposals
Remember that the expected cash flows for a capital project are estimates. How a health
plan evaluates the capital projects that it is considering depends in part on the accuracy
of its cash flow estimates. Once the health plan has calculated the relevant cash flows of
each proposed capital investment, the health plan evaluates all proposals and decides
which, if any, to accept and implement.
A health plan may use a variety of evaluation methods to quantify the value of each
proposed capital project. Quantifying the value of each capital project in financial terms
makes it easier for a health plan’s management to compare proposals with each other or
with some predefined decision-making benchmark. We discuss these methods later in
this lesson.
Most proposed capital projects are accepted or rejected based on their financial
attributes. However, some proposals are accepted even if their profit evaluations
suggest unacceptability. For example, health plans implement safety and regulatory
projects, despite their lack of profitability, to comply with legal or regulatory
requirements. On the other hand, a health plan does not approve all proposed capital
projects that receive a favorable evaluation. For example, a certain proposal may not fit
the health plan’s strategic goals, or the health plan may not have the resources to
undertake all acceptable proposals.
A manager analyzing the benefits and drawbacks of a particular capital project should
consider other possible outcomes of the project, asking the following questions:
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 Will the project reduce or offset the health plan’s tax liability?
 How will depreciation of the project, if applicable, affect the health plan’s financial
statements?
 What is the health plan’s required rate of return on the project?
 What risks are associated with the project?
 Is the project subject to any regulatory restrictions?
 How will the health plan’s internal operations be affected by the project?
Capital Budgeting Methods
Capital budgeting methods serve as a screening function. That is, a health plan uses
them to evaluate proposed capital projects to determine which ones meet a minimum
standard of financial acceptability. Four methods of analyzing the worthiness of a capital
investment are the (1) payback method, (2) discounted payback method, (3) net present
value method, and (4) internal rate of return method.
Admittedly, capital budgeting is imprecise because the process requires an estimation of

expected cash inflows and outflows. Therefore, a health plan often uses more than one
capital budgeting method to minimize the chance of making incorrect decisions about
investment proposals. A health plan’s management applies the health plan-defined
decision rules to the results of one or more of these analyses to decide whether to
accept or reject a particular capital project. Instead of emphasizing the mathematical
calculations inherent in these methods, the following sections highlight the decision rules
that a health plan may use and the way these methods assist in decision making.
The Payback Method
The payback method is a capital budgeting technique that calculates how long it will
take a health plan to recover its investment in a capital project. This recovery time is
called the payback period. The payback method compares the initial investment with the
additional cash expected to come into the health plan as a result of its investment in a
project. If the annual revenues or savings are expected to remain constant each year,
the payback method calculation is relatively simple: divide the actual cost of the
expenditure under consideration by the annual cash inflow.
To illustrate, assume that the Mainline health plan is considering the purchase of 20 new
laser printers at a cost of $75,000 (a cash outflow). The new printers will enable Mainline
to print all its forms in-house. Under the current system, Mainline spends $25,000 a year
to have forms printed by a local printing company. Thus, by purchasing the new printers,
Mainline should save $25,000 a year, and this savings is a cash inflow. (In reality, the
$25,000 cash inflow amount would change from year to year as the cost of external
printing increases or decreases and as the volume of printing increases or decreases.
For simplicity, this example ignores these factors.)
To compute the payback period, divide an health plan’s initial investment by the annual
expected cash inflow (in our example, $75,000 ÷ $25,000 = 3 year payback period). If
Mainline’s decision rule is to accept all proposed capital projects that have payback
periods of four years or less, then it would accept this proposal. If the decision rule
requires a payback period of less than three years, then Mainline would reject the
proposal.
The main benefit of the payback method is its simplicity. Also, the payback method
suggests a degree of risk inherent in a proposed capital project. Generally, a longer
payback period indicates a greater risk because the health plan’s initial investment may
not be recovered.
The payback method has several limitations. One drawback of the payback period is that
it does not measure profitability, so the payback period provides no information about
the rate of return on the health plan’s investment. Also, the payback method ignores the
time value of money and ignores all cash inflows and cash outflows that occur after the
payback period.
In our example, the new printers may reduce Mainline’s expenses by $25,000 for each
of the first three years (the payback period), but what about cash flows in the fourth year
and succeeding years? Because of these limitations, many health plans supplement the
payback method with another analysis method. Many health plans use the payback
method only as an initial screening device, because the payback period alone is not
enough justification for undertaking or rejecting a proposed capital project.
The Discounted Payback Method
Similar to the payback method is the discounted payback method, which overcomes one
drawback of the payback method by taking into account the time value of money. The
discounted payback method calculates, in terms of discounted dollars, how long it will
take a health plan to recover its initial investment.
Again, let’s assume that the Mainline health plan is considering the purchase of the 20
printers at an initial cost of $75,000, and that the savings (cash inflows) provided by the
printers will be $25,000 per year. Assume also that Mainline selects a 15% discount rate
based on its weighted-average cost of capital. The cash inflows for each year,
discounted to their present value, are shown in Figure 14B-3.
According to the discounted payback method, Mainline recovers only $57,100 of its
investment after Year 3 and $71,400 after Year 4. Not until Year 5 does Mainline recover
its entire $75,000 initial investment. Therefore, consideration of only discounted cash
flows has increased the payback period to more than four years (actually 4.29 years).
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Mainline would not approve this proposal if it had a decision rule to accept all projects
with payback periods of four years or less. Because it considers the time value of
money, the discounted payback method is superior to the payback method. However,
the discounted payback method also fails to measure profitability and ignores cash flows
beyond the payback period.
The Net Present Value Method
A third method of evaluating proposed capital projects is the net present value method.
The net present value (NPV) method evaluates a proposal based on its net present
value (NPV), or the difference between the present value (PV) of a project’s cash inflows
—revenues, cost savings, and interest income—and the present value (PV) of its cash
outflows—project or investment costs and expenses.
Unlike the payback method and the discounted payback method, which both evaluate
proposed projects according to the length of time needed to recoup a project’s initial
investment, the NPV method states a proposed project’s cash flows in terms of present
value for the entire life of the project.
Review Question
The following statements are about the capital budgeting technique known as the
payback method. Select the answer choice containing the correct statement:
The main benefit of the payback method is that it is simple to use.

The payback method measures the profitability of a given capital project.
The payback method considers the time value of money.
The payback method states a proposed project’s cash flow in terms of present
value for the life of the entire project.
Correct. The payback method calculation is very simple; divide the actual cost of
expenditure under consideration by the annual cash inflow.
Incorrect. The payback method does not measure profitability, and provides no
information about the rate of return on a health plan's investment
Incorrect. The payback method ignores the time value of money
Incorrect. The payback method ignores all cash inflows that occur after the
payback period
The Net Present Value Method
The NPV method has an advantage in that this method considers the time value of
money. The NPV calculation involves determining the proposed capital investment’s
useful life and selecting an appropriate discount rate. Again, an appropriate discount rate
for a health plan may be the health plan’s weighted-average cost of capital.
The decision rule for accepting a proposal under the NPV method is that the present
value of a project’s cash inflows must exceed the present value of the project itself. In
other words, the net present value of a project must be greater than zero for an health
plan to accept the project. Usually a health plan establishes additional decision rules.
For example, a health plan will select a project if its NPV is greater than or equal to
$1,000, $5,000, or $10,000, depending on the project.
If the proposed printers have a five-year useful life and Mainline’s discount rate is 15%,
then the NPV for Mainline’s printer proposal is $8,825, as shown in Figure 14B-4.
Assume that Mainline’s decision rule is to accept all capital projects that have an NPV
greater than zero. In this case, Mainline would accept the printer proposal.
The NPV method considers a health plan’s profitability with respect to a proposed capital
project, because a project’s NPV can be thought of as additional wealth to the health
plan. The NPV method also considers the time value of money, and all cash flows during
a capital project’s useful life, including those cash flows that occur after the project’s
payback period.
However, to use the NPV method, a health plan must first determine its WACC. Also, a
direct comparison of the NPVs of two or more capital project proposals may be
misleading unless all proposed projects require an health plan to invest equivalent
amounts.
The Internal Rate of Return Method
Another useful evaluation method is the internal rate of return method. The internal rate
of return (IRR) method, also called the time-adjusted rate of return method, determines
the discount rate at which the net present value of a capital project equals zero. In other
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words, the IRR method determines the rate at which a project’s cash inflows must be
discounted to recoup the project’s initial investment. A capital project’s IRR is
determined by analyzing the project’s yearly cash inflows, then using the appropriate
interest factor to calculate the present value of those cash inflows.
Let’s return to our example. To find an appropriate IRR for a project, divide the amount
of the required investment by the annual net cash inflows to obtain a present value
interest factor of an annuity (PVIFA). In our example, Mainline would divide the project’s
required investment of $75,000 by the project’s annual cash inflows of $25,000, to obtain
a PVIFA of 3.0. Next, Mainline would find the discount rate, given the appropriate
number of periods (five), that is closest to 3.0. Mainline would use a present value
interest factor of an annuity (PVIFA) table to find the discount rate.
Mainline finds that, on the PVIFA table, the factor that is closest to 3.0, for five periods, is
between 19% and 20%. Therefore, the IRR of Mainline’s proposed printer is between
19% and 20%. Calculating the precise IRR involves the use of PVIFA tables and
interpolation, which are beyond the scope of this course. The interpolated IRR for
Mainline’s printer proposal, assuming a useful life of five years, is 19.87%.
The decision rule for the IRR method requires that a health plan compare its WACC to
the proposed project’s IRR. If the project’s IRR exceeds the health plan’s WACC, then
the project’s benefits should exceed its costs. Thus, the project would be accepted
according to the IRR method. Otherwise, the health plan would reject the project.
Mainline’s printer project is acceptable because the proposed printer’s IRR of 19.87%
exceeds the Mainline’s WACC of 15%. If Mainline must choose among this project and
other proposed projects, then Mainline would accept the project that has the highest
IRR.
Figure 14B-5 summarizes the four capital budgeting methods we discussed and the
evaluation each one provided for Mainline’s proposed capital project.
As shown in Figure 14B-5, different capital budgeting methods may yield conflicting
evaluations of the same proposal. In our example, the decision rule for the discounted
payback period indicates that Mainline should reject the proposal, although the other
three capital budgeting methods indicate that Mainline should accept the proposal.
Conflicting results often occur when a health plan compares the accept-reject decision of
several capital budgeting methods. Therefore, health plans also consider other factors
when deciding which proposals to accept or reject.
An underlying assumption of capital budgeting is that investing decisions (what to

purchase) should be kept separate from financing decisions (how to purchase).
Combining the two can lead to inaccurate capital budgeting evaluations. For example,
assume that a health plan with a 13% WACC uses the NPV method to evaluate a capital
project that will be financed through a long-term bank loan at an interest rate of 10%.
It might seem logical for the health plan to use the 10% interest rate as the discount rate
for its calculation of the project. However, doing so could lead the health plan to accept a
proposal that has a rate of return that is less than the health plan’s WACC, although the
project’s return may be greater than the cost of a specific form of financing, such as the
10% bank loan.
Independent Proposals and Mutually Exclusive Proposals
When a health plan considers multiple capital project proposals, it must be aware of
whether the proposals are independent or mutually exclusive. Independent proposals
have cash flows that are unrelated; that is, the acceptance of one independent proposal
does not automatically eliminate any others. Mutually exclusive proposals involve
investment choices that perform essentially the same function, so the acceptance of one
proposal automatically eliminates all others from consideration.
A health plan may accept any number of independent proposals but only one in a group
of mutually exclusive proposals. For example, if a health plan was deciding whether to
move its home office either to Atlanta or to Miami, the acceptance of one of these
mutually exclusive alternatives automatically eliminates the other choice.
Capital Rationing
A health plan may find that it has more acceptable capital proposals than it has available
resources to fund them all. In these circumstances, the health plan would use capital
rationing. Capital rationing is the process of allocating limited resources to a health
plan’s capital project proposals. Under capital rationing, a health plan ranks all capital
project proposals according to expected rates of return and accepts only those with the
highest rankings. There are several ways to rank all acceptable proposals. If a health
plan relies on each project’s IRR to screen capital proposals, the health plan ranks them
by their expected IRR. For example, assume that an health plan has four acceptable
capital proposals with IRRs as follows:
If the health plan has resources to accept only

two proposals, it should choose proposals C and
D because they have the highest IRRs.
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Profitability Index
Recall that, unlike the IRR method, the NPV method does not allow for direct
comparisons of proposed capital projects, unless they require an equal amount of
investment. So, if a health plan uses the NPV method, the health plan calculates the
profitability index to rank proposals for comparative purposes. The profitability index
(PI) is the ratio of the present value of future cash flows expected from a project to the
amount of an health plan’s initial investment in the project.
Profitability Index
In our example, Mainline calculates the PI of its printer proposal, as follows:
A project that has a PI of 1.0 means that the project’s NPV is zero. The decision rule for
using PI involves rejecting projects that have a PI of less than 1.0. If a health plan is
considering several projects, then the health plan will rank the project from highest PI to
lowest PI.
Review Question
The Jade Health Plan used a profitability index (PI) to rank the following capital
proposals:
Proposal PI
A 0.45
B 1.05
This information indicates that, of these two projects, Jade would most likely select:
Proposal A, and the PI indicates that the net present value (NPV) for this project is
less than zero
Proposal A, and the PI indicates that the net present value (NPV) for this project is
greater than zero
Proposal B, and the PI indicates that the net present value (NPV) for this project is
less than zero
Proposal B, and the PI indicates that the net present value (NPV) for this project is
greater than zero
Incorrect. Health plans will move forward with projects whose PI is the largest.
Incorrect. Health plans will move forward with projects whose PI is the largest.
Incorrect. A project that has a PI of 1.0 means that the NVP is zero.
Correct. Health plans will move forward with projects whose PI is the largest.
As you have seen, capital budgeting involves making decisions under the assumption
that a health plan’s management has perfect knowledge of the future. Keep in mind that
any number of assumptions could be wrong. In the Mainline example, suppose the
printers actually could provide only $15,000, rather than $25,000, of cash inflows per
year. Suppose the printers could be usable for only four years instead of five. If either or
both were to happen, would Mainline still accept the printer proposal?
To address these types of circumstances, an health plan’s managers apply sensitivity

analysis. Recall from The Strategic Planning Process in Health Plans that sensitivity
analysis determines a variety of scenarios by calculating how far reality can vary from
estimates without invalidating an health plan’s accept/reject screening decision.
For example, sensitivity analysis reveals that Mainline must receive cash inflows of at
least $22,375 per year for five years for the proposal to “break even.” To determine the
break-even point of the printer proposal’s cash flows, divide Mainline’s cost of the
investment by the present value interest factor of an annuity (PVIFA) at 15% and five
years: $75,000 ÷ 3.352 = $22,375.
Mainline’s managers also would perform a similar calculation to determine the amount of
cushion in its estimate of the printers’ useful life of five years. In light of the new
information, Mainline’s managers would assess the likelihood that the printer proposal
will actually meet its investment thresholds.
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Health Plan Financials Explained

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Health Plan Financials Explained

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AHM 520

Health Plan Finance and Risk Management

After completing Health Plan Financial Information, you should be able to

• Define financial information and list examples of a health plan’s financial

Health Plan Finance and Financial Information

A health plan’s accountants, actuaries, underwriters, financial analysts, investment

Users of Financial Information 1

Many organizations and people rely on the financial information contained in a

External Users: Indirect Financial Interest

internal user with a direct financial interest

Uses of Financial Information

Legal Forms of Organization That Affect Health Plan Finance 13

Recall from Healthcare Management: An Introduction that there is a wide variety of

A health plan can be established on either a for-profit basis or a not-for-profit basis.

For-Profit Health Plans

Not-For-Profit Health Plans

Funds from Debt Markets: available to Verde and Noir

Types of Health Plans

Legal Forms of Organization That Affect Health Plan Finance

• Health plan members

Types of Health Plans

Types of Health Plans

Perhaps the best example of aligned incentives is a risk-sharing arrangement in which a

• Risk management tools • Accounting and financial

After completing Types of Risk, you should be able to

• Distinguish between pure risk and speculative risk

The Concept of Risk 1

• Example 1 — A health plan invested in 1,000 shares of stock issued by a

The examples that describe pure risk are

C-Risks and Solvency

Assets – Liabilities = Capital and surplus

C-Risks and Solvency

C-Risks and Solvency

C-Risks and Solvency

Management risk is always present in a business, because management constantly

Regulatory and Antiselection Risks

In a health plan environment, antiselection is the tendency of people who have a

Regulatory Solvency and Risk-Based Capital Requirements

Because employees typically contribute to the financing of employer-sponsored health

HMO Model Act and Solvency 5

HMO Model Act and Solvency

We discuss financial statements in more detail in Accounting and Financial Reporting,

HMO Model Act and Solvency

HMO Model Act and Solvency

having an initial net worth of at least $5 million

Regulatory Solvency and Risk-Based Capital Requirements

Disadvantages of the HMO Model Act Solvency Standards

The Development of Risk-Based Capital Requirements

The Development of Risk-Based Capital Requirements

• Affiliate risk—the risk that the financial condition of an affiliated entity

The Development of Risk-Based Capital Requirements

The Development of Risk-Based Capital Requirements

The second influence of provider reimbursement contracts on a health plan’s RBC

The Development of Risk-Based Capital Requirements

The Structure of the RBC Formula

Strategies for Controlling Risk

Avoiding the Risk

Transferring the Risk

As important as insurance is as a means of transferring risk, health plans almost always

Accepting the Risk

After completing this lesson, you should be able to

Risk Management in Health Plans