Dear Actuary: What are demographic and longevity risks?
A primer for plan sponsors on demographic and longevity risks and how they affect public pensions.
Given the current economic climate and the additional uncertainties regarding the implementation of healthcare reform, it is now more critical than ever for hospitals and other healthcare facilities to monitor and manage their expenses. Expenses related to the self-insurance of liabilities for professional liability and workers' compensation coverage may not be the largest liabilities carried on the balance sheet of most facilities, but they may be the most exposed to increases in the inflation rate. While the general rate of inflation has been at a low level in recent years, there is concern that it may increase, perhaps dramatically, in delayed response to certain economic stimulus programs. An increase in the general inflation rate would likely lead to an increase in the cost of claims. The extent of the increase varies by type of coverage, but claims related to medical professional liability and workers' compensation coverage, which both have long payout patterns, are particularly vulnerable to changes in claim inflation (or "loss trend").
An understanding of claim inflation’s potential impact on carried unpaid claim liabilities and on projected funding for future year claims may help a hospital to properly manage the risk of inflation on these liabilities. This risk is highly leveraged; a small change in the inflation rate can result in a much larger percentage increase on carried liabilities and on the necessary funding amounts for future years.
The critical factors in quantifying how inflation affects liabilities are (1) the rate of loss payments (the payout pattern) and (2) the expectations regarding the extent of the change relative to the current inflation rate. For some coverages typically self-insured by hospitals such as professional liability and workers' compensation, the average time to payment after a claim is reported or incurred is several years. Therefore, the impact of an increase in the claim inflation rate for liabilities for these coverages can be highly leveraged. What is the extent of the leverage? Depending on the coverage, it could be an increase of more than 10 times the increase in inflation. For example, for professional liability claims, a 1% increase in inflation can lead to liability increases of more than 4%. But, for workers' compensation claims, a 1% increase in claims inflation can result in increases of more than 10% in the outstanding liabilities.
Table 1 summarizes the estimated impact on liabilities and funding projections for a range of possible changes to the current claim inflation rate based on the results from a model created by Milliman. The model was based on industry payment patterns for medical professional liability and workers' compensation and an assumption of a permanent change in the claim inflation rate (as opposed to a one-time change). For workers' compensation, we have also tempered the modeled results to reflect that indemnity benefits (which roughly account for 50% of the total benefits) may not escalate in all states.
While the results shown in Table 1 were developed using an actuarial model, they can be roughly approximated using a rule of thumb similar to that used in finance. In finance, it is possible to estimate the sensitivity of an asset's price to small interest rate movements by using a measure known as duration. Specifically, duration is often used to measure the change in bond prices relative to changes in interest rates and is calculated as the present value weighted time to receive future cash flows. As an example, a bond with a duration of five would fall approximately 5% in value if the interest rate increased by 1% per annum.
Similarly, to determine the potential increase in loss reserves or future funding projections due to an increase in the claim inflation rate, we can use the average payment dates for the liabilities and multiply by the expected change in inflation. For example, if claims related to professional liability paid out, on average, four years after reporting, the impact of a continued 1% increase in the inflation rate would be approximately 4%.
Table 2 compares the average change in liabilities from Table 1 to those estimated based on this rule of thumb. As Table 2 shows, the estimated impact using the rule of thumb is close to the more detailed estimates from the model, particularly at smaller changes in the inflation rate and for shorter average payout patterns. This confirms that the rule of thumb can be used to quickly estimate the potential impact of a change to the claims inflation rate.
The impacts estimated in this article are based on unlimited losses. In many cases, healthcare facilities retain only a portion of their liabilities by purchasing commercial insurance to cover losses above a certain threshold. To the extent that there are limits on claim amounts, the impact of inflation on the retained liabilities would be tempered; the extent of tempering would be determined based on the payout patterns and the relation of the limit to the average claim size.
As discussed above, our modeled results reflect an assumption that indemnity and medical benefits each compose roughly half of the workers' compensation benefits and that the indemnity benefits will not escalate from their initial level. To the extent that the split in benefits is not equal and that state rules allow for escalation in the indemnity benefits, this would impact the modeled results and the comparison to our "rule of thumb" results, but we do not believe this would materially change our conclusions.
Also, reserves are often carried on financial statements on a discounted basis. To the extent that interest rates earned on investments react to inflationary increases, the increase in the carried discounted liabilities may be tempered as well.
While we have focused on the impact of inflation on liabilities, it is probably of equal importance to understand the impact on carried assets. If bonds are held to support liabilities, it is possible that a rise in inflation would result in higher interest rates, driving down the value of bonds, resulting in less capital to support the increasing liabilities. Dynamic testing can be done to model the impact of inflation and interest rate changes on both sides of the balance sheet.
It is also important to note that in relation to exposure to workers compensation and professional liability claims, there are usually other environmental factors that affect costs besides inflation. These include risk management programs, legislative changes, and changes in the local tort environment.
While an increase in inflation is likely not right around the corner, it is possibly not too far down the block. As with any risk, the first step in mitigation is to identify and quantify the possible impact. Using a simple rule of thumb based on average payment dates and expected increase in claims inflation, self-insurers should be able to get a reasonable idea of the impact on liabilities of any future changes to inflation that arise and begin to plan accordingly.