How Group Insurance is Funded

There are four ways of funding a benefits plan. They essentially fall along a continuum of risk and reward. Fully pooled benefits are the least risky as if your group has a catastrophic claim, it does not impact your premium at all. The downside is that you have no idea if you are getting good value as your premiums may be much higher than the claims you incur. Prospectively rated benefits plans are the most common, they involve an annual review of claims incurred and premiums paid. Premiums tend to track closely to claims incurred. Rates are more volatile than pooled plans but Prospectively funded plans are often less expensive in the long run. Retention Accounting is more commonly known as Refund Accounting, having lost favor with the insurance carriers Refund is currently only offered by a selective few carriers. Refund provides, in my opinion, the best possible arrangement from the clients perspective. Premiums are calculated similar to Prospectively rated groups, however, if claims are lower than predicted, a refund of the difference is paid to the group. More frequently the refund is help inside a trust account and used to smooth future rate fluctuations. ASO plans offer the most possible savings as there is no "cost of insurance" however, they trade potential savings for certain risk. Only very large groups should consider ASO funding. ASO also brings with it certain other possible problems such as cost sharing, pay roll deductions and the treatment of a surplus or deficit.


FULLY POOLED BENEFITS (Less than 10 members)

The policyholder pays whatever premium is charged by the insurer. The premiums are pooled among all of the policyholders for the insurer, and all claims and administrative expenses are taken out of the pool. All renewals are based on how the whole pool does, each policyholder has no control or input as to how the premiums are allocated. Cost-containment measures available to policyholders are to add deductibles, reduce reimbursement percentages by the insurer, or reduce or eliminate particular benefits. The advantage of fully-pooled plans is that they help spread of catastrophic claim for smaller policyholders. This disadvantage of fully-pooled plans is the lack of control over the allocation of premium dollars.

PARTIALLY-EXPERIENCE RATED BENEFITS (PROSPECTIVELY RATED) (10+ Members)

This method is a hybrid to the experience-rated policy and the fully-pooled plans. Insurers like these
policies because they can use the policyholder’s own experience to determine the renewal rates, yet they do not have to disclose the individual charges in which their premium dollars are used. Partially-experience rated plans can run up deficits, but should expect to face renewal increases to ensure future deficits do not occur. The advantage of the partial experience-rated plan is that the policyholder may run a deficit and terminate without financial repercussions. The disadvantage of the partial experience-rated plan is the limited information provided by the insurer. Although a break-even or target loss ratio is often provided to the policyholder, this does not reveal all of the charges being levied.

FULLY EXPERIENCE-RATED BENEFITS (RETENTION & NON-RETENTION ACCOUNTING) (100+ Members, or $100,000 in annual premium)
Under this method, the insurer works out each policyholder’s premium rating, based solely on the
policyholder’s own past experience for the benefit. At renewal, the insurer takes the paid premium for the year and then allocates various expenses against it. Apart from the actual utilization, there are claims paying charges, administration fees, taxes, insurer profit and agent/broker commissions. There are also requirements to fund reserves to pay for all of the outstanding claims that have not been submitted, or processed, and which must be paid by the insurer. There can also be a claims fluctuation reserve in which the insurer puts excess premium, if there is any. The advantage of the fully experience-rated plans is that all of the charges are fully disclosed. If retention accounting is used, the policyholder participates in the financial results of the group. This means that the policyholder owns both the surplus and deficit over the policy year. On a non-retention accounting basis, the policyholder would not participate in the financial results. The ideal policyholder for fully experienced-rated benefits is generating approximately $100,000 in annual claims, this will ensure that the utilization is “credible”. To protect against catastrophic claims by any individual plan member, the policyholder can purchase stop-loss protection from the insurer.

ADMINISTRATIVE SERVICES ONLY PLANS (ASO) (100+ Members or $100,000 in Annual Premium)

With this funding method, a policyholder pays an insurance company or third-party administrator to provide only certain services (i.e., adjudication, booklets, and wallet certificates). All charges are fully disclosed and negotiable. Stop-loss coverage can be purchased by the policyholder to reduce the risk of catastrophic claims by any individual plan member. The savings being generated may not be substantial in light of the additional resources required to provide the identical level of communication to the plan members, but the policyholder will never forfeit surplus premium. The advantage of the ASO funding method is the amount of control gained by the policyholder. The disadvantage of the ASO funding method is the potential risk of deficit funding. Dental Care can often be ASO funded at a lower level of approximately 25 members or $25,000 in premium. These lower levels are possible due to Dental Care claims being non-catastrophic in nature.

Funding explanations taken from Advocis Best Practice Manual.

To pool or not to pool - Small group insurance economics

Pooling is essential for insurance, a large group of people pitch in a little bit of money each, and the result is a large reservoir of cash. Any claims are paid out of this pool, the water level drops a little but soon rises back to the high water mark with the many added contributions.

Group insurance typically pools Life, Accidental Death, Disability and Critical Illness Insurance. Because these claims are so unpredictable, and so large in value there is no way a small group can absorb their cost on their own. Sometimes for small groups, usually 10 or less, Health and Dental Insurance are pooled as well. A more common way of pricing health and dental insurance though, is called prospectively rated, or experience rated. Just like if you are constantly in car accidents or regularly set your house on fire, your insurance rates increase. The same can also be true for health insurance, if you are constantly in the hospital or have higher than normal claims your rates go up. The opposite can also be true, if you claim less you pay less.

Health and Dental expenses are different because they are more predictable than a death or disability claim. You can fairly accurately predict that the average person will go to the dentist twice a year approximately 6 months apart. You can predict that a prescription for the birth control pill will be filled once a month. Because we have a pretty good idea of what is going to happen we start budgeting rather than insuring. The wonderful thing about a budget is that you can come under budget and bank the difference.

I normally like experience rated health and dental benefits because it lets me and the client set out a budget for their claims, if they are over or under budget we have that information and can react accordingly. The client knows that they are paying for only as much as they are claiming. Under a fully pooled plan the client might be paying far more than they are actually claiming, they have no idea if they are getting a good deal or not, the insurance company doesn’t tell them.

A pool is big, stable, and predictable, a small group is just the opposite, volatile, unpredictable. The pool is safe and calm, what little ripples there are you can see coming from across the water. Small groups can seem like river rapids; rates and claims wildly gyrating, swirling constantly changing and never knowing what is coming around the next bend.

I instinctively gravitate towards the river rapids, as I think it is the best value. However, the wild rate changes a group can experience can easily backfire against me. When I have to tell a group their rates are going up 30% next year it is never a good day for anyone. On the other hand, a large pooled plan might only go up 6% that same year, with the same claims from that same member group. It doesn’t mean that group doesn’t deserve a 30% increase it just means other member groups in the pool paid too much and offset my groups high claims.

Fully pooled plans are, by nature, unfair. Some groups pay more than their share, while others profit from it. But in the end everyone gets the same rates. I think as a first step a pooled plan can be good for a client, if they don’t want to worry about the plan, and just want it in place and they can think about it as a true insurance sunk cost. Then a pooled plan will probably be alright, but I will still feel like I’m not getting them the best value, and I lie awake at night worrying that they might be spending too much (seriously, I lose sleep over this stuff, it's a good thing I have those psychologist benefits). On the other hand they could go experience rated and see their rates fly through the roof, that doesn’t help them either as it means their benefits now cost more than the pooled plan would have. That client also can’t get the better pooled rate anymore since they have to disclose their experience to the pool before they join, so even if they did try and go into the pooled plan they will get a higher rate which reflects their past experience.

It is a tough choice, be ignorant of your actual cost but maintain stability in rates, or have transparency and volatility. I am an open information kinda guy, so I choose transparency and freedom of information over closed systems and being in the dark. I know of some clients who would have been better in a pool. But I have just as many that are far better off being experience rated. The choice ultimately comes down to what the client wants and their risk tolerance, If they are willing to accept some volatility in the name of potential savings. Or if they are willing to possibly pay too much to reduce their risk.

Group Insurance Primer

Group Insurance is usually set up as a Yearly Renewable Term policy. Meaning rates are calculated each year.

For Life Insurance, Accidental Death & Dismemberment Insurance, Critical Illness Insurance and Long Term Disability rates are based on the demographics of the group (age, gender, occupations) and the experience of the insurance company’s pool. If the insurance company has had few claims, rates remain stable of the total number of claims goes up rates tend to rise. Additionally, if demographics of a group change significantly, their rates will be affected accordingly. Pooled rates typically don’t tend to be influenced by the claims in any one group, so a life or disability claims usually doesn’t increase your rates as long as the pool stays healthy.

Health Care and Dental Care premiums are also partially based on the pool and demographics, but are greatly influenced by claims experience. Health Care is far more risky than Dental Care, so while it is experience rates it is also partially pooled. Large Health care claims are paid out of a pool similar to life and disability claims, this removes the risk of a catastrophic claim bankrupting the health plan. All non-catastrophic claims, under $5000 or so, are used to calculate claims experience.

Claims experience is simply a tally of the claims paid, compared to the premium collected by the insurance company. The insurance company sets a “Target” each year for how much claims will cost. They then add in their predicted expenses and together this creates the total premium. If the insurance company expect claims to be $10,000 for the year, and it assumes its expenses are 25% of claims, the total premium will be $12,500 for the year. For $12,500 the insurance company promises to pay any and all claims incurred in that year.

You might be thinking, “why pay an extra $2500 when claims are only $10,000?” Well, we can’t predict the future, claims very well may be $10,000 but they could also be $1,000,000. The insurance company is taking that risk, and they want to be compensated for it. Now you may be wondering, “Well if they might have to pay out a million, how do they make any money?” claims could just as easily be $1000, in fact it is far more likely that claims will be less than $10,000. If this is the case the insurance company keeps the difference. Many groups under claim for each one group that over claims. In the long run the insurance company knows the odds and plays to win.

While paying $12,500 in premiums, and collecting $1,000,000 in claims seems like a great deal, it is far more likely that you will pay $12,500 and only collect $8,000 or so in claims, which is not the best deal.
The systems works because people instinctively fear losing, more than they enjoy winning. When you have overpaid for your insurance, you think to yourself “Oh well, at least I was covered if something did happen” you move on and forget the wasted money. The only drawback is that each year, you overpaid and under claimed, and the insurance company asks for a rate increase. So every year you feel like you lose. As previously stated, people don’t like to lose.

Claiming more and “getting your monies worth” doesn’t work because you just get a bigger increase next year. And not claiming at all means that you are overpaying profusely. Lose-lose. So how do you win?

The answer, like many things, lies in moderation. You need to claim as close to that predicted Target as possible. if you hit it exactly, you receive an increase, but not too much. You got exactly what you paid for and were insured in case of a catastrophe. No one likes to pay more for their benefits each year but the fact of the matter is that if you hit your target, you will probably claim more next year simply because health care costs are escalating at an astonishing 15% per year.

So how do you hit your target and get the best bang for your buck? Each year at renewal your advisor looks at your claims and your premiums paid. We argue on your behalf that you either overpaid this year and are deserving of a break, or that you over claimed this year and that you are very sorry and you promise not to do it again. Either way our goal is to mold your premiums to match your claims over a period of time, sometimes it takes three or four years to get it right but over a long enough period of time we will make the premiums and the claims match. This is the best possible situation; you got exactly what you paid for, and had your protection all the way in case something terrible and expensive happened.