September 29, 1998 Medical Professional Liability/ Claims-Made Reserving Casualty Loss Reserve Seminar

2 Agenda A Brief History Reserving issues  Claims-Made  Self-insurance  Tort reform  Healthcare evolution

3 A Brief History Mid-1970s – Malpractice Crisis I Tort system less predictable; long tail emerges Frequency/severity increases Insurance affordability/availability crisis Response  self-insurance  claims-made form  tort reforms

4 A Brief History Late 1970s Frequency/severity trends subside Competition/cash flow underwriting begins Capacity increases Early 1980s Erosion of tort reforms Double digit frequency/severity trends

5 A Brief History Mid-1980s – Malpractice Crisis II Interest rates drop Insolvencies/capacity shrinks Response  rate increases  more self-insurance  more tort reforms

6 A Brief History Late 1980s/1990s Frequency decline Loss ratios decline Increased capacity/price competition

7 General Liability and Medical Malpractice Loss Ratios 1949–1997

8 Comparison of Calendar Year/ Accident/Report Year Loss Ratios Based on Schedule P Data 110% 126% 131% 119% 82% 122% 107% 86% 81% 128% 85% 78% 127%

9 Reserving Issues Claims-made products  Coverage triggers/extended reporting endorsements  DD&R Self-insurance  hospital accounting issues Tort reform  impact on reporting  impact on ultimate costs Healthcare evolution  loss portfolio transfers  new/evolving exposures

Claims-Made Products Coverage triggers/extended reporting endorsements  Not all claims-made coverage triggers are alike  “demand for payment” form  “incident reporting” form  In most instances, insurers are required to offer extended reporting coverage, with a maximum limit set on the price.  The different coverage triggers and the extended reporting endorsements that are available mean that insurers are still subject to reporting lags; i.e., IBNR has not been completely eliminated. 10

Claims-Made Products DD&R  Most claims-made policies for medical practitioners provide for free, unlimited extended reporting of claims in the event of death, disability, or retirement of the insured.  The disability provision requires that the insured be permanently and totally incapable of the clinical practice of medicine.  The retirement benefit normally vests, based on the age of the practitioner and number of years insured by the company. For example, a common provision requires that the insured be 55 years of age and with the company for 5 years, or any age and 10 years with the company. 11

Claims-Made Products DD&R (cont.)  The DD&R provision is essentially a promise that future insurance coverage will be provided under a specific set of circumstances.  The retirement benefit, specifically, is one that accrues over a multi-year time horizon.  As such, NAIC accounting guidelines require that a liability be established to recognize the expected future benefit that has been promised the policyholder. 12

Claims-Made Products DD&R (cont.)  According to the NAIC’s Accounting Practices and Procedures Manual for Property and Casualty Insurance Companies: “... a reserve is required to assure that amounts collected by insurers to pay for these benefits are not earned prematurely and that an insurer with an aging book of business will not show adverse operating results simply because an increasing portion of insureds is earning the benefits for which it has paid.”  Also, according to the NAIC, this is most appropriately treated as part of the Unearned Premium Reserve, but may be included as unpaid losses if approved by the insurance commissioner of the state of domicile. 13

Claims-Made Products DD&R (cont.)  factors which should be considered in estimating the DD&R reserve:  loss trends  time value of money  non-renewal rates  age and tenure eligibility requirements  age and tenure demographics of insured population  mortality  morbidity  other factors that impact the value of future benefits 14

Claims-Made Products DD&R (cont.)  Two papers which discuss extended reporting liabilities and specifically DD&R:  McClenahan, “Liabilities for Extended Reporting Endorsement Guarantees under Claims-Made Policies,” in Evaluating Insurance Company Liabilities, CAS, May  Walker and Skrodenis, “Death, Disability, and Retirement Coverage: Pricing the ‘Free’ Claims- Made Tail,” in CAS Forum, Winter

Claims-Made Products DD&R (cont.)  An example of calculating the level funding necessary to cover DD&R liabilities, which can then be used to establish an unearned premium reserve or loss reserve.  Assumptions:  representative death, disability, retirement statistics  interest rate of 8% used for discounting  annual loss trend of 5%  annual lapse rate of 6%  ERP premium is 157% of mature claims-made rate 16

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Claims-Made Products DD&R (cont.)  The DD&R funding load can be used to carve out a portion of the premium to remain as unearned premium reserve.  Annually the insurer can review the level of this additional unearned premium reserve, and as insureds terminate their claims-made coverage the portion held as UPR can be earned.  An IBNR reserve would then be established to correspond to the UPR that was released into income. 21

Claims-Made Products DD&R (cont.)  In addition to the previously listed factors, the appropriate level for DD&R reserves can be impacted by:  Competition: Insurers are liberalizing the vesting schedule (some now use Age 55 and 1 year with company) or grandfathering the retirement vesting for insureds new to the company.  Changing Demographics: There is some evidence that physicians are retiring earlier, some citing frustration with practicing medicine in a managed care environment as a reason. 22

23 Self-Insurance Hospital accounting issues  SOP 87-1/AICPA Healthcare Accounting Guidelines  trust funds  captive insurance companies  claims made tail  hospital specific vs. industry data

24 Tort Reform Impact of tort reform on claim reporting The Michigan example  non-economic caps  expert witness standards  statute of limitations  affidavit of merit  Effective April 1, 1994  Technical correction April 1, 1996

25 Tort Reform Michigan Hospital Professional Liability Adjusted Report Year Claim Frequency

26 Tort Reform Michigan Hospital Professional Liability Occurrence Year Pure Premiums

27 Tort Reform Reserving issues  potential acceleration in reporting prior to implementation  observe lags  impact on claims made form greater than occurrence form

28 Healthcare Evolution Loss portfolio transfers  Health care institutions which retained some portion of their professional liability risk (through a trust fund, captive, etc.) can transfer the remaining liabilities from past occurrences through a loss portfolio transfer.  The loss portfolio transfer can be for either known outstanding claims, IBNR claims, or both.

Healthcare Evolution Loss portfolio transfers (cont.)  Reasons for purchasing this coverage:  The consolidation of the healthcare industry leads some institutions to remove uncertainty from the balance sheet in preparation for, or upon completion of, a merger or acquisition.  Soft insurance market pricing presents the institution with the opportunity to discharge past liabilities, which were retained when insurance prices were high, below the cost of continuing to retain the liabilities.  In recent years the marketplace has seen proposals for LPTs ranging in size from the very small to excess of $100M. Several eight figure deals have been bound. 29

Healthcare Evolution Loss portfolio transfers (cont.)  If the LPT is written as a reinsurance contract (e.g., reinsurance of a captive):  Statutory accounting principles prohibit the use of normal premium and loss accounting and require that special deposit accounting treatment be used by both the ceding and assuming enterprises.  GAAP also require the ceding enterprise to use deposit accounting, but the assuming enterprise is not required to mirror the cedant’s accounting treatment.  Both GAAP and SAP are silent on the issue of ‘retroactive insurance.’ 30

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34 Healthcare Evolution New/evolving exposures  managed care, telemedicine, home health  little data, rely on pricing assumptions?  long-term care  divergent trends, review separately