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Jan 1991

Analyzing the health benefits promise. (includes related articles on prefunding and insurance arrangements)

by Akresh, Murray S.

    Abstract- Companies are faced with the problem of controlling the rising cost of health care benefits, particularly for unfunded retiree health obligations. In order to control heath benefits costs, companies must evaluate the plans by uncovering the needs of employees and retirees, studying health care utilization patterns, and gathering and analyzing facts. Companies should conduct a retiree health valuation, which includes examining the current benefit program to understand the costs effects of all plan provisions, gathering and analyzing demographic data to identify employees who are or will soon be eligible for benefits, and calculating estimates of expenses and obligations. Once obligations and costs are understood, costs can be reduced through cost-sharing strategies, by changing the nature of benefits plans, and by implementing managed care programs.

Controlling the rising cost of health care benefit plans has become a major business issue. In the last 20 years, health care spending has risen at about twice the average rate of inflation. As a result, all types of businesses look for ways to improve management and effectiveness of their benefit programs. Of special concern are rising health care costs for retirees and dependents. To better understand how to control these costs, managers need to examine employee relations and cost control issues as well as financing and accounting implications.


Outside factors have hindered many employers' attempts to hold health care cost increases to a reasonable level. Some have become so concerned that they have considered cutting benefits or eliminating them altogether. However, such drastic steps are usually not taken because they are inconsistent with the company's employee relations objectives, or are unrealistic in light of collective bargaining agreements or other business pressures. The situation challenges managers to develop cost- effective programs.

For many, unfunded retiree health obligations cause increasing concern. Health care costs have increased dramatically and Medicare has absorbed less of this increasing burden. As the baby boom generation ages, the magnitude of retiree health care benefits issues will grow significantly. The FASB's new statement will require companies to calculate the future costs of retiree health benefits and record the expense in financial statements. The proposed mechanics for this requirement are both complex and contentious. This statement adds to existing concerns about rising health care costs and provides an additional impetus to look more closely at retiree health programs.


Evaluating these plans has much in common with evaluating other health plans and retiree benefits as a whole. Many of the recommended actions are similar to evaluating these latter programs.

By studying the recommended actions, managers can focus on issues that will directly affect them while improving their understanding of related financial and accounting issues. Of course, the general action plan must be tailored to meet a company's specific needs and circumstances. While this article specifically focuses on retiree health benefits, similar action should be considered with respect to current health care benefit programs for active employees.


The first step is to establish objectives for the program.

Considering Broad Human Resource Strategies

Retiree health benefits are one component of a benefits package. Managers should first address the company's overall human resource needs, considering steps that should be taken to remain competitive in an increasingly tight labor market. Managers should consider recruitment, retention, and training issues as well as the policy, on early retirement.

Once these key human resource issues have been addressed, managers should evaluate the total compensation and benefits package-including retiree health care benefits-weighing cost and budget constraints against benefits that must be offered to attract and retain high-quality employees.

As part of this evaluation, managers should evaluate the demographics of the current work force and project the work force needed each year in both the near and long term. These projections should anticipate significant changes in factors affecting the work force, including anticipated changes in product mix, manufacturing technology, site selection, and human obsolescence. The projections may also show a need to change historic patterns in early/late retirement.

An employer forecasting a shortage of skilled workers may attempt to reduce early retirement trends by limiting health benefits available to early retirees. In one case, an employer amended its program for future retirees, so that employees retiring prior to age 65 were required to pay, significantly higher costs for their coverage than those who retired at age 65 or older, thus encouraging employees to retire later. Similar approaches may be used by more employers in the future.

Evaluating Needs of Employees and Retirees

Having assessed corporate needs and a company's philosophy, managers should then evaluate retirees' needs for health care benefits-bearing in mind that they will differ significantly from those of active employees. Because different groups of people have different health care needs, there should be an evaluation of the needs of different subgroups and dependents, including:

* Active employees not vet eligible for early retirement, e.g., under age 55;

* Active employees under age 65 eligible for early retirement;

* Retirees under age 65;

* Active employees age 65 and older, eligible for Medicare; and

* Retirees age 65 and older, eligible for Medicare.

Many employers have recently implemented changes to active employee health benefits such as managed care options and preventive health care coverage. Managers should consider whether such changes are equally important for the retiree health plan. The benefits offered to Medicare- eligible retirees also require special attention given recent, ongoing Medicare coverage erosion. These retirees may react negatively to program changes unless the employer assumes all or part of the cost of benefits not covered by Medicare.

Studying Utilization Patterns

Current utilization patterns should be studied to determine which retiree health benefit provisions are being used, thus providing a basis for evaluating possible changes. Claims-data analysis will reveal the extent to which the following trends hold true for a particular employer:

* Utilization patterns and costs vary by age. Accidents and childbirth account for a great percentage of costs for younger employees, while retirees spend more on drugs and other services related to long-term chronic illness.

* Utilization patterns and costs vary, by employment status. Retirees between the ages 55 and 64 typically have higher average per capita health care costs than active employees in the same age group.

* Utilization patterns and costs vary by geography and industry.

Collecting and analyzing demographic and retiree claims data are critical to understanding utilization patterns and current costs. An analysis of current retiree claims can show where health care dollars are being spent and can help identify specific weaknesses. Cost and utilization breakdowns by type of service, e.g., inpatient hospital care, outpatient services, physician office visits, pharmaceutical and dental care, provide valuable information.


The Health Benefits Promise

After program objectives have been established, managers need to understand their company's current health benefits promise. As a first step, a retiree health valuation should be performed. By understanding measurement and accounting issues, managers will be better able to develop a retiree health benefit program that will be both affordable to the company. and acceptable to retirees. Although many companies may have rough estimates of their retiree health obligations, relatively few have performed actuarial valuations to assess current costs. These valuations will help managers make informed, effective benefit planning decisions. While management must be involved in gathering the necessary data and selecting the actuarial assumptions, outside health care actuaries are generally hired to measure retiree health obligations.

Conducting a Retiree Health Valuation

The six steps for conducting a valuation include:

Step 1: Examine the current benefit-program to understand each plan provision affecting cost

Understanding current plan coverage is often difficult. Summary Plan Descriptions (SPDs) are frequently out of date and supplemented by internal memos or word-of-mouth revisions. For example, one company's SPD indicated that claim payments were integrated with Medicare using the "carve out" method, the least expensive for the employer. In practice, the plan administrator was using the "exclusion" method whereby plan benefits are based on the net amount of covered expenses after applying Medicare. This latter method resulted in far greater current costs and higher estimates of obligation and expense.

Step 2: obtain and analyze demographic data to identify retirees and dependents as well as active employees who currently are or soon will be eligible for benefits.

Certain information on those covered by the retiree health plan is often inaccessible or nonexistent. This information--which is necessary for understanding the full extent of the benefits promise--is often not reliable, difficult to extract from available sources, or has not been collected. Examples of key demographic data deficiencies are summarized in Figure 1 .

Step 3: Obtain and analyze claim data to assess current retiree benefit costs.

Measurements of retiree health obligations are typically based on current retiree health care costs. In performing valuations, several approaches can be used to assess current costs, depending on a company's needs. At a minimum, retiree health care claims should be broken down between retirees age 65 and older, who are eligible for Medicare, and those under age 65.

Generally, these analyses capture retiree claims data by age, sex and status-retiree or dependent--and often categorize costs by health care service, e.g., inpatient hospital, outpatient care, physician office visits, pharmaceutical. This detailed analysis promotes an understanding of current cost patterns and provides a benchmark against which the effectiveness of future cost management strategies can be measured. Examples of key claims data deficiencies are also listed in Figure 1.

Step 4.- Estimate average per capita (baseline) costs using plan, demographic and claims data as the starting point for projecting future costs.

Estimated future benefit payments are typically based on applying a health care cost trend to current average per capita costs. The authors have found that comprehensive data and obligation analysis is critical to management's estimate of baseline costs.

Step 5.- Select actuarial assumptions to provide the basis for estimates of future cash flows and the present value of the obligation.

At a minimum, these assumptions should include health care cost trends, discount rates, and demographic assumptions, e.g., mortality, turnover and retirement age.

Unique to the measurement of retiree health benefit obligations, the health care cost trend assumption predicts changes in an employer's future health care costs, thus having a dramatic influence on estimating the obligation. Predicting the health care cost trend over an extended period is a difficult challenge, requiring estimates of inflation, changes in health care utilization or delivery patterns, technological advances and changes in the health status of plan participants.

Comparing future health care costs to an external standard screens out illogical health care cost trend assumptions. For example, assuming a 10% annual increase, health care costs could be projected to constitute over 50% of our GNP by the year 2020. Economic, governmental and market factors will likely cause health care costs to stabilize at a more realistic percentage of GNP. This type of analysis max, result in a downward revision of assumed health care cost trend rate.

Step 6.. Calculate estimates of obligations and expenses

Having estimated future obligations under current conditions, managers will frequently assess modifications designed to reduce exposure to health care cost increases. Estimates of future costs and obligations should be prepared for each option being considered. Management should evaluate a reasonable range of possible results, using both optimistic and pessimistic assumptions.


Although no simple solutions exist to control retiree health care costs and meet the needs of employees and retirees, some benefit design alternatives can be effective. Possible changes can be categorized as:

* Cost-sharing strategies;

* Changing the nature of benefit plans; and

* Managed care programs.

Some companies have implemented a single change, such as increasing retiree contributions, while others have restructured their entire program.

Cost-Sharing Strategies

Sharing program costs with retirees and their dependents has become increasingly common. In cost-sharing strategies, plan participants bear a greater burden of the cost of their retiree benefits. Cost sharing can reduce an employer's costs and may also encourage retirees to make more cost-effective use of health care services, thus possibly reducing the level of future cost increases. Figure 2 shows more popular current cost-sharing techniques and their advantages for employers.

Changing the Nature of Benefit Plans

Changing the nature of the plan can significantly impact an employer's costs and achieve other objectives. Plan changes include using a schedule of benefits, placing caps on benefits, stressing catastrophic rather than basic coverage and providing multiple options or flexible benefits.

Currently, a frequently considered approach is the dollar-denominated benefit program, also called a defined dollar benefit program. With this program, the employer's commitment is expressed in terms of a dollar amount of coverage rather than an open-ended commitment to pay, regardless of cost. The retiree generally must pay, the cost of coverage exceeding the amount provided by the employer and not covered by Medicare. Shifting ail of the risk of future cost increases to employees and retirees through a dollar-denominated program may be an extreme solution. Determining the appropriate risk-sharing level will likely be a significant source of conflict between human resource needs and financial constraints.

Managed Care Programs

Unlike cost-sharing and benefit design strategies, managed care programs do not explicitly attempt to shift costs from employer to plan participants. Rather, they attempt to control total costs by changing the way health care services are delivered and financed. While most managed care programs are developed with active employees in mind, they can also be applied to retiree health benefit plans for those under age 65. Because this group is not yet eligible for Medicare benefits, managers are particularly interested in controlling costs for it. Managed care programs include those described in the following paragraphs.

Utilization Review (UR). Many managed care programs are based on strategies designed to limit unnecessary services, including requiring advance approval of non-emergency hospitalization, monitoring inpatient lengths of stay and managing large cases, e.g., cancer treatment, spinal cord injury rehabilitation. These programs have become common for hospital inpatient stays. UR programs review the utilization patterns of medical services and question services outside established norms.

Recognizing their relative effectiveness, inpatient UR programs are now being expanded to monitor ambulatory and specialty medical costs such as physician office visits, lab work, X-rays, substance abuse and mental health services. While these programs are in the early stages of development, they are expected to help control rising health care costs.

Price Management. Many employers have attempted to manage the cost of services charged by providers. One way is through alternative delivery systems, such as preferred provider organizations (PPOs) and health maintenance organizations HMOs). PPOs consist of networks of hospitals and physicians that accept reduced fees in return for quicker payments and, presumably, more patients. In HMOS, providers are paid a fixed fee for each subscriber, or a set fee, and agree to provide all the subscriber's health care needs. With these reimbursement methods, providers have direct monetary incentives to provide cost-effective care.

Multi-Option Plans. Various multi-option plans are currently available. Typically, the employer permits plan participants to choose from more than one type of health care plan. Choices generally include an indemnity plan with some type of UR, one or more PPOs, and one or more HMOs. This gives the participant flexibility, while encouraging the choice of a cost-effective provider. These programs may lock in the participant's choice for a period such as one year, or may allow the participant to choose providers at the time health care services are sought. These "point of service" plans have recently become popular. While employees and retirees maN, find this freedom of choice attractive, management must carefully evaluate different plan designs and their potential costs.

Wellness Programs. Some companies have attempted to hold down health care costs by promoting healthier lifestyles for employees and retirees. Program sponsors may offer:

* Screening to detect disease early;

* Assessment of health risks, e.g., exercise habits, family history, smoking, excessive weight, alcohol and drug abuse;

* Education programs to encourage healthier lifestyles; and

* Stress management, nutritional, exercise, and weight-loss classes.

Managed care programs have been reasonably effective in controlling costs. However, these programs are evolving quickly, and managers must be prepared to evaluate programs that are appropriate now as well as to adapt to future change. Some programs are less effective for Medicare- eligible retirees. Accordingly, management needs to analyze data regarding current claims and utilization patterns. For example, incentives to shift surgery from inpatient to outpatient settings may raise employer costs for the medicare-eligible retiree because Medicare pays less for certain outpatient services.

Projecting Impact of Possible Changes

Once viable benefit plan designs have been identified, managers should analyze and test specific alternatives. Consideration should be given to both human resources, i.e., qualitative effect on employee relations, retention and hiring, and the financial aspect, i.e., quantitative effect on future cash flows, obligations and expense. Both the short-and long-term impacts need to be addressed.

Managers should consider possible legal constraints to changing retiree health benefits and consult with legal counsel regarding the effects of contemplated changes. Sometimes, a concern regarding possible litigation forces management to "grandfather" retirees into the existing plan. Also, collective bargaining agreements and future union negotiations should be considered. Finally, management should evaluate whether to modify pension and other employee benefits in light of changing health care benefits. The full package of modifications to all employee benefit plans is important, not only from a cost perspective but also with respect to their effect on attracting and retaining the quality employees needed to remain competitive over the long term.


Developing a strategy to effectively manage retiree health benefit plans is a complex undertaking for which there are no easy solutions. Ensuring that a program addresses retirees' needs, as well as being manageable, efficient and cost-effective, requires the same management strategies commonly applied to other key business planning issues.


Prefunding retiree benefits is not required by law and employers have had few incentives to prefund. Consequently, most employer have not set aside funds for retiree health benefits. Recently, however, employer interest in prefunding these benefits has increased, partly to reduce liabilities that will be recorded under proposed accounting rules. In addition, employers in certain industries for which costs may be recouple, e.g., government contracting and utilities, have generally been restricted to recovering amounts that have actually been funded, not just those costs that bay

Despite the limited tax advantages, some employers have taken steps to prefund their retiree health plans, and many ore actively monitoring and evaluating funding options. The following are some of the options that may be considered under current law.

Separate Health Care Trusts. Within certain limitations imposed by federal law, some companies have established Voluntary Employees Beneficiary Associations (VEBAs) to partially fund their retiree health benefits. Income earned by VEBAs for retiree health benefits is generally, taxable and deductible employer contributions to the trust are limited to an amount based on current medical costs. Some companies are currently contemplating VEBA investments that would not generate taxable investment income, such as certain life insurance products and tax-exempt municipal bonds. More liberal funding and taxation rules may also make VEBAs attractive to companies that provide retiree health benefits to employees under collective bargaining arrangements or to companies that join with other employers to fund benefit through a multiple-employer VEBA.

Funding Through Pension Trusts. Under a so-called 401 (h) account, a retiree medical program con be prefunded as part of a company's pension plan. The employer pays no taxes on investment earnings and, Unlike a VEBA, Wealth care inflation can be considered in computing the employer's contribution. However, this arrangement is seldom used because the employer's tax deduction for the retiree health contribution generally cannot exceed 25% of the current year's pension contribution. As a result, companies with fully funded or overfunded pension plans are generally unable to make deductible 401 (h) contributions.

Life Insurance Arranaements. Recently, numerous life insurance products have been developed to prefund retiree health benefits. Given their tax advantages, some employers have purchased them as attractive long-term investments. Others have not exercised this option because they perceive the initial cask requirements to be high, and they may need to purchase numerous policies to cover the entire employee group.

Future Funding Opportunities. The advance funding alternatives discussed are available to employers under current law. Other alternatives have been discussed by human resource professionals. However, in this era of budget deficits and concerns over other health care issues, it is unlikely that Congress will soon enact new tax- favored mechanisms for funding retiree health benefits.

Employers will want to monitor and analyze proposed funding options and may choose to become actively involved in making their views known to Congress regarding desired tax incentives for advance funding.


In paying for retiree health care benefits, employers may use a variety of insured and self-insured arrangements. The following discussion highlights some typical arrangements.

Insured Contracts. Many small and medium-sized employers use conventional insurance arrangements to transfer the risk of retiree health claims to an insurance company. However, while the insurance company is legally at risk, the actual long-term risk for the insurer may be minimal. The employer may control its costs in any given year but the insure; will likely recoup annual losses by raising premiums in future years. Over the long term, if the employer remains with the carrier, the employer may pay the full cost of its claims, as well as the carrier's expenses and profit margin.

Insured contracts can be "nonparticipating" or participating." In a nonparticipating contract, the insurance company bears all the risk and retains any surplus remaining at the end of a contract period. In a participating contract, the insured company shares in losses or gains incurred by the insurer. Before entering into an insured contract, its advantages and disadvantages should be weighed.

Some employers may also want to consider pooling,' an insurance mechanism in which the insurer combines similar risks from many companies. Annual rates are based on the experience of the pool rather than on the specific experience of one company. The insurer typically pays claims for an individual that exceed a predetermined amount, e.g., 50,000 per year. Again, the insurer will likely increase premiums in future years to recoup any losses incurred by the pool in a given year.

Self-Insured Arrangements. Many larger employers self-insure their health care benefits, using an insurance company or third-party administrator to pay claims. The fees employers pay for these administrative services are often expressed as a percentage of paid claims, with the percentage decreasing as the size of the covered population increases.

A company, that has grown through a series of acquisitions, may be able to reduce claims administration fees significantly by using one administrator to process all claims. this may be done even if operations have different plans and coverage. In addition, employers with minimal fluctuations in annual claims may be able to reduce costs by switching from an insured contract to a self-insured arrangement.

Stop-Loss Coverage. Stop-loss insurance enables self-insured employers to transfer some risk to an insurance company by using either aggregate or specific stop-loss insurance. Aggregate stop-loss insurance covers a group's claim in excess of a predetermined amount. Specific stop-loss insurance covers claims for any individual in excess of a predetermined amount. Employers should compare the cost of using stop-loss insurance against the risk they are willing to take.

Risk-Negotiated Managed Care Programs. Insurance carriers frequently offer managed care networks as cost-effective means of providing and paying for health care services. Many employers with managed care programs have often shared the risk of controlling costs with the carrier. For example, if costs exceed a predetermined amount, the insurer may pay a penalty; if claims are lower the employer may pay the carrier a 'reward' for providing cost-effective health care coverage.



* Demographic information

* Information about spouses and children of retirees.

* Data on retirees not currently receiving pension benefits.

* Information on former employees eligible for retiree health care coverage.

* Disabled employees distinguished from early retirees, thereby preventing baseline costs for the retiree group from being distorted by the possibly larger health care claims of disabled individuals.

Claims information

* Accurate spouse and dependent claims information for the retiree group.

* Information including business unit, salaried versus hourly employees, and cost center or plan type is needed to assign costs to particular employee groups.

* Average per capita costs may 6e understated if claims are reported by insurance carriers and administrators on an 'as paid' rather than 'as incurred" basis without adjustment for unpaid claims,

* Detailed information on prescription drug benefits, which tend to be significant costs for retirees age 65 and older.



























Lee E. Launer, FSA, is a health actuary and a Partner in Coopers & Lybrand's New York Actuarial Benefits and Compensation Group and has over 20 years of experience in the group benefits area-specializing in health care including benefit plan design, pricing and administration

Barbara S. Bald, ASA, EA, is an actuary and a Partner in Coopers & Lybrand's New York Actuarial Benefits and Compensation Group and bas over 15 years of experience in employee benefits. Ms. Bald co-authored the 1989 FERF study entitled Retiree Health Benefits.- Field Test of the FASB Proposal "

Murray S. Akresh, CPA, is a Director in Coopers & Lybrand's New York Actuarial Benefits and Compensation Technical Services Unit specializing in accounting for employee benefits. Mr. Akresh co-authored the 1989 FERF study entitled, Retiree Health Benefits. Field Test of the FASB Proposal" and the 1985 FERF study entitled Non-Pension Benefits for Retired Employees.- Study of Benefits and Accounting Practices. "

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