Analyzing risk is at the heart of medical insurance underwriting.  Anyone who has ever had insurance has been at the mercy of underwriters.  Underwriters are those people that crunch insurance claim losses to come up with predicted future losses and produce insurance premiums that must be paid to be covered.  In short, they are charged with analyzing risk.  Underwriters are involved in all area of insurance: home, auto, life, etc.  This article will cover the basic steps involved in group medical insurance underwriting.  We will use past claims data to estimate the cost of incurred medical insurance for the 2012 calendar year.

Group Medical Insurance Underwriting

Group medical insurance is what most people have through their employers.  Instead of shopping for insurance individually, a group of like employees (in our case, the insured all have the same employer) purchase insurance together.  The law of large numbers helps to stabilize the cost of the insurance.

Law of Large Numbers

The law of large numbers states that as the number of samples in a population increases, the results of a statistical experiment on that sample become more and more valid.  In this case, the past claims loss history of a group of 100 employees is a more valid predictor of future results than the claims loss history of a group of 10.  The history of a group of 1,000 employees is more valid that the group of 100, and so forth.  In insurance, the validity of past claims performance is called credibility.  For this article we are going to assume that a group is fully credible, which means that the group's claims are looked at as a whole, and the individual health of each employee is not a factor.

Calculate Past Losses

Underwriters use past claims loss experience to predict future losses.  Therefore, the first step of medical insurance underwriting is to look at the most recent 12 months of claims data to calculate a baseline medical claims cost.  Lets use the following table as an example.

 Month Medical Paid Claims Covered Employees May 2010 \$490,456 1,271 June 2010 \$551,881 1,266 July 2010 \$607,336 1,261 August 2010 \$694,331 1,248 September 2010 \$774,382 1,254 October 2010 \$745,427 1,269 November 2010 \$658,329 1,264 December 2010 \$479,586 1,269 January 2011 \$611,633 1,307 February 2011 \$336,896 1,316 March 2011 \$558,209 1,321 April 2011 \$550,592 1,319 May 2011 \$770,281 1,331 June 2011 \$773,591 1,342

The reason there are 14 months listed instead of 12 is that when you are underwriting medical claims, you want to lag the medical plan enrollment 2 months behind the months used to sum paid claims.  This is because on average, a medical claim is paid approximately 6 weeks after the medical service is rendered.  So, for the purposes of medical insurance underwriting, we assume that the covered employees from May 2010 - April 2011 were responsible for medical claims paid from July 2010 - June 2011.  Of course, this isn't entirely accurate, but it is a reasonable, industry-accepted assumption.

If we sum the medical paid claims from July 2010 - June 2011 we come up with \$7,560,593 in paid claims.  If we sum the covered employees from May 2010 - April 2011 we come up with 15,365 covered employees.  The next step is to divide the paid claims by covered employees to calculate a Per Employee Per Month medical paid claims cost (PEPM).

\$7,560,593 / 15,365 = \$492.07

So on average, each employee that was covered under the medical plan from May 2010 - April 2011 incurred \$492.07 in medical claims (this is the PEPM).  As stated above, we assume that these claims were paid from July 2010 - June 2011.

This \$492.07 PEPM becomes our baseline number as we begin to move forward.  Now that we have the baseline PEPM how do we calculate the projected 2012 PEPM?  Two concepts must be utilized, trend and midpoint months.

Trend

Trend can be a complex idea, but basically it is the expected rise in the cost of medical services provided.  Trend is expressed as an annual percentage increase.  For our example, we will assume that the annual trend is 10%, i.e. a medical service that costs \$100 today will cost \$110 one year from now.

Midpoint Months

So how do we determine how far to calculate trend when our claims history is not based on a simple January - December time frame?  To determine how far to trend from our claims history to the 2012 calendar year we will determine the midpoint of each time frame.

Claims history: Since our goal is to determine the claims incurred in 2012, we will use the enrollment time frame since that is when we are assuming our historical claims were incurred.  The midpoint of May 1, 2010 - April 30, 2011 is around November 1, 2010

Projected time frame: The midpoint of January 1, 2012 - December 31, 2012 is July 1, 2012.

Between November 1, 2010 and July 1, 2012, 20 months will have passed by.  Therefore, we want to apply 20 months of the annual trend to determine the effective trend for our medical insurance underwriting.

Calculating Effective Trend

This part gets very mathy, but in order to calculate an annual trend of 10% for 20 months, the formula looks like this:

(1 + 10%) ^ (20/12) = 1.172

So we will need to calculate our baseline PEPM by 1.172 to determine the projected 2012 incurred PEPM.

Projecting Future Claims

If we multiply the baseline PEPM of \$492.07 by the effective trend of 1.172, we end up with a result of \$576.71.  This means that we can expect, on average, for each covered employee to rack up \$576.71 in medical claims every month (over \$6,900 per year).  If we assume that in 2012 there will be an average of 1,300 covered employees, the medical claims will total \$8,996,676.

Variables in Medical Insurance Underwriting

The medical insurance underwriting presented here is very basic.  There are several variables that can cause adjustments to be made in the claims projection.

• Plan Design - If the plan design is changed, a factor must be applied to the baseline PEPM since a different plan design will result in more or less of the medical cost being shifted to or away from the covered employee.
• Irregular Claim Activity - If the past 12 months does not seem to be indicative of the claim history over the last several years, it would be prudent to underwrite future claims losses based on other time periods than the last 12 months.  Then, reasonable assumptions can be made to determine how credible the last 12 months of claim activity are.
• Legislation - Health insurance legislation that mandates certain coverages must be factored into the baseline PEPM since the required coverages were not mandated during the baseline time period.
• Changing Demographics - If the demographics of the covered employees, such as gender, age, and number of total members is expected to change, a factor must be applied to the baseline PEPM to account for the changing risk in the group.

Conclusion

In our example, we just focused on medical claims.  Pharmacy claims will also need to be calculated.  Underwriting of pharmacy claims is very similar to medical insurance underwriting.  However, there is no lag involved since most pharmacy claims are paid very quickly after a script is filled.  Also, the trend for prescription drug claims will almost always be different than the trend for medical claims.

Medical insurance underwriting is a very important task that creates and can sometimes lose business opportunities for insurers.  Good underwriting is essential to help businesses complete budgets.  And most importantly, good underwriting is required to help people afford appropriate health insurance for their families.  It all boils down to analyzing risk when it comes to medical insurance underwriting.

Dictionary of Health Insurance and Managed Care
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