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By TONY BLOEMER, a principal and consulting actuary in the Chicago office of Milliman, and RICHARD FRESE, a consulting actuary in the Chicago office of Milliman

Many hospitals in this country have an unfunded liability that when realized could threaten their already slim operating margins: this liability is known as incurred-but-not-reported (IBNR) reserves for workers' compensation.

There is no specific reason why some hospitals choose not to book IBNR reserves for workers' comp. In fact, some hospitals are booking actuarially determined IBNR reserves for workers' comp, which raises the bigger question: why don't all hospitals?

The most common reasons given by hospitals are that there is little "pure" IBNR for workers' comp, workers' comp claims can be controlled, medical malpractice takes precedence, it costs too much and auditors don't require it. While each of these explanations may make sense, it's worth further examining each one to determine its validity.

A patient's injury stemming from medical treatment or mistreatment might not come to light for several years, so it is truly "incurred but not reported." In contrast, a hospital worker's on-the-job injury will quickly be apparent and reported with virtually no delay after occurrence. Therefore, "pure" IBNR losses should be minor compared to the overall reserves of the hospital. However, development of known cases is an area of concern.

IBNR for workers' comp is mainly case development. For example, a worker's injury lingers or worsens over time, thus protracting or reopening the case. Case managers typically set aside money for claims based on the most expected outcome. This will be adequate for most cases, but will underestimate the amount on cases that develop adversely--for example, the back injury that appeared to be healed but ultimately required multiple surgeries. While initially setting the case reserve at the commonplace expected outcome, the ultimate payment could well be many times that amount.

This type of development is common in workers' comp. The hospital that only books known case reserves would be missing this development and therefore could jeopardize its operating margin in the year that the adverse development occurs.

Perhaps the phrase "incurred but not reported" is hazy, causing auditors and CFOs to focus only on the "pure" elements of IBNR (which are believed to be insignificant and thus ignored completely) instead of all IBNR reserve elements. The "pure" elements, by most definitions, capture the claims that have occurred but have not yet been reported to the hospitals and the claims that have been reported to the hospital but have not yet been recorded, known as "pipeline" reporting.

What is missing is a provision for future development on known claims (case reserve development) and a provision for claims that reopen after they have been closed (reopened cases). Many hospitals consider their total reserve to consist of only known case reserves and perhaps a small amount for "pure" IBNR cases. All reserve elements, which include all parts of IBNR, should be booked for an adequate liability.

Some hospitals may feel that by establishing good safety measures they can limit workers' comp losses, resulting in modest levels of IBNR. But in fact, hospital employees are exposed to potential severe injuries such as needle sticks and back injuries from lifting patients, just as workers in any other business. The rate of injuries for hospitals mirrors that of other businesses, with the potential to grow higher depending on actual safety effectiveness. And while the frequency of workers' comp claims may be kept under check, the severity is usually not as easy to reduce.

In most jurisdictions, malpractice liability is a much larger risk than workers' comp for hospitals, which makes it the financial focus of hospital CFOs. A medical-malpractice loss can potentially top $20 million, while workers' comp losses usually do not result in such "shock" losses.

There is an important difference in the nature of payments between medical malpractice and workers' comp that is noteworthy. Whereas malpractice cases often have a definitive ending, for example a legal settlement or a verdict, workers' comp claims can be reopened and even continue for the life of the injured worker which cannot be accurately estimated by case reserve managers at the outset.

These, too, are part of the IBNR liability, in addition to case development on known case reserves. And while it is true that a typical hospital may not blink at annual settlements of multiple millions of dollars due to medical-malpractice losses, a loss with even a quarter of that magnitude in workers' comp should warrant at least a shudder. Enough new and reopened claims in any given year, along with case development on known incidents, can snowball and create a strain on an annual budget for a hospital with insufficient case reserves.

Understandably, CFOs do not want to put more liability on their books. Hospitals normally self-fund in anticipation of workers' comp claims so they are currently booking some liability. A typical hospital will pay the first $500,000 to $1 million per occurrence for workers' comp in what is called a self-insured retention. The hospital will also buy excess insurance to cover the rest of the loss, if the payout is greater than the retention. Financial statements should include this self-insured retention liability as part of the total liabilities of the hospital.

The temptation not to book IBNR claims for workers' comp is understandable. But while that strategy can make a hospital's current financials look more robust, the "beauty" is only skin-deep. Under the right circumstances, the combination of high-dollar, self-funded payouts with low booked reserves can pierce the financial-statement façade, resulting in a financial catastrophe that could have been avoided.

On average, $99.44 of IBNR is needed for every $100 of known case reserves when a hospital retains $1,000,000 per occurrence. Only $2.79 of the $99.44 is for pure IBNR. The bulk of the IBNR, $96.65, is for development of known cases. The amount of IBNR needed is greatly dependent on the hospital's per-occurrence retention. If a hospital retains only $250,000 per occurrence, it would need about half as much IBNR relative to its case reserves as it would if it retained $1,000,000 per occurrence.

There is no consensus among audit firms about hospitals' IBNR booking requirement for workers' comp. This is puzzling, especially considering how careful these same auditors are in other industries to book actuarially determined IBNR claims for workers' comp.

Maybe auditors may not be as concerned about nonprofit hospitals' books as they are about those of for-profit public corporations. It is also possible that hospital CFOs are less concerned about booking an ultimate liability for workers' comp exposure because nonprofits are not subject to the stringent for-profit reporting guidelines prescribed by Sarbanes-Oxley.

FUTURE FINANCIAL HEALTH

With this newly gained awareness of the potential dangers of an undervalued workers' comp liability, hospital management can turn to a few options available for action on financial responsibility. There are both advantages and disadvantages to each choice; however, the following option stands as the best way to accurately account for the liability.

First, a hospital can look at its own history and claim practices to determine if, in fact, there is case development and the extent of it. Management might be able to recognize the amount of case-reserve development and attempt to project this amount forward to current known reserves. This challenge is usually not easily accomplished by management as it requires a trained professional to accurately determine this amount.

Second, a hospital can use the industry standard of IBNR to known case reserves and hope that its experience will be similar. This method would likely result in the financials of the hospital being overstated for some years and understated for other years. This fluctuation is not desirable by hospital management.

Third, hospital management can have a trained professional conduct an individual analysis that accurately profiles the hospital's exposure. Actuaries routinely complete unbiased evaluations of hospitals' unique workers' comp risks. Their work products will guide hospital management to book reasonable estimates of workers' comp total reserves.

Ultimately, hospital management should choose the IBNR option that it believes is most financially responsible. Armed with an understanding of workers' comp IBNR, an actuary can assist management with this liability. The actuary can also determine forecasting to aid with planning for the future. This planning process will help keep financials smooth from year to year and mitigate unexpected changes.

Additionally, hospital managers seeking to effectively control losses and improve safety should learn about their unique workers' comp loss drivers--types of injuries such as shoulder injuries or specific departments causing losses such as nursing--and how they benchmark to industry. A thorough actuarial report will reveal this beneficial information and will help management with the first steps to initiating an effective safety plan that reduces the liability of workers' comp and ultimately controls losses.

In short, there are several potential reasons why hospitals ignore the IBNR for workers' comp, but there are even better reasons for not ignoring it. Hospital CFOs and auditors would be well advised to recognize the importance of booking the full actuarially determined IBNR losses for workers' comp and setting aside adequate reserves to cover them. At some point, auditors may require hospitals to book this liability--if not of their own volition, then under force by legislation. Preventive care is just as important in finance as it is in health and just as essential for hospitals as for any other business.

November 1, 2008

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