In part 1 of this series on the experience subsidy, we looked at how premium rates are set. Today we are going to look at another one of the facts of life: aging. Everybody does it, and each year we are all another year older.

As we get a little older every year we get a little bit less healthy.  As our health decreases, our healthcare expenses increase.

Let’s look back at the group we used to set premiums: it was 10,000 people, expecting $1,000,000 in claims, for an average claim of $100, which means a premium of $100.

This doesn’t mean we expect everybody in the group to have exactly $100 in medical expenses during the year. Far from it.

Let’s take a closer look at those 10,000 people. If all 10,000 people were exactly the same age, same health, same gender, then we would expect them all to have the same claims per person. But we know that no group is actually like that.

It turns out our group actually looks like this:

2,000 are age 20

2,000 are age 30

2,000 are age 40

2,000 are age 50

2,000 are age 60

There are still 10,000 people, and we still expect them to use $1,000,000 in medical benefits, but we don’t expect someone who is 20 to use the same amount as someone who is 60. So we take an even closer look, and see that their expected usage is actually as follows:

2,000 at age 20 used $ 50,000 (or about $25 per person)

2,000 at age 30 used $150,000 (or about $75 per person)

2,000 at age 40 used $200,000 (or about $100 per person)

2,000 at age 50 used $250,000 (or about $125 per person)

2,000 at age 60 used $350,000 (or about $175 per person)

There are still 10,000 people, still paying $1,000,000 in premiums, and they’re all still only paying $100 per person. But a person who is age 60 is actually getting more benefit than they’re paying for! And a person who is 20 is actually getting less! In effect, the 20 year olds are subsidizing the coverage for the people who are 60.

This spreading of costs is the fundamental function of insurance.

In reality this spreading actually looks something like this:

1a

(Please note: This table only extends to age 64 because at age 65 Medicare becomes a factor and many plans change at that point.)

 Now let’s take this concept and use it to look at post-retirement medical benefits. For purposes of illustration, we will assume that all employees retire at age 55.

People retire, by definition, when they get older. The New York State Employees’ Retirement System (NYSERS), for example, requires (almost) all employees to be at least age 55 before being eligible to retire.

If we look at an age 55 retiree on the chart, we see:

1b

Their expected claims already exceed their premiums. They are getting a benefit by being in the plan. This is the experience subsidy, and exists even if the retiree is paying the full premium.

If the plan is community rated, then this excess of claims is absorbed by the overall community group, rather than the employer and fellow employees. Therefore, the employer incurs no liability for allowing people to remain in the plan.

But if the plan is experience rated or self-funded, that benefit is being subsidized by the active employees and the employer. As a result, both FASB and GASB require employers to recognize the cost of offering that subsidy in their financial statements.

These excess claims represent the experience subsidy:

1c

Thus, even a plan that requires retirees to pay 100% of the costs for coverage may incur liabilities depending on how the benefits are funded.

If you are considering changing medical plans, particularly if the new medical plan uses a different funding method, you are encouraged to contact your actuary to see how that change will impact your financials. At Burke Group we would be more than happy to discuss with you the issues involved, or perform estimates of how changing plans might impact the bottom line beyond just how much cash is laid out in premiums.

To discuss this, please contact myself at tdennie@burkegroup.com