Even on their best days, FASB and GASB accounting rules can be hard. These are complex, jargon filled documents that outline rules for recognizing expenses that are often quite esoteric. And sometimes, what seem like minor changes can result in drastic shifts in liabilities and unexpected expenses.
For example, SFAS 106 and GASB 45 require accounting and recognition of post-retirement medical benefits while employees are still active, despite the fact that no money is actually being paid out. The benefits are rarely pre-funded, and in many cases the employer can choose to eliminate those benefits with little or no notice, if they should so choose.
But there is a logic to it all. Given the opportunity to choose between two identical jobs, with identical pay, whose only difference is Job A offers post-retirement medical benefits while Job B does not; a prospective employee is more likely to choose Job A because there is an added benefit to Job A (albeit deferred).
One of the most counter-intuitive ideas in both FASB and GASB accounting, however, is the concept that even by allowing an employee to remain in the medical plan at their own expense in retirement you are offering an employee benefit, and may even be incurring an expense under FASB/GASB rules just by doing so.
Consider the following two statements:
- A. Retirees may not participate in the medical plan upon retirement.
- B. Retirees may participate in the medical plan upon retirement by paying 100% of the premium.
Intuitively, it looks like both statements are zero cost prospects for an employer. Whether you forbid retirees from participating in the plan, or require them to pay the full premium, the employer is not putting any money into the plan. FASB and GASB disagree.
(It should be noted that a Person choosing statement B above is considered a “plan participant” under GASB’s 200 person threshold, while a Person choosing statement A is not. This is because Person B is still getting a benefit, access to health insurance, which is not available to Person A.)
How could there possibly be a cost in this situation? The cost is due to something which is informally known as the “Experience Subsidy.”
To understand what the experience subsidy is, we need to begin by defining a few basic terms and concepts.
1. The Premium
At its core, the premium represents one thing: The total claims expected for a group divided evenly amongst all of the members of the group. If you expect $1,000,000 in claims during the year, and you cover 10,000 people, then you would expect the premium to be $100 each. ($1,000,000 / 10,000)
In truth the premium reflects more than just the expected claims, and includes margins, stop-loss fees, administration fees, reserve funding, and other factors. And while these factors are considered by the actuary when calculating the liability, for our purposes the above simplification will be sufficient to understand why the experience subsidy exists.
2. The funding status
There are many ways of funding a medical plan, but 3 are most common in practice:
As we saw above, ALL premiums are experience rated premiums. A community rated plan, however, takes a whole bunch of little groups, and puts them all together into a giant pool. The claims for this pool are then split evenly amongst all the little groups. By doing this, even one group’s bad claims experience during the year is spread out so much that it doesn’t impact anyone’s premiums to an appreciable amount.
In an experience rated plan, the claims experience of the employer plays a significant role in determining the premium rates the group will pay. The administrator still pools claims across a group of plans, but a favorable or unlucky claims year will have a direct impact on the premiums that the employer pays.
In a self-funded plan, the employer is a pool, or the overwhelming majority of it. For SFAS 106 and GASB 45 purposes, a self-funded plan largely is interchangeable with an experience rated plan, as plan experience impacts premiums in both cases.
These are the fundamental concepts of medical insurance. In Part 2 I will use these concepts to explore exactly what the experience subsidy is and why it occurs.
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