Seeing The Big Picture: ERM In The Health Care Industry

Seeing The Big Picture
ERM In The Health Care Industry

By Robert Wolf

THE EVOLUTION OF ENTERPRISE RISK MANAGEMENT (ERM) series continues with a look at the health care industry. Read how ERM and actuaries can make an impact in this important sector.

Although overshadowed by the financial crisis prevalent today, the actuarial profession has the opportunity to invoke a state–of–urgency, taking a stand and developing practical solutions to the health care crisis. That said, I believe collaboration with other professions is needed. I challenge us to come to the table.

The Feb./March 2009 issue of The Actuary contained the third in a series of articles about enterprise risk management (ERM). The focus of that article is the current financial crisis and lessons learned within an ERM framework. In that article, I described five key elements of an ERM framework that are necessary for the process to achieve its inherent goals and its ultimate success. Failure to provide any of those elements (listed below), implies an incomplete implementation of ERM. Note: The actual words have been reframed since that writing and I am using suggestions by Dave Ingram to incorporate the points more succinctly.

In review, the elements are:

  • That incentive compensation must stop paying for excessive risk taking.
  • That those with authority to make decisions must have accountability for all the bets they take, not just for the winning bets.
  • That businesses must realize that risk history is not destiny.
  • That modeling is only an analytic tool; it is people that make decisions.
  • That to prevent the next crisis risk managers must question the answers.

As I have argued earlier in this series, ERM should be framed and conveyed as risk and return management, where management not only incorporates the what–ifs if exogenous events happen, but also the what–ifs of outcomes based on human decisions and behavior. The key understanding is that the behavior of risk and returns needs to be managed and/or regulated so that desired outcomes match incentives. Despite the sophisticated models we use in our day–to–day operations, our risk/return analyses will be deemed useless if this dynamic is not in place. The process of ERM and these five necessary conditions could be consistently applied across all practice areas and/or industry sectors. At the end of the day, one tries to earn rewards for the risk chosen and mitigate the risk you didn't choose but own anyway.

A Convoluted Industry

The actuarial profession resides actively within the health care industry. Approximately 4,000 SOA members of the Health Section act as experts in setting optimum rates/fees along with reserving for unpaid liabilities. Our best practices are evolving as we develop enterprise risk (and reward) management disciplines in our traditional areas of practice within the health insurance markets. A significant number of members of the Casualty Actuarial Society (CAS) also work in insurance companies offering medical malpractice, hospital professional liability, and errors and omission insurance to health care providers. They too are implementing ERM principles in those sectors of the casualty insurance industry.In addition, actuarial consultants at brokerage houses and consulting firms are advising on risk and return strategies for self–insured workers' compensation, medical malpractice exposure and hospital professional liability exposures for hospitals, physician groups, managed care organizations, and pharmaceutical firms.

Although extremely active in this industry and very influential, I believe one can deduce that actuaries have a concentrated focus in their practice areas. However, I do believe we are practicing and evolving ERM principles within the health care sector. In other words we are incorporating the E in ERM at the individual health insurer, property casualty insurer, hospital group, managed care organization, or pharmaceutical firm we work for or consult with. To solve the health care crisis though, I believe we need to further collaborate and extend the E.

When I began my days as a consultant in the industry, medical costs in workers' compensation made up about 40 percent of the total benefits, the rest being wage loss. In the casualty business, workers' compensation insurance is typically the largest business sector of a national commercial property–casualty insurance carrier. Medical benefits from workers' compensation losses have been and are continuing to grow at a rate far exceeding the increases in group health costs and the general medical CPI growth rate, nearly doubling from about $13.5 billion in 1999 to over $25.0 billion in 2007. Why is this? This has been a growing concern for property/casualty insurers in the last two decades. The question raised is, "Why would medical treatments cost more if you slip and fall at work as opposed to slipping and falling at home?" While workers' compensation and group health utilize essentially the same resources and health care providers there are differences, mainly driven by coverages, political and regulatory pressures. Group health generally includes disincentives for overutilization, such as copayments by patients, while workers' compensation benefits do not. This incents some patients to report their slip and fall at home as a slip and fall at work. This increases moral hazard. I see this as one of many areas of the health care sector where health and casualty actuaries can successfully collaborate. Both professional groups use similar tools and terms (e.g., IBNR reserves), but can learn from each other. For example, both have been embracing predictive modeling techniques in their pricing schemes.

In the initial article of this series, I opined that traditional risk management has viewed risk as a series of single elements. Each risk stood alone and analysis assumed that they were not related to the others. Optimizing risk management in each business unit meant optimizing risk management for the overall company. Since problems and/or failures of companies generally result from multiple correlated causes, I pontificated that only an integrated approach to risk management, namely ERM, could recognize and address the solution. We will extend these arguments here. Although one can provide ERM within an enterprise to optimize risk/return solutions to solve a localized crisis, we must extend the risk analysis to encompass multiple enterprises within a sector to produce solutions for society's problems. To truly play a key role in resolving the health care crisis, we must extend our solutions to include the E part of ERM. This includes society at large, providers and the government. Since health care permeates all actuarial sectors, not only health insurance practitioners, we must collaborate as a profession. As an example, the looming risk of pandemics permeates all industries and all of our traditional areas of practice. This is not to say that the actuarial profession is not serving in the industry and serving it well. This is an evolutionary process, not revolutionary. It is now time to organize, group and synthesize the cause to extend our boundaries and implement our solutions.

Medical care in the United States is a trillion–dollar business, spending approximately $7,500 per person in 2007, making up 17 percent of the Gross Domestic Product and 10 percent of the labor force. In the late 1920s health care was financed primarily by patients directly (approximately 81 percent). Today, only 11 percent of health care costs are paid directly by patients. The federal government, private insurance and charities grew as partners, shifting this burden from individuals to third parties. This not only changed the flow, but also the amount available—which was a good thing. Unfortunately the system became much more complex. It became unclear who was paying for what. Provider revenues can be paid as reimbursements from taxes paid to government agencies, employee and employer premiums to health insurance companies, HMOs or PPOs. Who decides which patient gets the kidney transplant? At the end of the day the process pools funds from many people to pay health care for those who need it—another good thing. Who gets this care and what care decisions are made by the professionals who run the health care organizations? There is no direct two–party buyer/seller transaction that is so typical in the other sectors of the economy.

Health care, unlike most other industry sectors, is mostly not about money for the public. So the following the cash aspect of ERM here has more layers and is challenging in different ways. Following the cash in this industry and gauging the alignment of incentives and performance is convoluted. Science and religion do not align regarding health care responses to birth and death. In a family crisis, people will pay almost anything for health care. The challenge in health care economics is looking beyond crisis mode to the larger picture in regard to costs and benefits, risks and rewards.

A patient's trust in professional services, in essence, takes precedence over pure price/cost considerations. This is unique relative to other purchases. Customers decide whether or not to buy a car, and which one. In health care, customers (patients) make choices based on information ranging from advised consent up to total deference to their doctor on treatments, drugs and other health remedies. Health care is thus a convoluted decision making process, hopefully optimized by the Hippocratic oath of doctors, the innovation and ingenuity benefits of a free society of medical and pharmaceutical researchers, and the lending and/or regulatory hand of government. With the actuarial professions' standards of practice, codes of conduct, along with other strong professional standards and ethical practices, we can continue to grow our influence.

In the United States, we arguably have a technologically advanced health care system that is responsive to public needs. That is the good news. There are both uninsured and underinsured populations, and that is not good news. It is an opportune time for the actuarial profession to help society understand the convoluted economics of the entire health care economy from a risk and opportunity perspective.

As a key focus in this series of articles, I continue writing about the need for incentive compensation to better align with ultimate performance. Health care ERM should continue to encourage and reward innovation and ingenuity. As in all industry sectors, behavioral economics should be considered in all ERM schemes. As a society, we are arguably predestined to do good. We, the actuarial profession, have the opportunity to leverage this predisposition to provide practical, real and common–sense solutions to optimum health care deliverance.

The risk/return tradeoffs in health care also relate to the timing of the risks and returns. The study of brain function or cell structure will do nothing for a patient in the hospital today and not much for the foundation that donated the research grant money. Today's miracle drugs were paid for by research paid for by the overhead built in to yesterday's health care costs. In some ways it sounds like inter–generational risk prevalent in the social security discussion. The people who benefit from medical research today are not usually the people who paid for it, much as current retirees benefit as taxes are collected from current workers. Part of our health care costs today invests in research that will benefit future generations. If we reduce these costs and eliminate research budgets, our children and grandchildren will suffer. These risk and return considerations we, as a profession, work in today must be considered in our respective domains. Common considerations include timing, when risk is taken and returns are realized, along with tradeoffs such as affordability and availability of care for customers.

Classic financial analysis dictates that something useful only in the future is not worth as much as something you could use today. But classical financial analysis does not consider our societal obligations to the next generation. In addition, it dictates that uncertainty also makes things less valuable. What makes health care so unique is that the benefits of tomorrow are both uncertain and financed by others. This makes it difficult to quantify. Do we, as patients, ever stop to compare costs and benefits before going to the doctor?


As a profession, we can make both immediate and long–term strides within an ERM framework in the industry. In the short–term, we have the opportunity to increase the efficiency of health care costs by enhancing risk and return tradeoffs and efficiency in delivering health care underlying group health insurance and workers' compensation. Health actuaries and property/casualty actuaries have common tool–kits, and each can learn from the other. Both specialties are growing in the use of predictive modeling in their price structuring. This could, perhaps be extended to a myriad of analytical assessments, such as assessing which doctors are providing the best outcomes for getting workers back to work and/or staying at work.

Long term, I call on our profession to form a focused and collaborative task force made up of members from the CAS Committee on Health Care Issues, the SOA Health Section, and the American Academy of Actuaries Health Practice Council. This task force could then form an alliance with organizations such as the American Society of Health Economists (ASHE), the American Society of Health Risk Managers (ASHRM), and the Disease Management Association of America (DMAA) in a collaboration to determine enterprise risk and return best practices in the health care industry.

We have started. In recent months, Kara Clark, FSA, took over as executive director at ASHRM. The SOA Health Section and SOA/CAS/CIA Joint Risk Management Section have already begun preliminary talks on a collaboration.

The Health Section is sponsoring research, led by Max Rudolph, FSA, CERA, on Best Practices in ERM in Health Care.

At the time of this writing, new SOA Health staff fellow Sara Teppema, FSA, MAAA, FCA, and the Health Section are launching a Call for Essays on the Health Care Crisis, similar to a 2008 initiative on the Financial Crises, in the interest of generating best strategies.

The future of the United States health care system was one of the leading domestic issues debated during the 2008 presidential campaign and is clearly among the top agenda items for the newly elected administration. Likewise, the recent economic environment has highlighted its critical importance for many Americans. With major corporations announcing unprecedented layoffs, questions of affordability of health care and access to adequate services are impacting a growing number of individuals. Surveying the current state of the health care system, it is readily apparent that there are opportunities for improvement. Shedding light on this overarching issue is the primary objective of this Call for Essays.

As experts in the economic risk and return tradeoffs in the health care sectors, we have an opportunity to bring our skill–set to help solve the health care crisis. The time to do it is now. As the popular commercial might say, "Health is priceless." Our opportunity to serve is endless.

Robert Wolf, FCAS, MAAA, FAC, is a staff actuary for the Society of Actuaries. He can be contacted at