Hospital self-insurers gain by equities investment
By Ken Quintilian, FCAS, MAAA
Casualty Actuary, Principal
Milliman & Robertson, Minneapolis
For a self-insurer of medical malpractice, increasing holdings of equities can often reduce risks to the fund. That may seem like an odd concept, because when it comes to investing, many self-insurers have chosen very conservative strategies. They realize that their claims results are already volatile, and they don’t want to take on more risk through their investments.
Can investing in more equities, which will increase the average return to the fund, actually reduce the fund’s overall risk? We have seen that the answer is yes. Risk reduction and a higher return — that’s like found money.
History shows that equities (common stocks) not only provide greater investment returns than fixed income securities (such as bonds), but they also carry a much higher risk of investment losses. Before selecting an investment strategy for its program’s funds, a self-insurer must consider both the risk and the return.
The assets supporting the fund are being well managed if these opposing objectives are in the best balance. The same kind of risk and return considerations also are routinely applied to the claims operation. Risk managers who utilize self-insurance often think of reducing this self-insurance risk by taking such steps as buying excess insurance. These risk reductions increase costs to the fund because there is a premium charged by the insurer of these excess policies.
Consider this example of a public, tax-exempt university hospital system. It has self-insured exposures in several coverages, but we focused on its medical malpractice exposure for this article. When performing such an analysis for an actual fund, we would look at all of the coverages at the same time to get a composite estimate of the fund’s risks and returns.
The fund normally incurs between $5 million and $10 million of losses each year. It currently supports undiscounted expected value loss reserves of about $25 million. It funds its liabilities at a rate of 100% of the undiscounted actuarial loss estimate. Its contingency margin (assets less discounted liabilities) is currently about 25% of its reserves, but the fund has been trying to increase this margin.
For purposes of estimating the risks that the fund faces, an extraordinary contribution by the self-insurer to the fund would be needed if the fund’s contingency margin were at any point to fall below zero.
The fund long has purchased only bonds, in an effort to minimize its investment risk. The fund has turned to the actuarial methodology called Dynamic Financial Analysis (DFA) to assist in determining whether it should begin to place a significant amount of its portfolio in stocks and, if so, to help determine how much is the right amount of stock to buy.
The goal of a DFA study is to estimate and compare the "risk" and "return" of various alternative business strategies — in this case, investment strategies. We began this process by creating a model of a typical self-insurer. We selected measures of risk and return by which to compare alternative strategies for investments. We then simulated economic, claims, and investment variables to project many possible financial outcomes over a 10-year time horizon.
We tested five investment strategies involving progressively higher levels of investment in equities (with corresponding decreases in taxable bonds, in which the remainder of the fund was invested). We display a graphical comparison of these alternatives in Figure 1, top of page.
For a measure of return, we used the expected fund balance in excess of the required actuarial claim liabilities. We assumed that the required actuarial claim liabilities would be set equal to 150% of the fund’s total present value claim reserve (i.e. the desired funding level is set higher than the expected losses, to provide a contingency margin). Any fund amounts accruing above this margin would be released from the fund back to the self-insurer (up to a maximum annual release intended to reflect additional conservatism).
We measured "risk" as the likelihood of an extraordinary fund contribution being needed, whether due to loss experience or investment outcomes. This risk measure is shown on Figure 1 as a dollar amount, because the likelihoods were adjusted to reflect the amount of the shortfall in each case. A shortfall occurs if the assets of the fund fall below 100% of the present value of the claim liabilities.
A comparison on Figure 1 of zero or low stock investments to a "moderate" level shows that the latter is actually the least risky of these three, while it yields a significantly higher return. This means that under the moderate scenario, in which the fund holds stocks equal to 20% of assets, the fund realizes a reduction in risk compared to the options with less stock, and at the same time gains additional investment income.
How is this possible? Aren’t equities inherently more risky than other kinds of investments?
Increasing investment in equities certainly contributes to the volatility of the fund balance. But this change also increases the average investment earnings, which works to offset the effect of the increased volatility. The contingency margin generally increases more quickly, providing more cushion against adverse events when they occur.
Clearly, the minimum optimal investment in stocks for this fund, on the basis of this analysis, is the moderate strategy. The lower options result in higher risk and lower return, which makes them unreasonable strategies on the basis of this analysis.
Lower contingency margin can boost risk
On the other hand, moving in Figure 1 from the moderate investment strategy to the more aggressive strategies accords with the conventional wisdom — the idea that increasing investment in stocks leads to both increased return and increased risk. Each of the three highest stock points is a good choice of investment strategy for a given risk target. If the self-insurer can accept more risk, it can be more aggressive. While the expected investment income will be higher, the chance of an adverse outcome also will be higher.
But a risk manager would want to insure that at a minimum, the fund would be at the level of stock investment that put it on the leftmost point of the graph. If the fund invests in less stock than that, then it is accepting unnecessary additional risk without being compensated for it.
We tested what would happen if the fund had a lower target contingency margin, equal to only 25% of its discounted loss reserve (see Figure 2, p. 132). Although the return is only slightly higher in Figure 2, the risk is fully triple what it was in Figure 1. Furthermore, the thinner contingency margin exposes the fund to substantially more investment risk: The risk minimizing strategy in this case is the "low stock" option, which entails investing only 10% of assets in stock. Clearly, an element of risk management is recognizing that the contingency margin can protect against more than just claims-related losses. When a fund decides to invest in more stocks, one logical strategy could be for it to increase its target contingency margin in order to provide it with additional protection against fluctuations in the value of the fund.
Time horizon affects projections
When we set up this model, we selected 10 years as the period over which the projection would be made. Some funds, when running an analysis such as this one, might choose a shorter period such as three years. This kind of change in parameters can affect the selection of the best investment strategy.
This analysis was conducted for a hypothetical self-insured medical malpractice fund, although the logic of this type of analysis applies equally well to any self-insurer. Many variables impact each actual fund, making them different from one another and from the fund studied in this article. Therefore, the wisest move for any fund manager is to conduct a similar analysis before making investment decisions like those discussed in this article.
But the important lesson is that asset management is not a different animal from risk management. They’re both part of the global approach to managing risk and return. Those who take this global view to heart will be able to take advantage of "found money" and use it to improve the performance of their funds.
(Editor’s note: Ken Quintilian has extensive experience modeling and projecting medical malpractice exposures. He is based in the Minneapolis practice of the national consulting firm of Milliman & Robertson. For contact information, see source box, below.)
Source
Ken Quintilan, Milliman & Robertson, Suite 1850, 8500 Normandale Lake Blvd., Minneapolis, MN 55437-3830. Telephone: (612) 897-5300, ext. 499. Fax: (612) 897-5301. E-mail: ken.quintilian@ milliman.com.
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