Herbert E. Goodfriend and William R. Horbatt examine the development and growth of the medical stop-loss market.

Health care is in a crisis condition in the US. The underlying problem is inability to control rising medical and hospital costs. More and more employers have chosen in recent years to reduce costs by self-insurance of employee group medical plans instead of purchasing fully insured group medical coverages from health insurers. The self insured plans need protection against excess losses. Such protection is afforded by medical stop-loss coverage.

History

Over time, medical coverage has been splintering into many different alternative approaches. Fifty years ago, a typical group medical plan was fully insured with an insurance company that simply paid claims as they were received. Cost controls were limited to applying deductibles and co insurance percentages to the insured and applying some measure of a maximum "reasonable and customary" charges to provider bills. The insurer fully accepted any risk that claims exceed premiums.

The development and growth of the medical stop-loss market is a direct result of the development and growth of self-insured health plans, which became increasingly popular in the late 1970s and early 1980s as spiraling health insurance costs threatened employers' abilities to manage or control their medical benefit expenses. Escalating health costs combined with recessionary conditions in the early 1980s prompted many employers to search for methods to gain better control of their health care expenses. In general, such efforts were directed to examining alternative coverage structures and methods for insuring such coverages; self-insured plans were developed in response to those needs. As the market and industry continued to develop, employers found self-insurance an attractive alternative to traditional fully-insured plans. The adoption in 1974 of the Employee Retirement Income Security Act (ERISA) increased the variability of these plans by placing them under the sole jurisdiction of federal regulators, and by eliminating state taxation on premium income previously paid to health insurers. In addition, newly available data processing capabilities enabled employers to examine and analyze medical cost data in order to more effectively control such costs. According to a national employee benefits consulting firm, in 1987, 47% of employers surveyed said that they self-insure their group health plans; by year-end 1990 that proportion had increased to 59%. Management believes that costs in the health care field will continue to rise in the foreseeable future, and that self-insured employer medical plans will continue to proliferate.

Self-insurance provides employers with certain advantages. Plans allow employers to retain for themselves the investment return on funds received prior to their disbursement that otherwise accrues to the benefit of the insurer. Such plans also provide employers with the flexibility to design coverage structures to meet their specific needs. While self insurance provides employers with certain advantages, it also exposes them to the substantial risks of excessive losses both on an individual and aggregate basis. This is especially true for employers with populations too small to permit accurate predictions of future costs. The medical stop-loss market responds to the needs of self-insured employers for protection from excessive losses by limiting an employer's liability to a predetermined amount for individual and aggregate claims.

The preemption of state regulation by ERISA has contributed to the growth of self-insurance and the medical stop-loss market. Medical stop-loss carriers and related service providers have benefited from the relative absence of the extensive regulations that characterize the fully insured marketplace. Employers have been able to custom tailor health benefit plans without having to provide state mandated health benefits. However, as self-insurance has grown from an alternative market to a recognized mainstream health insurance delivery system, state insurance regulators have increased their efforts to regulate this system, if not directly, then indirectly by regulating insurers and service providers. Moreover, failures of life and health insurers and scandals surrounding Multiple Employer Trusts (METs) have increased the demand for regulation of this business. Future regulation of the medical stop-loss business may ultimately eliminate companies that are financially unsound or which engage in questionable business practices.

The fully-insured group health insurance business historically has been subject to three-year pricing cycles. Such cycles are driven by periods of underwriting profitability, followed by excessive price competition which leads to periods of underwriting losses. The frequency of losses and the loss payout periods for the medical stop-loss business are different from those in the fully-insured market, and likely to develop a different pricing cycle. Medical stop-loss coverage is typically written with high specific attachment points, contrasted with lower deductibles found in most fully-insured group policies, and until 1996 was not subject to competition with respect to the portion of risk retained by the employer. However, the medical stop-loss market has become subject to price competition as that market matured.

Medical stop-loss coverage is a form of insurance that protects employers that self-insure their employee health care plans by limiting their exposure from the risk of loss to a pre-established amount. Provider excess coverage limits the financial risks health care providers face from medical plans that prepay the providers' fixed sums per plan participant (capitated fees) or provide specified rates for services.

Large companies may market medical stop-loss coverage through a network of as many as 800 TPAs, insurance agents, brokers and employee benefit consulting firms.

Reinsurers provide significant risk bearing capacity to a stop-loss market that has historically demonstrated little vertical integration. A typical self-administered program has stop-loss coverage obtained by the TPA, who in turn purchases the coverage from a managing general underwriter (MGU). The MGU provides a package of services, arranging for a licensed carrier to provide the "paper", an authorized insurance contract, as well as the reinsurance of substantially all of the risk away from the fronting company. The reinsurance can be obtained from a single reinsurer or from forming a pool that multiple reinsurers participate in. The reinsurers cover all policies written during a treaty year, so - particularly for programs written late in a calendar year - the coverage can extend over two full years.

There are large and well established companies currently offering health benefit products and services, and some in such companies have large, well-established sales forces and greater resources at their disposal.

The truly first medical stop-loss was introduced in 1980. An important trend within the medical stop-loss market is flight-to-quality, or movement of business to those companies with continuity of operations and the strongest financial standing. Competitive pressures are increasing the risk that insurance companies lacking adequate levels of surplus may be unable to meet their future policyholder obligations. As a result, larger more sophisticated producers are shifting more of their medical stop-loss business to companies that offer financial stability and higher levels of customer service. A precise measure of the size of the medical stop-loss market is not possible because data on the market are not routinely collected, compiled, or systematically analyzed. However, several studies provide snapshots of the market. A national estimate, based on 1993 data, was published in 1995 by the US General Accounting Office (GAO). According to the GAO, self-funded plans, the majority of which purchase stop-loss insurance, represent about 40% of ERISA plans, covering 44 million people, or 17% of the US population. Another 7 million state and local government employees are in self-funded plans, bringing the total to approximately 51 million or close to 20% of the population.

Competition increased during the early 1990s with reinsurers "shaving" rates from their manuals. As property/casualty reinsurers entered the market one chief actuary complained "with all this naïve capacity entering the market, there is little hope of redeveloping a rational pricing structure." Some reinsurers did not effectively monitor the extent to which they discounted premiums and were quite surprised during the mid 1990s when claims began to exceed premiums. A few of them threw in the towel and are now exiting the market.

In January, 1998 the Employee Benefit Research Institute (EBRI) published an update of the GAO analysis of ERISA plan participants, using 1995 data. EBRI found that about 48 million people, or 18% of the US population, were enrolled in self-funded ERISA plans. This represented about 39% of people covered by ERISA plans, EBRI commented on several recent surveys of employers:

"The surveys conducted by Foster Higgins show significant growth in self-funded plans with stop-loss coverage from 1995 to 1996. In addition, KPMG's annual surveys show an upward trend in the number of employees covered by a self-funded plan with stop-loss insurance from 1996 to 1997."

Despite the current competitive environment, medical stop-loss coverage remains an interesting and perhaps attractive market, as self-funding of health care continues to grow in size and importance.

Most large employers have traditionally been self-insured. Over 50% of all employers are currently self-insured and the percentage has been growing 3%-4% annually on a steady basis. Some insurance companies designed their programs for small and medium-sized employers, with 25 employees as the minimum number to qualify. One major participant, Centris' USBenefits division's strong growth has come both from employers shifting from other stop-loss programs to USBenefits and from their switching from insured programs to USBenefits' self-insured programs.

For those who entered the fray early on, this proved to be a wondrous period of rising volumes and excellent profitability. Moreover, unlike its conventional accident and health insurance counterpart, the TPA business appeared to be non-cyclical.

In the late 1970s and early 1980s, target markets were employer groups with perhaps 500 lives. As insurers faced erosion of this size account, attention was centered by the upstart TPAs on smaller groups, that is, as few as 25 lives.

As the group sizes fell below 500 lives they began to lose statistical credibility, so that the past experience of a group had less and less bearing on forecasts of future experience. stop-loss coverage for these groups, particularly aggregate coverage, begins to take on the characteristics of a traditional insured program with premiums increasing to larger and larger portions of the total employer cost.

Meantime, insurers facing rising costs, were forced to raise rates, placing themselves in even more vulnerable positions. The most important stimulus to employers seeking TPA stop-loss help was financial, not strategic or social. One factor not previously enjoyed by such employers was their new-found ability to retain cash for larger periods than was the case in fully-funded programs. Moreover, they were seeking relief from and more flexibility to react to unwanted, stiffer state-mandated benefits.

During this time, there were perhaps as many as 100 meaningfully-sized and as few as 50 TPAs in the game. These participants soon doubled as the market opened up, rising to a peak of around 300 in 1992 to 1993.

Given the relative new market, the paucity of large players (unlike the major indemnity health fully-funded one) was one which permitted pricing that was quite profitable, especially when compared to its predecessor (Lloyd's and other reinsurance markets). The contracts were crafted importantly by underwriters not actuaries. Ease of entry was a given for agents and brokers.

Several participants have been acquired and it is reasonable to expect this activity to continue. Many smaller managing general underwriters (MGUs), for example, Centris' acquisition of Global Excess Re, have lost their issuing carriers due to unacceptably high loss ratios on their books of business. There has also been consolidation in the third-party administrator marketplace, a primary source of business. The TPAs which remain are larger, more financially secure and seek to do business with sound, well-established companies.

A study published by KPMG in 1997 of firms with 200 or more workers in early 1997, showed the importance of self-insurance, especially self-insurance with stop-loss funding or reinsurance. Comparing 1997 to 1996, the percentage of workers covered by partly self-funded plans, where stop-loss reinsurance is "the most common form of risk-sharing", increased for the four plan types identified: conventional (fee-for-service), HMO (health maintenance organization), PPO (preferred provider organization), and POS (point-of-service). Comparing the same years, the percentage of workers covered by completely self-funded plans, where employers bear all financial risk associated with provider payments, decreased for all four plan types.

Aside from annual changes in the composition of the self-insurance market, the KPMG study shows that its market share is substantial: "approximately 60% of employees in firms with over 200 workers are covered by self-insured health plans." By plan type and firm size, the percentages of employees 18 to 64 years of age covered by completely or partly self-funded plans in early 1997 were:

These data, and the growth in the percentage of workers covered by partly self-funded plans, reflect a finding from an earlier study.

State regulatory requirements imposed on medical stop-loss plans vary from state to state. These include different licensing, reporting, policy form and solvency requirements for insurers issuing the policies. The states may also impose minimum values for specific and aggregate attachment points for a policy to be called a stop-loss policy.

However, for self-funded employee benefit plans, the authority of state regulators is diminished substantially because of ERISA preemption. Various case laws provide precedence for a safe plan design. For example, in a recent federal court case (Travelers v Curmo), both the trial and the appellate courts struck down New York State's requirements for conversion privilege, payment of run-off claims, and mandated benefits among others. That state's authority over these plans, however, is not denied. Despite the diminished regulatory authority, NY State has been successful in disallowing any stop-loss insurance in the small group market with less than 51 employees.

METs and MEWAs are, in general, not treated as favorably under state regulation and ERISA-preemption provision.

Profitability and cyclicality of medical expense reinsurance industry

The profitability of medical expense reinsurance business depends in large part on the ability to predict accurately and manage effectively health care costs. Results of operations are directly affected by premium rate adequacy (which depends on pricing and underwriting decisions), insurance benefits provided (which is influenced by the level of health care costs and utilization), the efficiency of administrative processes, investment returns and the impact of changing laws and regulations on the foregoing. The level of health care costs depends upon numerous factors, including the rate of medical cost inflation (which in the United States has increased more rapidly than the National Consumer Price Index in recent years and is expected to continue to do so), changes in health care practices, new health care technologies, major epidemics and natural disasters. Although medical expense treaties are typically renewable annually, there can be no assurance that actual medical cost inflation or utilization will not deviate over the annual term of a treaty, perhaps substantially, from forecasts used in setting premiums, which can have a material adverse impact on results of operations and cash flows.

The group health insurance industry has historically been subject to pricing and profitability cycles that are driven by competitive price pressures within the industry. Although the length and severity of the cycles have varied, the cycles generally have averaged approximately six years and have been characterized by three years of profitability followed by three years of losses. The pressures on medical cost increases reflect an increase in the amount of business under managed care contracts (which control costs), increased provider awareness of the necessity of cost containment, heightened concerns with proposed legislative reforms and consumer attention. The trend to managed care has forced greater systems and capital requirements. Such requirements may have discouraged new competitors in the group health insurance industry. Nevertheless, the extent to which structural changes in the managed health care and health insurance industry have altered the cyclical pattern is uncertain. There can be no assurance that the historical cyclical pattern will not recur or that a new cyclical pattern will not emerge, which could have a material adverse impact on operations.

The TPA industry is changing today as we write. In the area of workers' compensation, TPAs are integrating managed care operations with the claims services. Employers turn to self insurance with a primary goal of reducing their workers' compensation expenses. Quite often there is a secondary goal of gaining greater control over the management of the return-to-work process that is available to fully insured programs.

Workers' compensation has three major components: administrative, medical payments, and wage replacement (indemnity). The breakdown of the workers' compensation dollar is 40% indemnity, 20% administrative and 40% medical, and the 20% administrative cost is further split about 50% for claims processing and 50% for managed care.

Historically employers have used self-insurance to reduce workers' compensation program costs in three ways:

* Using lower overhead TPAs rather than insurance companies to process claims;

* Improving cash flow by controlling the claims payment and loss reserve, rather than paying insurance premiums up front;

* Isolating the employer's risk, then allowing the employer to realize 100% of the positive effects of its direct experience, including any cost savings from improving working conditions, implementing successful safety programs or making other improvements to their workers' compensation programs.

Recently, there has been increasing recognition of the benefit of managed care techniques and a corresponding demand for these services in order to obtain additional cost savings and improve the medical and disability outcomes. The TPAs in the workers' compensation field can play a vital role.

There continues to be significant growth in the alternative market and this trend is likely to accelerate as insurance premiums begin a widely-expected cyclical increase over the next three to five years. Moreover, the traditional market requires significant statutory capital, is very competitive and is subject to those cycle swings, while the alternative market is more stable.

Consolidation among the TPA industry and the managed care field is a given. The market for both TPAs and managed care services is highly fragmented with numerous small and moderate sized companies and no dominant company or companies in either service segment.

TPAs employ specialized workers' compensation claims adjusters to determine whether a claim is compensable, assure that claims are paid accurately and promptly in accordance with state mandates regulations, project the lifetime costs of each claim to assure adequacy of reserves to pay future liabilities, and manage the litigation which often results when employees hire attorneys to represent them in order to obtain contested benefits.

There are about 400 TPAs in the US offering workers' compensation services, and the total market is estimated at $4 billion in revenue. TPAs generally fall into two sizes - moderate sized national companies with 30% of the market and small, independent local companies. These firms, both local and national, have historically competed on price and relationships and are thinly capitalized.

As the demand for value-added services has increased, particularly in managed care, many TPAs have not responded. The smaller TPAs are not equipped with the required information technology or medical management skills and do not have access to the capital necessary to acquire these capabilities. The larger TPAs have more access to capital, but often lack the management talent and ability to change the claims processing organization culture, or the visions to develop managed care capabilities.

The managed services in the workers' compensation arena generate about $2 billion in revenues.

One approach is towards combining the claims handling services with managed care, being explored by the Florida based Synergy Insurance Systems (SIS), headed by Steve Picow, president. Although not officially a TPA yet (Mr Picow says that it will be licensed as a TPA by the end of this year), the firm is offering a complete delivery system for auto insurance carriers specifically under the personal injury protection (PIP) portion of personal lines auto insurance coverage.

One area in which TPAs have made significant inroads is workers' compensation. When workers' compensation premiums soared in the 1980s, often by as much as 15% to 20% a year, many employers turned to self-insurance, hiring TPAs for professional risk management. Today, even though rates have fallen considerably, a long term view has kept self-insureds from switching back to traditional insurance. In Missouri, for example, there are 560 self-insureds working with some of the state's 245 licensed TPAs. In Kansas, where TPAs are not licensed, there are 10 to 15 and about 270 self-insureds.

One licensed TPA operating out of New Jersey is Presidium, Inc., a firm that, according to Maryellen Peters, vice president in charge of claims services, is positioning itself to become the leading provider of disability management services to self-insured employers. The company operates from 15 offices with approximately 450 professionals who provide claims adjudication, return-to-work and specialty managed care services. In early 1997, it acquired Business Health Services Inc., a full service managed care company specializing in workers' compensation.

Mr Picow explains: "SIS was developed to fill a tremendous void affecting auto insurance carriers. Auto carriers, unlike most other companies delivering health care, have not enjoyed the benefits afforded by the managed health care environment. The opposite has really occurred. As medical providers have their fees cut by health carriers, cost shifting creates even greater pressure to over-bill and overuse PIP benefits. PIP coverage remains the last oasis of unmanaged care left in this country."

The firm does not charge the auto carrier for any of its services, Mr Picow points out. All administrative costs and profits come from the discounts created by having contracts with providers at fees well below the carrier's usual and customary allowables. "But Synergy does not stop at discounting fees," he says. "We eliminate many legal costs associated with PIP suits, do internal peer review and manage soft tissue treatment by imposing limits on total collectable fees. All this is done on a contractual basis to limit, and in most cases, reduces or eliminates the carrier's legal exposure."

Mr Picow says that Synergy guarantees a 12% saving on policies that do not have a deductible. In some cases, savings exceed 40% and that is after Synergy's deductions for administration and profits.

"Our company is dedicated only to auto carriers and PIP claims. We have no confusion in our mission to decrease the terrible waste that occurs in this industry. We do no work with traditional health payers or with workers' compensation carriers. We believe that to finally address this problem requires complete focus and dedication."

Therefore, it appears that TPAs are very much in the future of the insurance industry and self-insureds, but that they are now moving towards more specialized services and, out of necessity, including managed care services in their offerings.

Page Lord, of the risk management consulting firm, Risk Management Solutions, based in Florida, says that TPAs are playing an increasingly important role for carriers and for self-insureds and are being more innovative every day in terms of the services they offer. "For self-insureds, it puts them in control over their own destinies. For carriers, it is a cost saving. Some TPAs are operating on a profit-sharing basis and others are actually sharing risks with their clients. It is a field that has just begun to grow."

The business world has rapidly become a global culture. As a result, having studied developments in health care delivery and financial markets overseas, particularly in Europe and Latin America, there appears to be considerable opportunity in the years ahead. As populations age and their health care requirements increase, and as new technology drives up health care costs, governments in developed countries are shifting financial responsibilities for health care, pensions and other social benefits from the state to employers and providers and are looking to the private sector to create funding vehicles for those benefits. Similarly, governments in a growing number of emerging countries, such as Argentina and Brazil, are opening up insurance opportunities for both domestic and foreign companies to foster competitive markets and to accommodate growing middle-class demand for secure financial products and services.

Marketing

Some companies market and distribute medical lines products through a network of TPAs, insurance agents, brokers and consultants (collectively "Producers"). Producers have non-exclusive arrangements that enable them to submit requests for coverage quotations on behalf of their clients for which a fee or commission to Producers is paid for placing the coverage, the amount of which is based on a percentage of the premium written and is negotiated on a case-by-case basis. Additionally, an annual production bonus to Producers may be paid based on the amount of new business and rate of retention of accounts during the calendar year.

Many smaller managing general underwriters have lost their issuing carriers due to unacceptably high loss ratios on their books of business. There has also been consolidation in the TPA marketplace.

Products

There are basically two types of medical stop-loss products: specific excess and aggregate excess. Employers can elect to purchase specific excess coverages only, or a combination of specific and aggregate coverage. Generally, self-insured employers purchase a combination of specific and aggregate medical stop-loss coverage in order to minimize their exposure. Medical stop-loss coverage is written on a basic form which can be customized to meet the employer's individual needs and ability to retain risk. Medical stop-loss coverage indemnifies only the employer for its obligations under its self-insured plan of medical benefits; no plan participant or beneficiary is covered by the medical stop-loss policy.

Provider excess

Provider excess limits the exposure which providers of medical services incur when they enter into capitated fee arrangements; it protects these providers from excessive losses that can arise when expenses exceed a predetermined level.

An underwriting manager markets two types of medical stop-loss products: specific excess, which limits a self-insured employer's financial exposure to a predetermined maximum loss per participant under a plan in any one year, and aggregate excess, which limits the self-insured employer's aggregate financial exposure for all participants under a plan to a predetermined maximum loss in any one year.

Companies deal with employers' self-insured medical plans through independent service providers (TPAs) who are the plans' authorized representatives, and who purchase medical stop-loss and other insurance products for their client from other insurance companies.

The salient competition then was Safeco, Hartford and Employers Re, and USBenefits (Centris subsidiary) also rose to the challenge.

Credible data as to market size and growth characteristics, etc, are hard to come by, but suffice to say the growth curve was a pronounced substantial one, until the early 1990s, as employers evidenced their intent to wrest more control from carriers and hospital costs and force a shifting of these responsibilities to patients. It was also a period that was coincident with the blossoming of PPOs.

At the present time, in marked contrast, the business is much more actuarially driven in its terms and conditions. It is therefore more sophisticated in its assessments and that has led to a substantial consolidation of participants able to bear such costs. Indeed in the last two years, profit margins have eroded a lot and the business has felt the pain. In the doing the use of reinsurance per se and cat cover reinsurance specifically, have faced very sharp pencils of treasurers, cfos and corporate risk managers.

These factors have imparted to many employers their needs to offer a wide array of plans and choices ranging from HMOs to PPOs to broadened networks and even conventional indemnity contracts.

The keenest competition today is centered in the admittedly broad band of 25-500 lives of employer groups. The good news is that results have become more commodity (actuarially) predictable and hence, priced more as commodity-type. Axiomatically, the smaller the group, the less this is true.

But what is also true is that in contradistinction to early TPA years, underwriters and employers show strikingly lower loyalties to TPA organizations. One source complained, apropos, that whereas it was rare to see an account moved by less than a 15% price savings, such switching today can be seen for as little as $500.

For all the Sturm und Drang as to integration and the managed care behemoth absorbing multi-functions, the US stop-loss market has yet to embrace marriage between TPAs and others. The TPA justifiably owes its allegiance to employers with an arms length relationship with all others. But it is also true that recently, large players have been trying to manage their costs more systematically via technology and away from managed care to an increasing degree. In fact, in the last two years, more risk-taking management is much in evidence. One factor that makes these shifts imperative is the unfortunate increase of new-wave health hazards where costs to contain and cure are very high.

Conceding the uniqueness of the stop-loss TPA business, one common denominator stands out in bold relief with property/casualty: where the business comes from; while many TPAs may be dealt with by a single stop-loss carrier, the legendary 80-20 rule still thrives - 80% of revenues is generated by only 20% of the producers.

Compensation varies inter alia but as a general rule, TPAs receive $10-$20 employee from the employer as well as a commission from the carrier of perhaps 10%-12%, so long as the contract is in force.

It is hard to quantify the size of the market per se but industry experts believe that about three years ago, self-funded stop-loss TPA efforts had captured 25% of all the claims generated in their market.

Fragmentary data are provided periodically in studies prepared by the Employee Benefits Research Institute. The most recent one was published in early 1998. It concluded that some 48 million employees are covered in US self-fundings. These represent 39% of ERISA plans and 18% of the population. The peak of self-funding and TPA clout is believed to have been in 1994. A steep downturn thereafter took place through 1995 and 1996. Most of the business relinquished went to the HMO market. Last fall, this slide was arrested and the situation at least stabilized, if not turned up. Why? Because within HMO plans, capitalization clauses (limits) and cost containment measures forced new conversions to self-funding.

The national backlash against managed care is, of course, a thorn in the sides of all those involved, whether reinsurer, primary carriers, TPAs, providers, not the least, patients. Looking at the glass more brightly than darkly, TPA stop-loss underwriters see their functions as quasi-beneficiaries, indeed hedges buttressing the public's freedom of choice.

Should Federal legislation be passed to regulate HMOs, as some now believe could happen, these practitioners see more light at the end of the managed care tunnel brightening their long term vistas because in theory, at least, more freedom of choice and stable rate structures should evolve.

For all its maturation and growth, today's stop-loss reinsurance field can hardly be described as "mainstream". For one thing it is distinctly less capital-intensive than other reinsurance sectors, with a claim life span typically in the 18 to 24 month range. This contrasts with 4:5:1 capital rating of many life companies and longer liability curves for many property/casualty carriers.

These time frames find reflection in the investment portfolios of stop-loss reinsurers (such as Centris et al), which tend strongly to be conservatively constructed with governments and short term in durations.

Industry officials tend to agree that the biggest concerns (which they tend to share) of rating agencies center on adequacy of reserves and related plans to measure them, still an art form for many and less actuarial science prone.

Beyond this year (and Y2K) a stop-loss company's ability both to anticipate and respond to a swiftly-changing scene will prove crucial, more the latter than the former. Provider organizations are in flux and so are patients. but a three year look forward may not prove to be so enlightening, in profound change terms. In the interim what does seem evident is that capitation for employee groups of less than 100 lives is on the rise, and all plans for all lives must become more cost effective. More HMOs are moving to capitation and the larger ones have already begun introduction of self-funding within their domain.

The given to which all health claim participants must accept themselves is the euphemism: "quality of care". It is hard to define, but as with the US Supreme Court's of view of pornography, industry execs and patients alike know it when they see it.

The trend toward integration with providers will continue. Employer groups will engage in more direct contractual relationships with providers and less so with the HMOs.

MGUs and TPAs roles will be both facilitated and demonstrably altered by changes in the market, including compensation pressures. The TPAs appear to be in the stronger position than MGUs. Greater price stability should ensue after the current cyclical phase, a la HMO syndrome.

Nor are opportunities confined to these shores. Reinsurers, carriers and TPAs are finding warm responses to their solicitations abroad. This is particularly user-friendly in Latin America, South Africa, the Middle East and Western Europe. In South America, the introduction of "Centers of Excellence" is permitting direct patient tertiary care transfer to US facilities.

If there is one problem plaguing stop-loss medical reinsurers and TPA professionals that has no clear resolution dead ahead, it is regulation at both Federal and State levels.

Described by some as "churning", the paths for health financing are muddy indeed. This condition is all the more pesky for smaller employers and actions taken to date are viewed as merely the tip of a very large uninsured populace iceberg.

Over the next three years, in fact, MGUs as we know them may evanesce into oblivion, for as reinsurers know all too well, what is increasingly demanded by the market plan is risk-taking. Reinsurers are eminently qualified to do so. There are some 210 companies in the market now. Perhaps fewer than 100 may stand tall before inspecting officers in 2002 pursuant to more consolidation.

For those who measure up, more consistent and somewhat better margins should inure.

HCC Insurance Holdings, Inc. has acquired Midwest Stop Loss Underwriters Inc., J.E. Stone and Associates Inc. and Sun Employer Services Inc. Midwest, based in Minneapolis, is a managing general underwriting agency specializing in medical stop-loss insurance for employer sponsored, self-insured health plans.

Stone is a Houston based actuarial and benefits consulting firm and will be combined with HCC's existing retail benefits agency subsidiary, The Kachler Corporation also based in Houston.

Sun, based in Montgomery, Alabama, is a managing general underwriting agency specializing in workers' compensation insurance for small and medium sized businesses.

Sun, which will become a stand-alone subsidiary, represents HCC's entry into the workers' compensation market with an estimated 1999 gross written premium of over $100 million.

Major medical stop-loss coverage player Centris Group Inc's recently announced acquisitions underscore the key trends in this specialty class: an industry shakeout with mergers and consolidation and a firming of policy pricing.

USBenefits Insurance Services Inc. is the medical stop-loss and provider excess underwriter of parent Centris Group.

"With the acquisitions," said Craig Kelbel, president and chief operating officer of USBenefits, "we are the largest medical stop-loss writer and in the top five with provider stop-loss."

Not including its two most recent acquisitions, Centris has about $200 million of medical stop-loss business and approximately $425 million in provider excess.

Further acquisitions seem to be part of Centris' growth plans. "We believe we can acquire business rapidly," Mr Kelbel remarks. "The time is now to buy business. There are no distress sales, but there are stress-fueled sales."

Mr Kelbel acknowledges that this is an era of "consolidating with number of reinsurers exciting the market. That forces consolidations or cutbacks in company writings, which in turn drives up the cost of coverages. That forces consolidations or cutbacks in company writings, which in turn drives up the cost of coverage. That's a good thing from our standpoint.

"We have had 1% to 2% rate increases in the last few years, and it is averaging 10% in 1998. That figure is to rise to about 15% next year. The overall trend for medical costs shows 1998 rates averaging a 7% to 9% annual increase from last year's levels."

Group health plans costs are on the upswing, but Mr Kelbel warned employers not to cut their employee benefits packages despite the trend. "Employers need to keep their employees happy, so they are going to have to pay the price. There are not many options."

If employers drop their group health plans, Mr Kelbel believes that "their better employees might leave. Companies cannot afford to scale back with productivity on the upswing. They have to keep their key players or productivity would suffer and they would have to retrain or retool, which would boost their operating costs."

Pricing

stop-loss is normally offered to a group with a combination of specific (for example, claims over $50,000 on a single person) and aggregate (for example, total claims over $500 per person) coverage. The price is normally quoted per capita (for example, $25 per month per insured). A number of actuarial firms (for example, Tillinghast, Milliman and Robertson) maintain (and sell) pricing manuals for stop-loss as do a number of reinsurers. Pricing is normally a function of medical plan design and reinsurance attachment points.

In rating stop-loss coverage, accuracy of expected claims and claim trends are extremely important. Effects of underestimation of expected claims and claim trends are magnified and could be very costly. For example, in a stop-loss policy with an aggregate attachment point set at 110% of expected claims, an error of a small 5% underestimation could increase, many fold, the true probability of actual claims exceeding the attachment point (the actual effect depends on the group size, claim frequency, shape of the underlying claim distribution, etc). Accuracy of projection and adequacy of margin are much more important in stop-loss rating situations than those considered in normal insurance-rating situations. Such estimation errors would warrant the establishment of adequate claim reserve even for stop-loss policy written on a claims-paid basis. Simulation and sensitivity analysis could be very helpful in gauging the volatility of stop-loss coverage.

Effect of a lack of any trend assumption or any underestimation of trend in claims could also cause disappointingly adverse results. Here trend has a leveraging effect comparable to the leveraging effect of trend by deductible, but because of the relatively small amount of stop-loss premium could quickly wipe out any built-in cushion in the premium. Leveraging of trend has two components causing the adverse effect. The first component has to do with the claims which would be below the attachment point in the absence of any trend, but would exceed the attachment point when adjusted upward for trend. The other component relates to claims which exceed the attachment point before trend adjustment, and the effect of upward trend adjustment for these claims would be to increase the stop-loss claims by more than the proportionate increase in stop-loss claim before adjustment. Obviously, there wold be no effect of leveraging for stop-loss policies with a dynamic aggregate attachment point tied to expected claims: however, the full effect of leveraging would be felt for individual stop-loss features which invariably include a fixed attachment point.

Distribution

stop-loss may be preferred by an insurance carrier in conjunction with either a traditional insurance plan or an ASO program administered by the insurer. Alternatively, stop-loss may be purchased in conjunction with an ASO program administered by a TPA. The TPA frequently purchases stop-loss through an MGU who develops a stop-loss program using a licensed insurer to write the contract with the group ("the paper") and who arranges to reinsure all or most all of the risk away from the licensed insurer. The reinsurance frequently is provided by pools of multiple reinsurers. Historically, the MGU has been compensated by receiving a flat percentage (frequently 10%) of stop-loss premiums.

After ERISA was passed, increased interest in self-funded programs developed and TPAs stepped in to provide the service. One attractive element of ERISA was the pre-exemption of state insurance laws for "uninsured" programs. Several years later, during the 1980s, MGUs grew significantly. This was a time of turmoil in the indemnity insurance industry as managed care programs expanded their market share, displacing skilled group underwriters who formed or joined MGUs. Competing for business against an ever-larger growing number of peers, MGUs kept sharpening their pencils, shaving premium rates from the reinsurer's manuals. They used arguments such as a 70 life group having demonstrated favorable experience, which is clearly pig headed since such a small group's experience has virtually no statistical credibility. Coincident with this, well managed HMOs developed effective ways to reduce medical claim costs that the TPA industry had to compete against. All the TPAs had to use were relatively weak rented PPOs, that could not negotiate the favorable terms or manage health care utilization (without the HMOs strong "gate keepers").

The reinsurers, with the exception of companies like Allianz, that maintained more direct contact with medical care through their direct writing affiliates, were unaware when the market turned around 1992. They did not see the worsening claim experience from the 1992 treaty year until late 1993 or early 1994. By then they had finalized the 1994 treaty terms that evolved into even more significant losses in 1995 and 1996. Loss ratios sped up from under 80% to 110% or 120% or more.

The reinsurers failed to exercise reasonable controls. They were too willing to shave rates and did so too often. Reinsurers frequently did not measure the amount of discounting that they were applying overall and they provided no incentives for the MGU to better manage their risk. (As Brian Featherstone of LifeRe said to me, there is a lot of "naive capacity" out there - companies that either do not know what they are doing or are just plain sloppy).

Reinsurers are now trying to mend their ways. Some are withdrawing from the marketplace. Others are raising premium rates, requiring the MGUs to share some underwriting risk (2%-3% of premium is no experience dependent), rating the employer groups themselves, etcetera. However, there is still substantial reinsurance capacity available and MGUs are still able to move business rather than accept what they perceive to be onerous terms from their prior reinsurers.

Specific excess limits the employers' exposure to a pre-determined maximum loss per employee participant in any one year; and aggregate excess limits the total exposure for all employees. The premium for the excess coverage is sometimes written by another carrier and the underwriter compensated in the form of fees and commissions.

Appendix - Glossary of terms

Aggregate excess. A form of medical stop-loss insurance which limits a self-insured employer's aggregate financial exposure for all participants under its self-funded plan to a predetermined maximum loss in any one agreement year.

Medical stop-loss. A form of insurance coverage which limits the liability of a self-insured employer under its plan of health benefits for its employees and their dependents on a per participant and/or aggregate basis.

Self-insurance. The practice of covering an entity's own risk with its own funds rather than insurance. Losses and expenses are paid from general or specifically segregated funds of the entity. Excess insurance such as medical stop-loss may be purchased by the self-insured entity to protect against catastrophic losses.

Third party administrator (TPA). Service providers engaged in the business of administering self-insured employee health plans. The TPA is the authorized representative of the self-insured employer.

Specific excess. A form of medical stop-loss which limits a self-insured employer's financial expenses to a predetermined maximum loss per participant under its self-insured plan in any one agreement year.

Herbert E. Goodfriend is managing director, financial services, Insurance Practice at KPMG Peat Marwick LLB in New York. Mr Goodfriend has over 30 years of experience as an investment banker and securities analyst specialising in insurance. He joined KPMG's Insurance Management Consulting Division in 1991 from Prudential-Bache Securities Inc., where he was a senior vice president. Prior to Prudential-Bache Securities, he had been a research director and analyst-investment banker at Loeb Rhoades and Company and Bear Stearns and Company in similar capacities.

William R. Horbatt is a manager at KPMG Peat Marwick LLB in New York. He is responsible for providing life and health insurance, actuarial and management consulting services. His broad base of experience enables him to provide both technical, operational and strategic services to the insurance and related industries.