Tag Archives: auto claims

Is the Data Talking, or Your Biases?

In April, a large life insurer announced plans to use Fitbit data and other health data to award points to insureds, providing impressive life insurance discounts for those who participated in “wellness-like” behaviors. The assumption is that people who own a Fitbit and who walk should have lower mortality. That sounds logical. But we’re in insurance. In insurance, logic is less valuable than facts proven with data.

Biases can creep into the models we use to launch new products. Everyone comes to modeling with her own set of biases. In some conference room, there is probably something like this on a whiteboard: “If we can attract people who are 10% more active, in general, we will drive down our costs by 30%, allowing us to discount our product by 15%.”

That is a product model. But that model was not likely based on tested data. It was likely a biased supposition pretending to be a model. Someone thought he used data, when all he did was to build a model to validate his assumptions.


That statement should make us all pause, because it is a common occurrence – not everything that appears to be valid data is necessarily portraying reality. Any data can be contorted to fit someone’s storyline and produce an impostor. The key is to know the difference between data cleansing/preparation and excessive manipulation. We continually have to ask if we are building models to fit a preconceived notion or if we are letting the data drive the business to where it leads us.

Biases hurt results. When I was a kid, my Superman costume didn’t make me Superman. It just let me collect some candy from the neighbors. Likewise, if insurers wish to enter into an alternate reality by using biased data, they shouldn’t expect results that match their expectations. Rose-colored glasses tend to make the world look rosy.

Here’s the exciting part, however. If we are careful with our assumptions, if we wisely use the new tools of predictive analytics and if we can restrain ourselves from jumping through our hypotheses and into the water too soon, objective data and analytics will transport us to new levels of reality! We will become hyper-knowledgeable instead of pseudo-hyper-knowledgeable.

Data, when it is used properly, is the key to new realms, the passport to new markets and to a secure source of future predictive understanding. First, however, we have to make it trustworthy.

Advocating good data stewardship and use.

In general, it should be easy to see when we’re placing new products ahead of market testing and analysis. When it comes to insurance, real math knows best. We’ve spent many decades perfecting actuarial science. We don’t want to toss out fact-based decisions now that we have even more complete, accurate data and better tools to analyze the data.

When we don’t use or properly understand data, weak assumptions begin to form. As more accurate data accumulates and we are forced to compare that data with our pre-conceived notions, we may be faced with the reality that our assumptions took us down the wrong path. A great example of this was long-term care insurance. Many companies rushed products to market, only later realizing that their pricing assumptions were flawed because of larger-than-expected claims. Some had to exit the business. The companies remaining in LTC made major price increases.

Auto insurers run into the same dangers (and more) with untested assumptions. For example, who receives discounts, and who should receive discounts? Recently, a popular auto insurer that was giving discounts to drivers with installed telematics, announced that it would begin increasing premiums on drivers who seemed to have risky driving habits. The company had assumed that those who chose to use telematics would be good drivers and that just having the telematics would cause them to drive more safely. The resulting data, however, proved that some discounts were unwarranted; just because someone was willing to be monitored didn’t mean she was a safe driver.

Now the company is basing pricing on actual data. It has also implemented a new pricing model by testing it in one state before rolling it out broadly – another step in the right direction.

When we either predict outcomes before analyzing the data or we use data improperly, we taint the model we’re trying to build. It’s easy to do. Biases and assumptions can be subtle, creeping silently into otherwise viable formulas.

Let’s say that I’m an auto insurer. Based on an analysis of the universe of auto claims, I decide to give 20% of my U.S. drivers (the ones with the lowest claims) a discount. I’m assuming that our mix of drivers is the same as the mix throughout the universe of drivers. After a year of experience, I find that I am having higher claims than I anticipated. When I apply my claims experience to my portfolio, I find that, actually, only the top 5% are a safe bet for a discount, based on a number of factors. Now I’ve given a discount to 15% more people than ought to have had it. Had I tested the product, I might have found that my top 20% of U.S. drivers were safe drivers but were also driving higher-priced vehicles – those with a generally higher cost per claim. The global experience didn’t match my regional reality.

Predictions based on actual historical experience, such as claims, will always give us a better picture than our “logical” forays into pricing and product development. In some ways, letting data drive your organizations decisions is much like the coming surge of autonomous vehicles. There will be a lot of testing, a little letting go (of the driver’s wheel) and then a wave of creativity surrounding how the vehicle can be used effectively. The result of letting the real data talk will be the profitability and longevity of superior models and a tidal wave of new uses. Decisions based on reality will be worth the wait.

Solution to Brain Drain in Insurance?

What was once science fiction is fast becoming a fact of today’s business world. Computers that mimic the human brain are already entering the workforce in the healthcare, financial services and retail sectors, among others.

Like humans, cognitive analytic computers can understand “natural” language (such as English) and learn lessons from the data they analyze, as well as from the users who “mentor” them. In other words, the machines possess an artificial intelligence more powerful than anything seen before.

Unlike humans, cognitive analytic systems can process, analyze and store enormous volumes of data at Internet speed. In addition to tapping conventional databases for the information needed to aid in decision-making, the machines are capable of scanning myriad emails, reports, articles, books and other sources of knowledge to deliver recommendations and reach conclusions beyond the ability of any one person or team of people.

In a 2014 white paper on cognitive analytics, Rajeev Ronanki and David Steier of Deloitte Consulting note that in the healthcare industry, “[cognitive analytic] systems are being used to improve the quality of patient outcomes. A wide range of structured inputs, such as claims records, patient files and outbreak statistics are coupled with unstructured inputs such as medical journals and textbooks, clinician notes and social media feeds. Patient diagnoses can incorporate new medical evidence and individual patient histories, removing economic and geographic constraints that can prevent access to leading medical knowledge.”

In financial services, cognitive analytics is used to recommend and execute trades and to also assist in fraud detection and risk underwriting.

Many of us are familiar with less advanced forms of cognitive analytics. In the consumer electronics realm, examples include Apple’s Siri voice recognition software and the oral command interface used in the Xbox video game system.

Virtual Decision-Making Assistance

It doesn’t take much imagination or intelligence (human or artificial) to envision how cognitive analytics could revolutionize auto insurance, especially the claims sector.

Cognitive analytic computing could be of enormous benefit to an industry that will see fewer claims adjusters in the near future, thanks to the number of veteran adjusters who are retiring or planning to retire. Cognitive analytics could empower the remaining adjusters with decision-making assistance that was previously inconceivable – decision-making based on huge volumes of data drawn from a near-infinite pool of sources.

Not long from now, computers will be able to scan photos of accident damage and instantly retrieve historical data on how similar claims were assessed and settled in the past. For example, a computer could analyze a person’s injuries relative to where they were sitting when the accident occurred and how the injury was sustained.

The systems could also be used in first notice of loss (FNOL). Imagine an intelligent learning system that can reference every text related to previous claims and outcomes, as well as every law and vehicle code from all 50 states, to deliver settlement information in milliseconds.

Let’s say a customer submits an FNOL. “I was in a parking lot, but when I backed out of my space I hit someone driving past.” Based on the information provided, the machine could determine liability and assign fault. It could also decide whether the claim is best processed with the help of a human adjuster or via self-service. If a customer reports an accident that leaves a small scratch on the car and no injuries, the computer would automatically send a self-service text to the claimant’s cell phone so she could take photos of the damage and transmit them back to the computer. The machine would then analyze the photos and develop an assessment.

Yes, the computing system could be that advanced – so advanced that it removes much of the human element from the process.

‘Brain Gain’ Instead of ‘Brain Drain’

Many adjusters in their 50s and 60s are retiring, which means a lot of valuable expertise and experience is leaving the industry. In fact, I’m probably a member of the last generation that remembers widespread use of full-service, multi-skilled adjusters – people who know every aspect of the business. Younger adjusters frequently work in silos. These compartmentalized workers are very skilled in certain things but don’t have the “Renaissance man” backgrounds that allowed their predecessors to wear “multiple hats” when the situations called for it.

Thanks to the new technology, however, the older generation’s experience and know-how doesn’t have to be lost forever. That information and wisdom can be transferred to complex cognitive computing systems that instantly retrieve the data on every one of their past settlements. This will let the remaining adjusters use the machines as virtual assistants, calling on them to provide the most logical settlement paths to the best possible outcomes.

If achieving the best outcomes to claims is the goal, then cognitive computing systems will prove to be an invaluable tool. With access to a virtual universe of prior decision-making (good and bad), cognitive analytics has the potential to help adjusters find the right solution to each and every auto claims case.

How Big Data Can Transform Auto

Big data is everywhere and is becoming more powerful in every aspect of our daily lives. The hunger, and ability, to parse and analyze diverse data sets goes to the highest levels of our government, large corporations and even start-ups, which are finding ways to add immense value. Although we in the claims industry are not involved in international intrigue or attempting to create a surveillance network, we can harness data to effectively influence our decisions. This will ultimately achieve better outcomes by putting specific files in the most skilled hands, streamlining processes and eliminating unnecessary touch-points.

As technology continues to advance exponentially, the auto claims process can be radically improved. For many years, auto insurance claims departments squelched innovative thinking, in favor of tired cost-cutting measures. The departments would look at cycle time, average appraisal cost, repair cost, parts usage and total loss option documentation, but these data points are only a small portion of the picture and don’t fully address or reveal the root causes. To get to that, we need to dig a bit deeper.

Today, so much more data can be effectively captured and analyzed that a  claims manager could nearly predict outcomes and channel resources for the best results. Need more staffing in the field? What are the historical repair costs of a certain year, make and model with a matching impact location? Where are higher labor rates going to result in more total losses? Which companies allow their policyholders excessive rental on subrogation demands?

Here are a few examples of how auto claims technology and resulting data can be channeled to improve workflows, eliminate unnecessary touch points and create a more efficient process.

  1. Predictive Dispatching. Imagine putting the right claims into the right hands every time. Through predictive modeling based on a series of data points, the likely repairability of a vehicle can be ascertained to a solid degree from first notice of loss. Combine that with a robust dispatching solution, and the right field representative could be sourced based on factors such as; closest location, past performance, experience levels, historical cycle time results, CSI ratings, estimating software platform, workload volume, current volume for the day and comparisons with other representatives. Algorithms can instantly give the file to the person who is most likely to provide the best outcome. Should the file qualify for a self-service type claim or even trigger a potential total loss, the appropriate resources can be called into action, thus saving money and wasted time.
  1. Subrogation Demand Analysis. Why do some insurers focus intently on the front end of a claim to ensure accuracy yet will accept subrogation demands from carriers without the same scrutiny? Sure, much of the disconnect may be because of the compartmentalization between various departments within a claims organization, but, with data analysis, subrogation reviews can be parsed, reviewed and stored to track trends. Which companies overpay their insureds for rental when the repair is minor? Do a large number of your files end up in arbitration? If so, what are the triggers? Data can even catch potential fraud if, say, a VIN has been reported multiple times for the same damage.
  1. Where and when? For quite a while now, most digital cameras have had information embedded in each photograph. With the spread of smartphones and tablets, geocode location data can also be included. What does this mean? If detailed photo information is needed, oftentimes exchangeable image format (EXIF) data can document what brand of camera took the photo, the time it was taken and the exact coordinates. This means a field representative’s day can be reconstructed or a re-inspection date can be confirmed to ensure the condition of a vehicle at a specific point in time. While it’s never guaranteed that every phone or camera will provide the exact EXIF information, adjusters will find that, in most situations, a lot of valuable information can be gleaned.
  1. Claim delay analysis. In auto claims, the standard cycle time for a vehicle damage inspection is 48 hours. Can this always be achieved? If each step of the appraisal process is documented from assignment to completion, any issues and resulting data points along the way can lead to a treasure trove of information. You might discover that an incorrect phone number or vehicle location leads to 25% of all delayed files. This would be a valuable training tool to discuss with adjusters, stressing the importance of documenting accurate information before a dispatch. On the other hand, data may show that a certain percentage of files are delayed because an appraiser is overloaded. This could lead to an immediate focus on better allocating field resources. Capturing and recording specific data points along the way can serve as a tool to detect bottlenecks, inefficiencies and areas for process improvement.
  1. Location volume analysis. Do you need to increase your field staff? Just think if you could pull up a map at a moment’s notice and track volume in a certain location. You could track average repair costs in various zip codes, cities and states and break the information down to an even more granular level. Detailed data can be run over time and compared with newly written policies to predict staffing needs in certain areas before the losses even occur. Think about doing this in real time without needless Excel files and manual processes. This can help in forecasting and budgeting for future years, enabling efficient management and allocation of expenses.

Data, when simplified and made usable, is incredibly powerful. Nary a one of us leaves the house today without a smartphone in his pocket packed with valuable data: phone contacts, mapping directions, family photos, etc. In the claims industry, we must likewise surround ourselves with data, innovating and developing in ways that will let claims leaders manage from quantifiable data instead of basing decisions on emotion and misperceptions.

Navigating Through Tough Times With The Aid Of Employee Ownership

How Employee Stock Ownership Plans and/or Management Stock Ownership Plans Can Become Viable Economic Allies

Is it just the employees' attitude of thinking like owners that has helped companies to survive in tough economic times? The authors of this article, with over 80 years of collective experience, suggest that in some situations, perhaps yes, but in many others, company management and the board of directors have used employee stock ownership plans and/or management stock ownership plans to provide vital liquidity during critical times when the cost of capital is prohibitive, and liquidity from banks, private equity groups, or other outside sources is not readily available.

Today, even the best of companies may find themselves in a financial “perfect storm” that threatens their survival. This article looks to first develop your understanding of why Employee Stock Ownership Plan (ESOP) companies have better survival rates and often are successful in difficult times. It then will explore how employee ownership in the form of an Employee Stock Ownership Plan and/or Management Stock Ownership Plan (MSOP) as a technique of corporate finance can assist companies in temporary economic distress to increase cash flow and survive until conditions improve. A number of proven and successful techniques are examined. The authors caution that only experienced professional advisors, including attorneys, consultants, appraisers, and third-party administrators should be engaged when any of the strategies outlined in this article are pursued by a company.

Survival And Success

Employee Stock Ownership Plan companies have better survival rates in tough economic times. Examples of the collective experience and methodical research since the formal beginning of Employee Stock Ownership Plans in 1974 include the following:

  1. A 1997 study examined the stabilizing effect on a company caused by employee ownership plans. Results showed that the survival rate for the companies that shared ownership with employees was markedly higher than for their comparison companies and that shared ownership firms had a significantly lower variance in employee numbers from year to year. The firms sharing ownership with employees also outperformed competitors in terms of return on assets and total shareholder1 returns.
  2. In 1987, the Government Accounting Office (GAO) had done a similar survey focusing on productivity and profitability, and the conclusions were the same.2
  3. In the largest and most significant study to date of the performance of Employee Stock Ownership Plans in closely held companies, Douglas Kruse and Joseph Blasi of Rutgers University, in 2002, found that Employee Stock Ownership Plans increase sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected absent an Employee Stock Ownership Plan.3
  4. The Employee Ownership Foundation states: “There is nothing magic about employee ownership. Employee ownership does not guarantee success, nor prevent or cure business problems. But it does stand to reason, and experience and research have shown, that employee owners have a different attitude about their company, their job, and their responsibilities that makes them work more effectively, and increases the likelihood that their company will be successful. Fundamentally, employee owners are more accountable for their job performance — and their fellow workers' job performance — simply because they have a common stake in the success of their company. It's a simple formula: if employees perform extraordinarily well, company performance is more likely to be extraordinary, and that translates into significant stock value for the employees. Someone once said that ownership is a powerful incentive for ordinary people to do extraordinary things.”4

Additional research can be found at the websites for the National Center for Employee Ownership and The ESOP Association.

ComSonics' Story

A good illustration of the impact of employee ownership is an event that happened at ComSonics, Inc., a company headquartered in Harrisonburg, Virginia, that serves the cable television industry in a number of ways. The Employee Stock Ownership Plan was established in 1975, and until 1990, the stock of the corporation had appreciated every year.

The company recognized from an early date that employee involvement and education would maximize the Employee Stock Ownership Plan's effectiveness. A significant amount of financial and performance information was shared freely with employee owners, providing them with constant measurement criteria regarding the performance of the company and its varying functional areas.

In 1990, an economic downturn hit the cable industry particularly hard. Management agonized regarding a layoff as one had never occurred in the history of the company. When they finally announced a 10% layoff, the response from many of the remaining employees was, “Why did you wait so long?! We could see the constant deterioration of our performance and profitability; you should have laid off people sooner.”

Encouraged by that response, management initiated a second 10% layoff shortly thereafter. As a result, the company survived and prospered. Since the early 1990s, the stock that declined a small percentage during the recession is now valued at more than five times the 1990 price.

Financial Techniques To Conserve Cash

For companies that currently do not have an Employee Stock Ownership Plan, as well as companies that do, we will discuss a number of approaches to strengthen a company's cash position in troubled times.

401(k) Company Stock Match
Virtually all of our clients have 401(k) plans, and the vast majority make some type of annual, cash-matching contribution. The investment of these matching contributions is normally directed by the employee participants. An approach to conserving cash is to replace the cash match with a match made in company stock to an Employee Stock Ownership Plan. If an Employee Stock Ownership Plan does not already exist, then a new Employee Stock Ownership Plan can be adopted by the board of directors of the corporation. In addition to the normal “company stock” and “other investment” accounts, the Employee Stock Ownership Plan can have a “stock-matching” account where the stock resides. Those individuals who make a deferral to a 401(k) plan receive stock in the stock-matching account.

The plan described above is not a combination Employee Stock Ownership Plan and 401(k) plan (KSOP). KSOPs can be adopted by the company, but they are complex to administer and not necessary if employee wage deferrals will not be used to purchase company stock.

Because employees are not given the option to invest their employee wage deferral in company stock, thus not making an investment decision, and because the 401(k) operates as a separate plan, there should be no disclosure or security law filing requirements.

Newly Issued Stock
Another approach to increasing corporate cash is to utilize newly issued stock, frequently called “treasury” stock. C corporations can make contributions to an Employee Stock Ownership Plan of newly issued shares that are tax deductible to the corporation. This will reduce what the company will pay in income tax in any given year. If the contribution will generate a loss, then the company can recapture taxes paid in the prior two years. Note: the American Recovery and Reinvestment Act of 2009 allows a carry-back of 2008 losses for five years. The same rules do not apply to an S corporation because the income or loss of the S corporation is reported on the individual tax returns of the S corporation shareholders. The individual S corporation shareholders may apply for carryback of an individual net operating loss, but the taxes recaptured may not be as significant. The individual tax refund can be loaned to the corporation by the shareholder. A C corporation or S corporation can contribute stock and get a tax deduction valued up to 25% of qualifying payroll to an Employee Stock Ownership Plan each year. Contributions to all other qualified retirement plans must be included in calculating this limit. In certain circumstances, the contribution limits referred to above can be exceeded.

A contribution of newly issued common shares is dilutive; therefore, the individual or individuals owning 100% of the common stock before the contribution to the Employee Stock Ownership Plan will own less than 100% of the company after the Employee Stock Ownership Plan contribution has been made. The impact of the dilution can be substantial if the value of the company has declined significantly due to economic distress. One strategy to lessen this dilutive impact is to have the company contribute preferred stock rather than common stock. The value of preferred stock does not fluctuate like common stock. The preferred stock must pay a market rate dividend determined by an independent appraiser. However, it is possible for the dividend to be a “payment in kind” (PIK) dividend rather than a cash dividend. Because preferred stock is not convertible (“straight preferred”), the stock is not defined as qualifying employer securities and must be contributed to a stock bonus plan rather than an Employee Stock Ownership Plan. There are many similarities between stock bonus plans and Employee Stock Ownership Plans, but there are also important differences that are beyond the scope of this article. Later in this article, we will discuss the use of a stock bonus plan to help create cash flow.

Conversion Of Existing Plan Assets
Converting profit-sharing plan (PSP), 401(k), or other qualified plan assets to an Employee Stock Ownership Plan allows for the purchase of stock. If the stock is newly issued, this creates an infusion of cash for the company.

Approach this strategy like you would a porcupine — very, very carefully. While there is significant risk in this strategy, it has occasionally been used with success. Employees can be given a one-time option to move funds from a qualified profit-sharing retirement plan or the discretionary employer contributions made to a 401(k) plan into an Employee Stock Ownership Plan to purchase company stock. An independent Employee Stock Ownership Plan trustee may not be willing to take the fiduciary risk to make this decision, but offering the investment choice to employees, if done properly, greatly reduces the fiduciary risk.

Full Disclosure
Federal and state security law exemptions may apply regarding the offering to employees. However, employees are required to be given full disclosure under state law prior to making their investment election. A full disclosure package that will resemble a prospectus must be prepared and distributed to all eligible employees, and there is significant cost involved in compiling, distributing, and presenting the information. We know of instances where employees have elected to convert a substantial percentage of their liquid account balances to purchase stock and other situations where the percentages were very low.

Seller Financing — “Becoming the Bank”
This structure does not increase corporate cash flow like the other strategies discussed above. It addresses the situation in which a shareholder desires to sell and also to perpetuate the business. One or more shareholders may desire to sell their stock for a variety of reasons, including retirement, death, or disability, change in family situation, etc. Even if a bank loan can be found, the terms and conditions offered by the bank may be unacceptable. Loans by private equity groups may be deemed too expensive, even though these loans will normally be made without requiring any collateral. If no alternative to a “cash sale” can be found, the shareholder may be forced to sell to an outside buyer, despite the desire to perpetuate the business. Assuming an independent appraiser determines a value acceptable to the selling shareholders and the sellers are willing to hold an uncollateralized loan at a high rate of interest, the sellers can “become the bank”; that is, they can take back a note at the market rate of interest. In many cases the corporation can provide warrants or an “equity kicker” to increase the rate of return on the seller loan. Because the selling shareholder takes the risk of an unsecured creditor, he or she is entitled to a return as determined by the market returns achieved by private equity groups.

Example: The seller note is for seven years at 4% above the prime rate with a 10% warrant that can be exercised on a “cash-out” basis when the Employee Stock Ownership Plan debt is repaid. If the company grows at a modest pace over the seven-year term of the note payment, a typical warrant could be worth approximately 20% of the sale price. For example, if the sale to the Employee Stock Ownership Plan was for $5 million at 7% interest, the warrant could potentially have a value of $1 million at the end of seven years. It is the risk the seller is taking that justifies a potential total return that can equal or exceed 15%. However, if the company did not grow at all, the warrant would have no value.

Existing Employee Stock Ownership Plans Only

For companies that have existing Employee Stock Ownership Plans, there are other options to conserve cash in addition to the strategies outlined above.

Distribution Policy
Distribution policies drive the outlay of cash to departed plan participants in all Employee Stock Ownership Plan companies. This policy dictates when the company must repurchase shares and distribute cash to terminated, retired, or disabled participants or beneficiaries. Many Employee Stock Ownership Plan companies, especially if there is no Employee Stock Ownership Plan debt, make lump-sum distributions to participants shortly after they terminate service. During times of economic distress, the company may find it necessary to defer the starting dates for payments and to “stretch out” installment payments over the maximum period allowed under the law and by the plan document.

The law allows payments to be deferred for approximately one year after the retirement, death, or disability of a plan participant. For other terminations, distributions can be deferred for approximately six years. If the shares were acquired with proceeds of a loan, then the payout can be deferred for the greater of the six years referred to above, or until the Employee Stock Ownership Plan loan is repaid.

Once the payout begins, regardless of the reason, payment of the total account balance must be completed in a maximum of five years and made in equal, annual installments over the five-year period. This translates to a maximum of six annual installments. There are provisions for lengthier payouts when account balances exceed $985,000. For example, an Employee Stock Ownership Plan participant retires with 120 shares in her Employee Stock Ownership Plan account. Shortly after the year-end allocation statement is distributed to participants, the participant receives a payout in cash equal in value to 20 shares of stock. Each year after the fair market value has been determined by an independent appraiser, he or she will receive a check equal in value to 20 shares. At the end of five years, his or her full account balance has been cashed out.

New Or Revised Distribution Policy
If a company has a current Employee Stock Ownership Plan distribution policy, it would then modify the policy in close consultation with Employee Stock Ownership Plan counsel. If the company does not have an Employee Stock Ownership Plan distribution policy, it is imperative to establish one, clearly stating the reasons for the distribution policy that is being adopted.

The best practice among Employee Stock Ownership Plan companies is to adopt a distribution policy that is more specific than the plan provisions, which normally allow maximum flexibility regarding Employee Stock Ownership Plan payouts. The distribution policy typically is not part of the plan document and can be changed from time to time without amending the plan document. One of the principal reasons that an Employee Stock Ownership Plan company's board of directors and an Employee Stock Ownership Plan trustee would review and determine a need to change the timing of Employee Stock Ownership Plan payouts is because of the cash position of the company. If the company is experiencing difficulties in generating sufficient cash flow, it is very appropriate to look at the cash position of the company and modify the existing or de facto distribution policy to defer payments in the event of other terminations, and to spread out payments in installments to participants entitled to a payout due to death, disability, retirement, or other termination. Provided that the Employee Stock Ownership Plan allows for distribution flexibility, the change in the distribution policy should not be a “cutback” under Employee Retirement Income Security Act rules.

Refinancing Existing Employee Stock Ownership Plan Loans
To the extent that the existing Employee Stock Ownership Plan has a loan with a bank, a private equity group, or from a selling shareholder, the company can attempt to negotiate better terms in a form of extended payments and/or a reduced interest rate. However, it is essential that the Department of Labor (DOL) guidelines be followed in refinancing an Employee Stock Ownership Plan loan. These guidelines require that the refinancing is “arranged primarily in the interest of participants and beneficiaries.” In layman's terms, the refinancing needs to be a “good deal” for the Employee Stock Ownership Plan, while at the same time the refinancing can also be beneficial to the company. An example would be a lower interest rate with an extended payment term. While reduced cash flow from a company in economic distress is certainly a valid reason to attempt to renegotiate the loan, it is still imperative that the company's board of directors and the Employee Stock Ownership Plan trustee be aware of and in compliance with these Department of Labor guidelines.

Existing Cash In The Employee Stock Ownership Plan
Some Employee Stock Ownership Plan companies will have accumulated a significant amount of liquid investments that reside in the “other investments” account of the Employee Stock Ownership Plan. The board of directors of the corporation can offer to sell newly issued shares to the Employee Stock Ownership Plans. The stock could be common stock in an S corporation or common or preferred stock in a C corporation. The Employee Stock Ownership Plan trustee could then purchase the newly issued shares with some of the cash residing in the Employee Stock Ownership Plan. There are a number of fiduciary issues that the trustee must consider before making this decision. At the top of the list is the issue of the long-term prospects and viability of the company. If the crisis is clearly short term and purchasing newly issued shares would almost certainly cause the company to survive the crisis, the trustee should be comfortable in using Employee Stock Ownership Plan cash. On the other hand, if there is clearly no end in sight to the crisis, or selling liquid investments held by the Employee Stock Ownership Plan will incur substantial losses, the trustees incur significant fiduciary risk if they use existing Employee Stock Ownership Plan cash to purchase stock. Immediately prior to the purchase of shares, the trustee must obtain a current valuation of the company by an independent appraiser that considers the dilutive effect of the newly issued shares.

Management Incentive Plans

A 19th century French colonel and military theorist wrote:

Four brave men who do not know each other will not dare to attack a lion.

Four less brave, but knowing each other well, sure of their reliability and consequently of mutual aid, will attack resolutely.5

Just as in sports, team play is essential for business success. The management team of a successful company must be able to attack tough business problems, like those being encountered today, without worrying about whether members of their team may be marching to a different beat. The successful CEO carefully selects and coaches his or her key people to ensure that there are no ego-driven, selfish members on the team.

Providing key executives an opportunity to get some “skin in the game” through direct stock ownership assures their constant interest in the financial performance of the company, both to protect their investment and to create real wealth over time as share value increases. When a manager invests more than he or she can afford to lose, he/she will aggressively learn the entrepreneurial game!

A major trend under way in recent years in both public and private companies is the requirement that senior personnel have a significant investment in the company. Where such an expanded internal market is installed, it will often produce an entrepreneurial spirit and a shared commitment to ensuring the long-term success of the enterprise among those key players.

Entrepreneurs who offer stock purchases often find that employee investors take a more active interest in their company and are more likely to ask questions about financial performance and take action to maximize results. Stock purchases help build employee commitment to the company.

To be effective, an equity-based incentive plan, hereinafter a Management Stock Ownership Plan, must be carefully designed so as to create the right mix of incentives for the participants in the Management Stock Ownership Plan without creating unacceptable disadvantages or penalties for other shareholders. Ultimately, a Management Stock Ownership Plan must be a good deal for both the participants and the company.

The following factors should be considered in the design or modification of such a plan:

There are several methods that can be used to create opportunities for direct stock ownership and/or create other equity-based incentives for key personnel.

Employee Stock Purchase Plans6
We have concluded after more than three decades of designing such plans for privately held companies that, wherever possible, if a company permits direct stock ownership by employees, the stock should be purchased by the key individuals so as to ensure that they incur a degree of risk in their investment. In doing so, they have a significant amount of their own “skin in the game,” and thus feel the same pressures as other owners in sharing both the risks and rewards that all owners of private firms experience. Stock purchases by participants of a Management Stock Ownership Plan also provide an infusion of cash for the company, which may be not only welcome but vital in difficult economic times. As an incentive to encourage key employees to take this risk, we normally recommend two following additional measures: a special cash bonus plan and a qualified incentive stock option plan.

Special Cash Bonus Plan
Senior management and other key employees may participate, by invitation, in a cash bonus program that is tied to specific performance objectives. These objectives, normally financial, may be either a financial goal for the firm or a financial goal for a discrete business activity such as a division or subsidiary. This ongoing cash bonus program is distinguishable from other cash bonuses that may be used from time to time to reward employees for specific performance or events of short duration, or it may employed as an ongoing bonus tied to other performance measures. In the case of an ongoing cash bonus program tied to discrete financial measures, a continuing incentive is created that provides a powerful motivation for the participating employees to achieve the financial objectives that are prerequisite to achieving the cash bonus. The criteria might be a corporate financial objective, such as year-to-year growth in earnings before interest taxes depreciation and amortization (EBITDA), achieving a margin or profitability objective in a discrete operation, or a combination of both.

Qualified Incentive Stock Option Plan
As an enhancement to a stock purchase plan, a qualified incentive stock option plan (ISO)7 with appropriate “golden handcuffs” can be established. The plan could provide that each participant who agrees to purchase a certain number of shares at fair market value (FMV) (with his or her own money) will have the opportunity to acquire a multiple of the number of shares purchased via qualified incentive stock option plans, exercisable over a period of years.

Many privately held companies favor stock options because they vest over time — as long as 10 years — and tend to encourage key employees to remain with the company to avoid loss of benefit should they voluntarily leave. In addition, if incentive stock options are granted, there should be no tax or cash impacts on either the company or participants until the options are exercised and the underlying shares are sold by recipients.

In a Management Stock Ownership Plan such as this, participants are required to purchase a block of company stock, which then entitles them to receive a grant of incentive stock options exercisable over a period of years and subject to vesting tied to achievement of company performance objectives. The incentive stock options vest based upon achieving performance objectives as discussed in the previous paragraph, and they are also subject to a use or lose provision that requires the participant to exercise vested options or lose the right to the currently vested options and all future options. In this way, participants have a very powerful incentive to ensure that the objectives' prerequisite to vesting of the options are achieved each year, and further, that the financial performance of the company as a whole is very strong in order to maximize the growth in value of company stock over time. The use or lose provision will eventually separate the stars (crusaders) from the average performers (cruisers). This initial investment requirement creates a powerful incentive for participants, by virtue of having their own skin in the game, to ensure that objectives are met so that their capital investment is preserved and grows in size and value over time.

Restricted Stock Bonus Plan
In addition to a stock purchase and/or incentive stock option plan, a restricted stock bonus plan may be used as a further reward for extraordinary performance by one or more top achievers. Such a plan might provide for discretionary awards of restricted stock, or it could stipulate that recipients receive a portion of bonus compensation in the form of restricted company stock, which would be deductible to the company at grant or as the stock vests, depending upon the participant's tax election.8 A restriction, such as a period of time, a performance measure, or both, is normally applied to the grant and must lapse or be achieved before vesting occurs. This measure would increase company cash flow, as the stock bonus would be deductible as a compensation expense. A special cash bonus might also be added to assist recipients in paying taxes on the stock bonus. Normally, vesting of restricted stock would be subject to a financial or other metric to encourage the recipient to focus on and enhance corporate performance.

In addition to the equity-based plans described above, there are also other equity-based incentives that are not qualified — meaning that they are not entitled to special tax treatment and are not generally subject to the Employee Retirement Income Security Act (ERISA). Therefore, employers have substantial freedom to tailor arrangements to suit their needs and objectives as well as those of their executives. One objective of all of these plans is to incentivize the recipient toward performance directly linked to the goals of shareholders — normally, increased stock value over time.

These deferred-compensation arrangements, under which the employer promises to pay a key individual an amount of money in the future based upon the performance of the employer's stock, are known as synthetic equity plans and include two variants: stock appreciation rights (SARs) and phantom stock plans.

Stock Appreciation Rights (SAR)
An SAR is generally an unfunded promise by an employer to pay an executive an amount of money equal to the appreciation in value of a share of the employer's stock on the date the SAR becomes payable as compared to the value of the share on the date the SAR was granted.

Under a Stock Appreciation Rights program, participating executives do not have ownership of employer stock. Participating executives are awarded SAR units, which have no initial value. A participating executive is not required to pay cash in order to exercise the SAR.

The valuation of employer stock is a critical issue in privately held, non-Employee Stock Ownership Plan companies. A fair and consistent method of valuation is essential to achieving long-term results from a Stock Appreciation Rights plan and has acquired additional importance since implementation of new IRS rules regarding deferred compensation under IRC Sec. 409A.

SARs are generally not pension benefit plans and therefore are not subject to the Employee Retirement Income Security Act. For financial accounting purposes, increases in the value of a Stock Appreciation Rights unit generally result in additional accrued compensation expense for the company.

For income tax purposes, the participating executive does not recognize income until the SAR is exercised. Upon exercise, the participating executive has taxable compensation income and the employer is entitled to a tax deduction.

Phantom Stock
Phantom stock can be regarded as a variation of the SAR. A phantom stock plan is typically an unfunded promise to pay an amount of money equal to the value of a share of the employer's stock. Again, the idea is to provide the participating executive with the economic equivalent of stock ownership and the benefit of growth in share value over time without actual ownership and legal rights (i.e., voting rights).

For financial accounting purposes, phantom stock plans are similar to SARs. Compensation expense results as the value of employer stock rises and the increases in value must be charged against earnings. Like SARs, phantom stock should not produce income for the executive until he or she cashes in. At that time, the employer is entitled to a deduction.

Note: Several important changes to the IRC regarding deferred compensation9, antiabuse tests for Employee Stock Option Plans in S corporations10, and Financial Accounting Standards Board (FASB) standards for accounting for stock options11, have been implemented recently, which may have a significant effect on the tax and financial implications of a stock-based incentive plan for senior managers and other key employees, especially in companies with Employee Stock Option Plans that have elected to be taxed as an S corporation. These must be taken into account when designing such a plan. In view of the complexities and potentially serious consequences of implementing a defective plan, it is wise to engage the services of an experienced professional advisor who is knowledgeable in this area.

Wage Forbearance

In situations of dire economic circumstance such as that being experienced today, even the best companies can find themselves in a financial perfect storm that threatens the very survival of the enterprise. A wage-forbearance plan is one action that a company in such a circumstance might take to overcome adversity and survive long enough for economic conditions to improve.

Wages and benefits are typically the biggest operating expense of most companies. An approach to consider is a carefully designed wage-forbearance plan that trades near-term reductions in employee wages and/or benefits to improve the company's cash flow for an equity position in the company that will provide future value that may offset, or exceed, the current loss of wages and/or benefits. A carefully designed wage-forbearance plan can provide near-term cash flow improvements that might be the difference between survival or failure of the enterprise, while at the same time helping to bring all employees into the process of working as an entrepreneurial team that will apply its collective energy, creativity, hard work, and enthusiasm toward achieving the survival and future success of the enterprise.

A company might start by reducing payroll expense by 10-15% through a careful process of eliminating nonessential employees. Then, payroll expense might be further reduced by designing and implementing a wage-forbearance plan that provides for near-term compensation reduction — with wage and benefit reductions totaling another 10-15% — proportional to compensation, that includes creation of a new stock bonus plan for all employees. This new plan would include a contribution by the company of a block of newly issued, nonvoting, preferred stock with a dividend [possibly a payment in kind (PIK) dividend until cash flow allows a cash dividend] to the stock bonus plan. The company may make a contribution to the stock bonus plan of up to 25% of qualifying payroll12 (maximum of 100% of an employee's income or $49,00013, whichever is less) as future compensation for the current wage reduction in order to provide an incentive to employees. In companies with an Employee Stock Option Plan, the company may make a contribution of 25% of payroll to both the Employee Stock Option Plan and the stock bonus plan14, the importance of which will be explained shortly.

The wage-forbearance plan might also include a cash performance bonus plan that will pay quarterly bonuses if certain financial metrics are achieved at the company, department, and individual level. These bonus payments, when the company achieves profit goals, could offset some or all of the wage/benefit forbearance.

Vesting for the new stock bonus plan does not have to consider past service and can be based on future service. This serves to help tie the employee to the company while lessening the potential impact of repurchases on cash flow. In addition, the distribution policy for repurchases can be designed with extended payouts, similar to Employee Stock Option Plans, so as not to place a cash flow burden on the company.

We hasten to note that this approach requires careful coordination with an experienced appraiser. The discretionary stock bonus plan contribution in many cases will be considered by an experienced appraiser to be an extraordinary event, which should minimize the impact on value of the common shares.

Example: In this situation the company has been cut off by its bank due to declining profits, while simultaneously facing significant net operating losses for both the current year and next year. Following are the specifics:

The C corporation is the best candidate for this plan, because S corporations pass income and loss down to the individual shareholder level, which would negate the benefit of the cash refund to the company discussed below. However in an S corporation, such a plan might still produce cash benefits to individual shareholders, which could then be loaned to the company.

The company implements a $2 million reduction in wages and benefits, half from a carefully considered head count reduction and half from a wage-forbearance plan, which will take effect in 2009.

The company makes a contribution of newly issued preferred stock to the recently created stock bonus plan trust of $2 million, which is 25% of reduced 2009 compensation. If the company has a leveraged Employee Stock Option Plan, it could also make another contribution of up to 25% of 2009 compensation. The leveraged Employee Stock Option Plan could acquire newly issued common stock.

Thus, if the company made the maximum allowable contributions to both the Employee Stock Option Plan and the stock bonus plan trust, the net loss for 2009 would be increased from the projected $1 million to roughly $5 million. The dilution of existing shareholders must be considered carefully in such a plan, but in dire financial situations such as this, most shareholders will accept the dilution in exchange for keeping the enterprise alive.

This plan serves to increase the loss to facilitate recovery of federal and state taxes paid in the two previous years. In this scenario, the company might recover 35% of the current year loss, or as much as $1.75 million in cash from federal taxes paid the prior two years (2008 losses may be carried back five years), plus (in some states) a portion of any state taxes paid. By filing for an IRS (and possibly state) quick refund, this cash could be recovered within 90 days after the close of the company's fiscal year.

The $2 million wage and benefits reduction in 2009 could eliminate the projected loss for 2010. The increased earnings due to the wage and benefits reductions should also serve to lessen the reduction in the fair market value of the company. Since in this example the company has an Employee Stock Option Plan, the preferred stock accounts in the stock bonus plan trust might offset to some extent the loss in common share value in the Employee Stock Option Plan for employees. Cash dividends on the preferred stock can be accumulated in the trust and used to help offset future repurchase liability of the new stock bonus plan, or a payment-in-kind dividend, as discussed earlier, might be paid.

In determining whether a wage forbearance plan can work for a company, the bench strength and partnering culture of management must be carefully assessed. Companies with a well designed and established Management Stock Option Plan have a much better chance in successfully implementing a wage-forbearance plan such as this, where key executives who are personally invested in the success of the enterprise will have a much stronger motivation to ensure that a wage-forbearance plan succeeds.


This article began by citing research that demonstrates that Employee Stock Option Plan companies have greater survival rates and discussed some of the reasons for these results. The article then examined a number of proven financial techniques employing an Employee Stock Option Plan, Management Stock Option Plan, or a combination of both that companies can use to increase liquidity and cash flow. While several of the techniques apply to companies that already have an Employee Stock Option Plan, the majority of them can be utilized by the companies if they install a new Employee Stock Option Plan and/or Management Stock Option Plan. While the use of these techniques is not confined to companies facing economic distress, they deserve more attention in turbulent economic times because of their ability to assist companies in energizing their employees to help the company survive in difficult times and to create critically needed cash flow that may ultimately mean the difference between corporate life and death.

© 2009, Society of Financial Service Professionals. Used by permission.

The authors of this article appreciate and recognize the contribution and editorial comments of Patrick H. Flynn, CPA.

Bryan Golden collaborated with Ronald J. Gilbert, Dickson C. Buxton, and Paige A. Ryan in writing this article.

Ronald J. Gilbert, CLU, ChFC, is president of ESOP Services, Inc. and holds an MSFS from The American College. He serves on the board of the National Center for Employee Ownership, the legislative committee of The ESOP Association, and the boards of four ESOP companies. He is coeditor and coauthor of Employee Stock Ownership Plans: ESOP Planning Financing, Implementation, Law and Taxation published by the Beyster Institute, and he has worked with Louis Kelso.

Dickson C. Buxton, CLU, ChFC, founded Private Capital Corporation in 1976. He is the former chairman of Kelso & Company, a cofounder of two private equity groups, a cofounder of the ESOP Association of America, and conducted the first ESOP productivity study for the Senate Finance Committee. He is author of You've Built a Successful Business – Now What and Lessons in Leadership and Life, Secrets of Eleven Wise Men.

Paige A. Ryan, MIB, is ESOP Services, Inc.'s senior West Coast representative and has over 17 years' experience in finance, has served on several corporate boards, and holds a Master's degree in International Business from the University of San Diego. She has presented to The ESOP Association, National Center for Employee Ownership, Association for Corporate Growth, Beyster Institute, California Society of CPAs, and the United States Agency for International Development (USAID).

1 Margaret M. Blair, Douglas L. Kruse, and Joseph R. Blasi, “Employee Ownership: An Unstable Form or a Stabilizing Force? The New Relationship: Human Capital In The American Corporation,” Margaret M. Blair and Thomas Kochan, eds. (Washington, DC: Brookings Institution Press, 2000). Abstract available at SSRN http://papers.ssrn.com/sol3/papers.cfm?abstract_id=142146.

2 General Accounting Office, “Employee Stock Ownership Plans: Little Evidence of Effects on Corporate Performance,” GAO/PEMD-88-1 (Washington, DC, October 1987).

3 National Center for Employee Ownership, “Largest Study Yet Shows ESOPs Improve Performance and Employee Benefits,” http://www.nceo.org/library/esop_perf.html (accessed January 2009).

4(4) Employee Ownership Foundation, “The Importance of Employee Ownership,” http://www.employeeownershipfoundation.org/ownership.asp (accessed January 2009).

5 Colonel Ardant du Picq, French Army, translated by Colonel John N. Greely, U.S. Army, Battle Studies, Ancient and Modern Battle (New York: The MacMillan Company, 1921): 110.

6 IRC § 423 Employee Stock Purchase Plans.

7 IRC § 422 Qualified Stock Options.

8 IRC § 83(b) Property Transferred in Connection with Performance of Services.

9 IRC § 409A Inclusion in Gross income of Deferred Compensation Under Nonqualified Deferred Compensation Plans.

10 IRC § 409(p) Prohibited Allocations of Securities in an S Corporation.

11 FASB 123(R) Share Based Payment (2004).

12 IRC § 404(a)(3)(A) Limits on Deductible Contributions.

13 IRC § 415(c)(1) Limitations on Benefits and Contributions under Qualified Plans for 2009.

14 PLR 200436015 IRC § 404, 09/03/2004.

  1. Impact of dilution on all shareholders including the Employee Stock Ownership Plan, if there is one
  2. Appropriate “golden handcuffs” (and “golden harpoon”) provisions to prevent the possible loss of talented people after a rapid run-up in stock value, or in the event of a business downturn
  3. Ultimate cost to the company of the projected benefits for the plan participants
  4. Whether the plan will increase or decrease capital available to the company

    • XYZ company is a privately held C corporation.
    • The company has been profitable each of the past two years and has paid over $1 million in federal income taxes in each of the past two years.
    • The company pays $10 million in wages annually.
    • The company projects a net operating loss of $1 million for 2009 and $1 million for 2010.

Hospital Cost Shift

A big decline in both auto accident and severe injury frequency has not produced a corresponding decline in loss costs. The slack has been taken up by inflated soft tissue injury claims fueled by hospital cost shift. Financially savvy hospital administrators and new software that “enhances” billing techniques have overcome claim deterrents so effectively that the industry seems unaware. There is an answer, but the industry may be satisfied with the status quo for now.

A 2008 report by the Insurance Research Council (IRC) provides empirical evidence that since 2000, a significant decrease in auto claim frequency has been mysteriously offset by an equally significant rise in severity, leaving loss costs essentially unchanged. Of particular note, the Insurance Research Council report points to a study by the National Safety Institute showing that improved automobile safety engineering has been lowering the frequency of serious injuries and deaths. This makes the rise in bodily injury and personal injury protection claim severity particularly vexing.

The graph below is taken from the Insurance Research Council report and it depicts the described trends:

Percentage Change in Countrywide Claim Frequency, Claim Severity, and Loss Costs

This paper is the result of research that was aimed at discerning the root causes of the three simultaneous trends and whether their relationships are coincidental or causal.

In summary, the findings were as follows:

  1. The decline in claim frequency was (is) primarily causally related to lower per-capita driving, which in turn is causally related to the combination of a significant rise in gasoline prices coupled with rising unemployment over the same period.
  2. The rise in property damage severity is largely causally related to an increase in vehicle repair and replacement costs that is in turn driven by the efforts to make vehicles safer, such as airbags.
  3. The rise in bodily injury and personal injury protection severity is the result of a significant shift of the total cost of national health cost burden from the government and private health insurers to the Property & Casualty insurance industry.

The Root Cause Of Medical Cost Shifting
The decline in claim frequency and the rise in property damage severity were considered transparent enough not to warrant further elaboration in this article. This turned our focus to unraveling the seemingly mysterious rise in bodily injury and personal injury protection severity, especially in light of the decline in the rate of severe injuries that can be causally related to the property damage severity rise.

Our findings in this regard are a confluence of causally related phenomena as follows:

  • The government has been tightening payment controls and cutting reimbursement rates for medical providers under programs like Medicare and Medicaid.
  • Private health coverage payments to providers have declined as fewer employers provide coverage; for those who do, the deductibles and co-payments have grown considerably.
  • Hospitals and other significant medical entities have responded by appointing financially savvy administrators and implementing electronic medical record systems that have morphed from being efficiently focused to being revenue enhancement driven.
  • These savvy administrators and their new software programs are defeating the government and private software tools designed to vet electronic billing submissions. They accomplish this via “diagnostic upcoding,” a means of reporting an injury or illness as being more severe than in actuality.
  • Though these tactics are aimed primarily at the government and private health plans, they have worked equally well at overcoming Property & Casualty company claim deterrents, driving up the cost of what were once considered small soft-tissue personal injury protection and bodily injury claims.
  • While the tactics are effective against the government and private health insurers, those entities have mitigated their effects by lowering medical procedure reimbursement rates. Because the Property & Casualty industry lacks the means to do the same, it is absorbing an ever increasing share of total national health care costs, a phenomenon referred to as “cost shifting.”

Understanding Diagnostic Upcoding
The rise in bodily injury and personal injury protection severity is the manifestation of the growing cost shift from hospitals and other medical providers that are passing a progressively greater percentage of the total cost of national medical costs to the Property & Casualty industry.

In many ways, this shift is an unintended consequence of a financial stalemate between the government and private health insurers on one side and hospitals and other medical providers on the other. Hospitals and other providers turned increasingly to upcoding to offset the steadily decreasing reimbursements from the government and private health. But the Property & Casualty industry, which accounts for only about 10% of hospital utilization, was subjected to those same programmed upcoding schemes, seemingly without awareness, or at least without taking mitigating actions.

It is evident that something is driving the increase in medical care costs

The following are direct quotes from the IRC (emphasis added):

“We use the following indicators and more: extent of disability, rate of hospitalization, days unable to perform duties. And we see that injuries are not becoming more serious nor have they changed much. But, it is still evident that something is driving the rise in severity. Since injuries do not appear more serious, medical usage and treatment costs are driving the increase in medical care expenses.

“Low reimbursements from public health insurance programs, such as Medicare and Medicaid, have prompted hospitals to shift costs to automobile insurance companies — raising auto injury claim costs. Cost shifting in 2007 resulted in $1.2 billion in excess hospital charges. The full impact of hospital cost shifting, including that occurring in other insurance coverage, is likely much greater.

Medical Coding 101
The medical profession has a well-established regimen of coding to describe both the nature of injuries and illnesses as well as the therapies utilized to treat them. The coding classification that defines the nature of pathology, the diagnosis, is referred to as “ICD-9 codes.” For therapies, the codes are referred to as “CPT and HCPCS codes.”

ICD-9 codes form the basis for CPT and HCPCS codes because the diagnosis precedes the selection and introduction of the appropriate therapy or therapies. So if in the same instance the ICD-9 code indicated a bruised hand but the CPT/HCPCS code reflected a coronary bypass, software programs employed by the government, private health care providers and the Property & Casualty industry can detect the mismatch and prevent the payment.

The government and private health insurers tie their reimbursement rates to the CPT/HCPCS codes. When the therapy code is correct for a particular diagnostic code, the software can discern the appropriate payment amount based on a programmed fee schedule. With such a system, it is easy for the government to institute an across the board fee reduction of 10% or to apply the reduction in a variable way and accurately estimate its aggregate impact.

The Property & Casualty insurance industry is able to follow government fee schedules in some instances (mainly Workers' Compensation) but in most states relies on “usual and customary” charges for auto, the aggregate average of what medical providers bill for each CPT/HCPCS code. There has been significant controversy and litigation related to the sources of the “usual and customary” data.

Overall the government, private health care and the Property & Casualty industry all use software programs to vet medical billing that start by insuring that the CPT/HCPCS coding for each therapy match the ICD-9 diagnostic code and then, checking the amount charged for each therapy against a fee schedule or, for the Property & Casualty industry, the “usual and customary” charge.

From “Patient Centered” to “Profit Center”
The belief that doctors would not falsely inflate a diagnosis, outside of outright fraud, was common at the outset of the electronic vetting system, and with good reason. But the confluence of government fee reductions and the decline of private health care created significant financial duress for hospitals and providers. Something had to give, and turning away the uninsured was not an option, although more and more providers are opting out of Medicare and Medicaid.

That answer came in the form of savvy hospital administrators and slick new software that added efficiency but even more so, drove up revenues. It did so by making certain that the highest legitimate diagnostic code was being selected. It also provided upfront audits to spot instances such as a therapy that overshot the initial diagnosis so that “coding corrections” could be made before the billing process was invoked. Increasingly, such corrective activity was administered by support personnel who lacked medical knowledge and sought only to satisfy the systems requirements.

The Impact Of Diagnostic Upcoding
The medical coding system is logical and it lends itself well to automation, which vastly increases efficiency for everyone. But its cornerstone is the ICD-9 diagnostic code and while expert systems can aid a doctor in making a diagnosis, the ultimate decision (at least for now) still rests with the doctor's judgment.

With enough information, a system could flag potential upcoding in certain instances. Gradually such a system will evolve and become increasingly effective, but for now, expert human intervention is required to decide whether the reported ICD-9 diagnostic code is reasonable in light of numerous data points derived from a forensic examination of the mechanism of injury.

This chart reflects a huge shift in ICD-9 supported CPT coding from 2002 to 2008:

Increase in Emergency Department E/M Billing Levels

Most Doctors Are Victims Not Perpetrators
It should be noted that hospitals and other providers were likely losing legitimate revenues by not paying sufficient attention to billing practices in the past. Therefore, some of the change in the above chart is likely justified. But like a pendulum that may have swung too far in one direction in the past, there is ample evidence of over-compensation on its way back.

A Few Recent Headlines

4-18-2011: CtW Investment Group Calls for Board Accountability

7-21-2011: Prime Healthcare Accused of Medicare Fraud

8-31-2011: Alleged Fraud Uncovered During EMR Training

9-12-2011: Dallas Hospitals To Pay $1.4M, Settle Upcoding Investigation

9-21-2011: Doctors Protest CEO at Knapp Medical Center

This is not meant to suggest that all hospitals and providers, or even the majority, cross the line, but a systemic change has occurred and one manifestation is the alarmingly frequent allegations of billing related maleficence.

Examples Of Recent Articles From Hospital Industry Publications:

Examples Of Recent Articles From Hospital Industry Publications

The Property & Casualty Industry Response
Had cost shifting not occurred in parallel with the significant decline in accident frequency, loss costs would have dropped and companies would have utilized the capital windfall to lower their prices and gain market share. That would have led to a significant decline in premiums accompanied by expense reductions significant enough to maintain underwriting and claim expense ratios.

Many of the financial incentives in the industry are determined as a percentage of premiums. Shrinking premiums produce shrinking companies, lower cash flow, weakening balance sheets and endangered financial ratings. None of those are desirable outcomes for carriers. Independent Agents and Brokers work on commission, a percentage of written premiums, so if they earn 15% on an $800 auto policy that without cost shifting may have shrunk to a $600 policy, they would have taken a 25% revenue cut.

There may be Nash equilibrium in play, with everyone being happy under the current circumstances. But as the Insurance Research Council points out, if accident frequency returned, first loss costs, and then premiums would spike. The longer and larger the cost shift is allowed to grow, the greater the potential market disruption becomes when the day of reckoning arrives. But for anyone who is not betting on a near term economic revival, and/or the significantly lowered gasoline prices that could fuel increased frequency, this may not be a burning issue.

Is Anybody Hurt By Cost Shift?
Auto insurance consumers are financing the cost shift through artificially high insurance premiums. To the extent that some of those same individuals consume more medical services than are paid for, there seems to be fairness. But for those who shoulder the full burden (or more) of their medical expenditures, “the affluent,” this resembles income redistribution.

What Does This Portend For Claims?
As things stand, most claim department leaders either don't realize what has happened, or believe that their particular policies and practices have prevented this for their company. A benchmark comparison of company loss costs against like competitors would force one to choose to either disbelieve the phenomenon entirely or accept that they are as vulnerable as everyone else.

The standard industry claim deterrents for medical cost containment are two software programs, medical bill repricing and automated bodily injury evaluation. Both are highly susceptible to diagnostic upcoding, but few claim leaders understand the algorithms that drive these systems and imbue them with capabilities that they don't have. Those claim people far enough into the details to know better are not empowered to act.Efforts to inform claim leadership typically meet with stiff resistance, because they genuinely believe that they “have it covered.” And even if they knew they did not, why would they want to have such significant leakage called out when loss ratios are stable, and nobody is pointing a finger in their direction? But acknowledging and addressing the issue would create more work on top of what already feels insurmountable.

Closing Thoughts
This article was written for the purpose of calling out the significance of cost shifting to the industry. I do not believe that the industry is purposely allowing the cost shift, but when a bad situation creates comfort, a sense of urgency is elusive. The more entrenched the problem becomes, the more difficult the exit strategy.

The Property & Casualty industry will continue to represent a relatively small percent of hospital utilization, but it is continuing to pay a growing disproportionate share of the total cost. Even if driving never perks up again, as the cost shift grows a tipping point nears where premiums become too high.

Finally, there has been too much focus on automating claims over the past twenty years or more and far too little focus on basic claim handling. This is one example of numerous significant pockets of leakage that arose as a result.