By Jeff Adams, January 14, 2013
It can be called many different names, some correct and some incorrect. It is an estimate of the dollar amount of claims that are incurred on or before the valuation date but have not been paid by the valuation date. Many entities such as employers, providers, and payors are required to estimate this liability and accrue it in their financial statements to comply with Generally Accepted Accounting Principles and Statutory Accounting Principles.
My preferred name for this accrual is Incurred but not Paid (“IBNP”). Unpaid Claims Liability and Claims Reserve are fine also. Using the name Reserve instead of Claims Reserve can result in confusion as there are other types of reserves, such as Surplus Reserves and Statutory. Incurred but not Reported (“IBNR”) is generally not a correct term as it only represents a portion of the IBNP. Remember that IBNP = IBNR + (Reported but not Paid). In other words. Claims Reserve equals claims that have been incurred by the valuation date but have not been reported PLUS claims that have been incurred and reported by the valuation date but have not been paid. For example, if the IBNP valuation date is December 31, 2012, then the IBNP would represent an estimate of total claims incurred December 31, 2012 and prior that were not paid by or on December 31, 2012, and are estimated to be paid after that date, regardless as to whether those claims had been reported or not.
The reason for requiring the IBNP accrual for some employers, providers, and payors is to ensure that all liabilities of the entity as of the valuation date are reflected in the financial statement and that expenses are consistent with revenues. For example, if an employer has a self-insured health plan, then that employer would be required to accrue an IBNP for members covered under that plan. If the employer is compiling its December 2012 financial statement, it would need to account for an estimate of claims incurred in December 2012 and prior by members under the self-insured plan, but that will be paid after December 31, 2012. Claims paid through December 31, 2012, would appear as an expense in a paid claims account, so it is only necessary to accrue for claims incurred by December 31, 2012, that were not paid as of December 31, 2012. In another example, an insurer who receives a premium from an employer or policyholder will generally be required to cover any claims incurred for that month. This implies that the December statement would include both premiums for that month and claims incurred for that month, regardless of it was paid by the end of the month or not.
The first step in determining the IBNP is to determine the members for whom the accrual should represent. This includes all members for whom the entity’s liability for a month may include a paid premium or claims amount for the month plus additional claims payments after the end date of the financial statement. Examples are an employer having to accrue IBNP for all members to whom it gives self-insured health benefits. Another example is an insurance company having to record IBNP for any member that the insurer covers and for which it takes risk. An insurer may have an IBNP-type of accrual going through the revenue portion of its financials for policy types such as minimum premium.
The next step is to determine the best method for estimating the IBNP. Many employers who need to accrue IBNP but for whom the IBNP is not significant as it relates to the financial statement use a percent, such as 25%, of the latest twelve months of paid claims as the IBNP estimate. The employer’s auditor will often allow this as a conservative estimate. However, the auditor may require a more detailed estimation, such as that described below, in certain situations (such as a significant membership change, unusual claims trend, or some other situation) that might alter the IBNP substantially.
For many employers, providers, and payors, the best method is to use paid and incurred information. Some payors may feel the best method is to use incurred and received information. Use of incurred and received information could be more accurate if well-received information is available since received information is available sooner than paid information. The ultimate objective of the first few steps of this process is to obtain monthly incurred claim estimates. There is flexibility as to the method of obtaining these estimates, but they are generally obtained through the use of a lag model or completion factor model. These models use historic information on how quickly claims are paid or received to determine what percent of the total incurred claims are paid or received with each additional month of data. For example, suppose the IBNP as of December 31, 2012, is to be estimated. In that case, the model may determine that, on average, 80% of claims incurred are paid or received, depending on whether paid or received data is used after three months. This would then mean that claims paid to date for incurred October 2012 would be divided by 0.800 to obtain total estimated incurred claims since it has three months of paid or received claims (October, November, and December 2012). Since months with only one or two months of paid or received information may have a small portion of the incurred claims paid or received in that time, the most recent months incurred estimates may be obtained by trending forward prior months, adjusting for the days impact, seasonality, and any other known impact such as payment arrangements between the provider and payor. Note that the days and seasonality impacts may be greater than trend in many cases.
Lag and completion factor models vary widely. These variations include the number of total months of data used, the number of prior paid months used to determine lag or completion factors, the selection of months that are used to trend forward to the most recent months, the ability to trend forward prior months, the use of days’ impact, and the use of seasonality.
Once monthly incurred estimates have been obtained, the corresponding paid claims that appear in the financial statement are subtracted from the incurred estimates to obtain the IBNP. It should be verified that the financial statement paid claims that are subtracted from the incurred claims are consistent with the underlying data input into the IBNP estimation model. An additional administrative cost of processing the IBNP may be included.
IBNP models are not difficult to develop. I can assist you in developing a model, or I can develop it for you. Remember, though, these models are only a starting point for the IBNP estimation as much thought and analysis are necessary. Number-crunchers who use the figures directly from the model output will run into substantial difficulty at some point in the future when the entity’s environment changes.