Class 10 Insurance and Risk Management

1
Class 10Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2007

2
Agenda

• Social Insurance Basics
• Old-Age, Survivors, and Disability Insurance
  (OASDI)
• Medicare

3
Basic Characteristics of Social Insurance

• Most programs are compulsory
• Programs are designed to provide a floor of
  income
• Programs pay benefits based largely on social
  adequacy rather than individual equity
• The benefits are heavily weighted in favor of
  certain groups, such as low-income persons, large
  families, and retirees
• Benefits are loosely related to the workers
  earnings

4
Basic Characteristics of Social Insurance

• Programs, benefits, and benefit formulas are
  prescribed by law
• A formal means test is not required
• A means test involves disclosing income and
  assets
• Full funding of benefits is unnecessary
• For example, it is not necessary to fully fund
  Social Security because workers will always enter
  the program and support it
• Programs are designed to be financially
  self-supporting
• Programs should be almost completely financed
  from the earmarked contributions of covered
  employees

5
Old-Age, Survivors, and Disability Insurance
(OASDI)

• Commonly known as Social Security, OASDI is the
  most important social insurance program in the US
• Enacted in 1935
• It covers more than 9 out of 10 workers

6
Current Structure of Social Security Program

• Old-Age, Survivors, Disability and Hospital
  Insurance (OASDI-HI)
• Two components
• OASDI
• HI (Medicare)

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Groups covered under Social Security Program

• Employees in private firms
• Virtually all
• Federal civilian employees
• After 1983 compulsory
• State and local governments
• Voluntary agreement between state and federal
  government
• Employees of nonprofit organizations
• If paid at least 100 during the year

8
Covered Occupations (cont.)

• Self-employment
• If annual earnings of at least 400
• Domestic employees
• Domestic employees in private homes who earn
  1500/year or more (in 2006)
• Miscellaneous other groups, including ministers,
  US military personnel, and railroad workers
• Ministers may elect out because of conscience or
  religious principles
• Railroad workers do not pay OASDI taxes directly

9
Social Security and the Federal Government

• OASDHI expenditures exceed any other federal
  program including defense.
• Equal to approximately 20 of total expenditures
  of the federal government
• OASDHI payroll taxes (FICA) represent 25 of all
  tax revenues.
• FICA Federal Insurance Contribution Act

10
Types of OASDI Benefits

• Retirement
• similar to defined benefit retirement plan
• Survivor
• life insurance
• Disability
• disability insurance

11
Determination of Insured Status

• Fully insured
• Currently insured
• Disability insured

12
Eligibility for OASDI Benefits

• Workers and their dependents are eligible
• Amount of benefits depends on
• Wages earned
• Amount of time working
• Unit of measurement
• earn a quarter of coverage for each 1,000 in
  annual earnings (in 2007) up to 4 per year

13
Old-Age, Survivors, and Disability Insurance
(OASDI)

• A worker becomes eligible for benefits by
  attaining an insured status
• To attain a fully insured status, a worker must
  have 40 credits
• In 2007, a credit is earned for each 1,000 of
  covered earnings
• A maximum of 4 credits can be earned each year
• You are currently insured if you have earned at
  least 6 credits in the past 13 calendar quarters
• The number of credits required to be disability
  insured depends on the age when you become
  disabled
• Eligibility for certain benefits depends on
  insured status
• Fully insured retirement and survivor benefits
• Currently insured survivor benefits
• Disability insured disability benefits

14
Retirement Eligibility

• To be eligible for retirement benefits, you must
  be fully insured.
• You are full insured for retirement benefits if
  you have 40 credits.

15
OASDI Retirement Benefits

• Social security retirement benefits are an
  important source of income for most retired
  workers
• Full retirement age for unreduced benefits is age
  65, but will gradually increase to 67
• Workers and their spouses can retire at age 62
  with actuarially reduced benefits
• More than half of the OASDI beneficiaries apply
  for retirement benefits before the full
  retirement age
• Monthly retirement benefits can be paid to
  retired workers and their dependents

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Exhibit 18.1 Social Security Full Retirement Age
and Reduction in Benefits by Age
17
OASDI Retirement Benefits

• The monthly retirement benefit is based on the
  workers primary insurance amount (PIA)
• The PIA is based on the workers average indexed
  monthly earnings (AIME)
• Indexing results in a relatively constant
  replacement rate so that workers retiring today
  and in the future will have about the same
  proportion of their work earnings replaced by
  OASDI benefits
• The AIME is based on a weighted benefit formula
  which weights the benefits heavily in favor of
  low-income groups

18
Exhibit 18.2 Examples of Monthly OASDI Retirement
Benefits at the Full Retirement Age (FRA)
19
OASDI Retirement Benefits

• A delayed retirement credit is available if you
  delay receiving retirement benefits beyond the
  full retirement age
• Cash benefits are automatically adjusted each
  year for changes in the cost of living
• The program has an earnings test that can result
  in a reduction or loss of monthly benefits for
  workers with earned incomes above certain annual
  limits
• Beneficiaries who have attained the full
  retirement age or beyond can earn any amount and
  receive full OASDI benefits
• To encourage private savings and investments to
  supplement the benefits, the earnings test does
  not apply to investment income, dividends,
  interest, rents or annuity payments

20
Survivor Benefit Eligibility

• Require either
• Fully insured status, or
• Currently insured status
• You are currently insured if you have
• earned at least six credits during the last 13
  calendar quarters ending with the quarter of
  death.

21
OASDI Survivor Benefits

• Survivor benefits can be paid to the dependents
  of a deceased worker who is either fully or
  currently insured
• The benefits provide a substantial amount of
  financial protection to families
• For the average family, the benefits are equal to
  a 354,000 life insurance policy

22
Disability Eligibility

• Number of credits required to be disability
  insured depends on your age when you become
  disabled.
• If you are age 31 or older, you must have earned
  a certain number of credits as shown by the chart
  on page 387.
• At least 20 of credits must be earned during the
  past 10 years immediately before becoming
  disabled.

23
OASDI Disability Benefits

• Disability benefits can be paid to disabled
  workers who meet certain eligibility requirements
• The benefits provide protection against the loss
  of income during a long-term disability
• For the average family, disability payments are
  equivalent to a private disability insurance
  policy worth over 233,000
• The worker must meet a five-month waiting period,
  and satisfy the definition of disability
• The worker must have a physical or mental
  condition that prevents him or her from doing any
  substantial gainful activity and is expected to
  last at least 12 months or is expected to result
  in death

24
OASDI Disability Benefits

• Major groups eligible to receive OASDI disability
  benefits include
• A disabled worker under the full retirement age
• The spouse of a disabled worker
• Unmarried children of the disabled worker, if
  under age 18
• Unmarried children age 18 or older who become
  severely disabled before age 22

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Taxation and Financing of OASDI Benefits

• Some beneficiaries who receive monthly cash
  benefits must pay an income tax on part of the
  benefits
• The amount depends on the level of your combined
  income, which is the sum of your adjusted gross
  income, tax-free interest, and ½ of your Social
  Security benefits
• Social Security benefits are financed by a
  payroll tax paid by employees, employers, and the
  self-employed
• In 2006, a worker paid a payroll tax of 6.2 on
  covered earnings up to a maximum of 94,200

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Long-range OASDI Actuarial Deficit

• The present program is running an annual surplus,
  but the OASDI trust funds will experience serious
  financial problems in the future
• Projected OASDI tax income will begin to fall
  short of outlays in 2017
• The program can be actuarially balanced over the
  next 75 years in various ways, including
• An immediate increase of 16 in payroll tax
  revenues
• An immediate reduction in benefits of 13
• Using general revenues of the federal government
  to pay benefits
• Or, some combination of these options
• One proposal would create voluntary personal
  retirement accounts, allowing workers to divert
  two full percentage points from the OASDI payroll
  tax into voluntary personal retirement accounts

27
How is OASDI Financed?

• Sources
• Payroll (FICA) taxes
• Largest source of funds
• Employer and worker each pay 6.2 of taxable wage
  base
• Maximum taxable wage base in 2007 97,500
• Employer and worker also each pay HI taxes
  1.45 of all wages

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How is OASDI Financed?

• Sources (cont.)
• Income taxes paid by high income beneficiaries
• Interest on OASDI trust funds

29
Social Security Vs. Private Insurance

• Participation
• Social Security is compulsory
• Insurance is a matter of free choice
• Benefits
• Social Security predetermined by formula
• Insurance benefits negotiated by purchaser and
  insurer

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Social Security Vs. Private Insurance

• Funding
• Social Security operates as a pay-as-you-go
  system
• It is self-supporting
• But also backed by the federal governments
  taxing power
• Insurance companies are required to be fully
  funded
• Change in Benefits
• Social Security benefits can be changed by
  legislation
• Insurance benefits are contractual and generally
  are not subject to change

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Social Security Vs. Public Assistance

• Contributions for benefits received
• Social Security recipients make contributions for
  the benefits they receive
• Welfare recipients make no such payments

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Social Security Vs. Public Assistance

• Demonstration of financial need
• Social Security benefits are the legal right for
  all eligible people
• Recipients do not have to demonstrate financial
  need
• Richest people in America are entitled to
  benefits, as soon as they become eligible
• Public Assistance recipients must demonstrate
  financial need
• Must pass a means test

33
Social Security Vs. Public Assistance

• Demonstration of financial need
• Social Security benefits are the legal right for
  all eligible people
• Recipients do not have to demonstrate financial
  need
• Richest people in America are entitled to
  benefits, as soon as they become eligible
• Public Assistance recipients must demonstrate
  financial need
• Must pass a means test

34
OASDI Benefit Amounts

• Benefits are based on Primary Insurance Amount
  (PIA)
• Step 1 Calculate average indexed monthly
  earnings (AIME)
• Method Index past earnings to growth in average
  wage rates so all earnings are comparable

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Primary Insurance Amount (cont.)

• Step 2 Take highest 35 years of indexed wages
• Divide by number of months

36
Primary Insurance Amount (cont.)

• Step 3 Calculate PIA using a formula
• Example 4,000 PIA
• Formula
• 90 of first 612 in AIME
• 32 of AIME between 612 and 3,589
• 15 of excess
• 550.80 984.64 46.65 1,582.09
• PIA is rounded to 1,582
• 612 and 3,589 were bend points in 2004

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Relationship of PIA to AIME
38
Other Features

• Cost of living adjustment
• Earnings test
• Retirement benefits are reduced if wages exceed
  certain thresholds
• Strong disincentive for elderly to work full time
• Income taxation of benefits
• Higher income individuals pay tax on part of
  their benefits

39
Pay-as-you-go Financing

• Basic idea
• Current payroll taxes pay current benefits
• No pre-funding
• Exception
• Starting in1983, payroll taxes were increased to
  help fund future benefits
• Trust fund invests in government bonds

40
Projected OASDI Deficits

• Projections indicate large deficits in the future
• Around 2018
• Projected OASDI income will fall short of
  benefits paid
• The OASDI trust fund will start to decline
• By 2042
• OASDI income will finance only 73 of scheduled
  annual benefits
• The OASDI trust fund projected to be exhausted

41
Projected OASDI Deficits (cont.)
42
Factors Affecting Benefits and Taxes

• Simple framework for understanding pay-as-you-go
  systems
• Average benefit
• payroll taxes/number of beneficiaries
• Payroll taxes
• (tax rate) x (average taxable wage) x (number
  of workers)
• Then, average benefit
• (tax rate) x (average taxable wage) x (ratio
  of workers to beneficiaries)

43
Factors Affecting Benefits and Taxes

• If average benefits are kept constant and taxable
  wages remain constant, then
• tax rates must ?
• if the ratio of workers to beneficiaries ?
• Example
• ratio of workers to beneficiaries in 1997 3.4
• estimated ratio in 2030 2.0

44
Proposed Changes to Social Security

• Changes that maintain the current structure
• Benefit reductions
• Tax increases
• Investing trust assets in common stock
• Crediting trust funds with any budget surpluses

45
Proposed Changes to Social Security

• Changes that modify the basic structure
• Privatization
• Allow workers to invest their payroll taxes on
  their own
• Benefits to existing and new retirees would still
  have to be paid long transition period
• Convert to a welfare program
• Make benefits means tested
• Workers in their 40s, 50s, and 60s would lose
• Moral hazard problem many low income people
  would not save at all

46
Medicare

• Medicare covers the medical expenses of most
  persons age 65 and older
• The program also includes prescription drug plans
  and health care plans of private insurers
• Beneficiaries can select among an array of plans
  including
• The original Medicare plan
• Medicare Advantage plans
• Other Medicare health plans
• Medicare prescription drug plans

47
Medicare

• Under the original Medicare plan
• Beneficiaries can elect any provider that accepts
  Medicare patients
• Medicare pays its share of the bill, and the
  beneficiary pays the balance
• The original program provides benefits in two
  parts
• Hospital Insurance (Part A) provides coverage for
  inpatient hospital stays and other services
  including skilled nursing facility care, home
  health care, hospice care, and blood transfusions
• Hospitals are reimbursed for inpatient services
  under a prospective payment system
• A flat amount is paid for each service based on
  its diagnosis-related group (DRG)

48
Medicare

• Medical Insurance (Part B) is a voluntary program
  that covers physicians fees and related medical
  services
• Covered services include physician services,
  clinical laboratory services, home health care,
  outpatient hospital services, and blood
• Beneficiaries must pay a monthly premium for the
  benefits
• Currently beneficiaries with annual incomes under
  certain levels pay 25 of the cost of the
  program, and the federal government pays the rest
• A means test will be applied beginning in 2007
• The beneficiary must meet an annual Part B
  deductible
• The program pays 80 of the Medicare-approved
  amount for most physician services, outpatient
  therapy, preventive services and durable medical
  equipment
• Payments to physicians are made on an assigned or
  nonassigned basis

49
Medicare

• Medicare hospital insurance (Part A) is financed
  by a payroll tax paid by covered employees,
  employers, and the self-employed
• The program is subsidized by a small amount of
  general revenues
• Medical insurance (Part B) is financed by monthly
  premiums and the general revenues of the federal
  government
• Medicare Part A has serious financial problems
• The projected 75-year actuarial deficit in the
  Hospital Insurance Trust Fund is 3.51 of taxable
  payroll
• The fund is expected to be exhausted by 2018

50
Medicare

• Medicare Advantage Plans (Part C) are private
  health plans that are part of the Medicare
  program
• If beneficiaries choose this alternative,
  Medicare pays a set monthly amount to the private
  plan
• Most plans provide extra benefits and have lower
  co-payments than the original Medicare plan
• Plans include
• Medicare HMOs
• Medicare PPOs
• Medicare Special Needs plans
• Medicare Private Fee-for-service plans

51
Medicare

• Medicare HMOs are managed care plans operated by
  private insurers
• The plan may require members to choose a primary
  care physician and get a referral to see a
  specialist
• If the plan covers prescription drugs, members
  must pay a co-payment or coinsurance charge for
  each covered prescription
• Under a Medicare PPO, beneficiaries can generally
  see any doctor or provider that accepts Medicare
  patients
• Members do not need a referral from a primary
  care doctor to see a specialist
• A Medicare Special Needs plan provides more
  focused care for specific groups of people, such
  as those with chronic illnesses
• Under a Medicare Private Fee-for-service plan,
  the private company, rather than Medicare,
  decides how much it will pay and the amounts
  members must pay for the services provided

52
Medicare

• Medicare beneficiaries have other choices for
  coverage besides the Advantage Plans
• Under a Medicare Cost plan, members receive care
  from primary care doctors and hospitals that are
  part of the network
• Services obtained outside the network are covered
  under the original Medicare plan, but members
  must pay the Part A and Part B coinsurance and
  deductibles
• A PACE program combines medical, social, and
  long-term care services for the frail elderly

53
Medicare Prescription Drug Plans

• Medicare prescription drug coverage (Part D) is a
  relatively new benefit, available to all
  beneficiaries
• Beneficiaries in the original Medicare plan can
  add prescription drug coverage by joining a
  stand-alone plan
• Monthly premiums depend on the specific plan
  chosen
• Plans must provide at least standard coverage
• Beneficiaries pay part of the cost of
  prescription drugs, and Medicare pays part of the
  cost
• The cost sharing provisions are complex
• Costs are reduced for low-income beneficiaries

54
Exhibit 18.3 Example of Cost-Sharing Provisions
Under Medicare Prescription Drug Coverage (2007)
55
Medicare Prescription Drug Plans

• The new law contains several other provisions
• The potential for importing drugs from foreign
  countries is under consideration
• The federal government is prohibited from using
  its purchasing power to negotiate lower prices
  with pharmaceutical companies
• Private firms will administer the program on a
  regional basis
• Under a demonstration project, the original
  Medicare plan will face competition from private
  plans beginning in 2010

56
Medigap

• Medicare beneficiaries can purchase a Medigap
  policy to cover part or all of medical expenses
  not paid by Medicare
• The policies are sold by private insurers, and
  are strictly regulated by federal law
• There are 12 plans (A-L) which offer different
  sets of benefits

57
Financing of Medicare

• HI
• Financed by payroll taxes
• Both worker and employer pay
• 1.45 of all wages
• Deficits are forecasted
• SMI
• Beneficiaries pay monthly premiums that cover
  about 25 of the costs
• Remaining 75 is financed from general tax
  revenues

58
Summary Basic Characteristics of Social
Insurance

• Compulsory programs
• Floor of income
• Emphasis on social adequacy rather than
  individual equity
• Benefits loosely related to earnings
• Benefits prescribed by law
• No means test
• In a sense, full funding unnecessary
• Financial self-supporting
• Social Insurance is not the same as public
  assistance or welfare