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Title: 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)

7
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

16
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

25
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

26
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

28
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

30
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

31
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

32
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

35
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

37
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
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