Printer Friendly

A historical perspective on the present value assessment of medical care.

A Historical Perspective on the Present Value Assessment of Medical Care

Abstract

This article presents the results of an integrated historical evaluation of the relationships among the variables that determine present value awards for future medical care expenses in present value awards for future medical care expenses in personal injury and medical malpractice litigation. The relationships between interest rates and growth rates in the prices of individual components of medical care were relatively stable from 1952 through 1985, but the relationships varied dramatically across different types of medical care. Substantial misstatements in present value awards may result if expenses for different types of medical care are aggregated improperly or if the analysis does not accurately specify the taxable status of medical expenses for purposes of determining the tax liability of future incomes.

Introduction

In personal injury and medical malpractice litigation the largest element of economic loss is frequently the present value of future medical expenses. Life care plans developed for individuals who have suffered catastrophic injuries often produce present value assessments of future medical costs in the millions of dollars. Although a number of articles have focused on the proper determination of present value awards for future lost earnings, very little has been published regarding the assessment of awards for future medical expenses.

While common elements exist in the present value determination of both lost earnings and medical expenses, the assessment of awards for medical costs raises some unique issues. Among these issues are the intertemporal relationships between the interest rates one can expect to earn on invested monies and the growth rates in the prices of individual components of medical care, the effect of tax consequences emanating from varying Court treatments and Internal Revenue Service rulings regarding the tax deductibility or nondeductibility of medical expenses, and the effect of aggregating different components of economic loss in arriving at a total present value determination.

This study evaluates the historical relationships between interest rates and growth rates in medical care prices and the present value determination of medical care for alternative specifications of the tax deductibility of medical expenses. Historical data from 1952 through 1985 was used to evaluate the after-tax relationships between interest rates and the growth rates in medical care prices related to hundreds of present value computations for seven comprehensive medical care price indices, for alternative tax treatments of medical expenses, for varying dollar values of yearly medical costs, and for different numbers of years of loss.

Background

Several articles have appeared over the last ten years that focus on the relationship between interest rates and growth rates in earnings. In 1977 Franz [11, 12] illustrated that changes in the rate of price inflation impact similarly on interest rates and growth rates in wages. Franz suggested that present value assessments of future lost earnings should be based on the assumption that these future interest and earnings growth rates will be equal over the period of loss. A number of articles have subsequently appeared that report on the magnitude of the relative difference between interest rates and growth rates in earnings (i.e., the net discount rate), with estimates ranging from -1.6 percent to 1.0 percent [2, 5, 10, 18, 19, 20]. Each of these studies is limited because only one aggregate wage time series was evaluated and because taxes on earnings and interest income was not incorporated.(1)

In a recent article Schilling [24] illustrates that, historically, the relationship between long-term corporate bond rates and growth rates in wages has varied dramatically. He suggests that it may not be possible to establish a benchmark relationship between the growth rate and interest rate that will perform well in terms of producing awards allowing plaintiffs to replicate actual lost earnings over time. Schilling's analysis, however, is based on the assumption that the plaintiff will invest in long-term bonds, preventing the interest rate earned on the award from varying over the period of loss with changing economic conditions and the growth rate in wages. Furthermore, Shilling disregards the complex issues of the tax consequences of capital gains and losses, reinvestment in those years in which interest income exceeds lost earnings, and optimal bond management.

Anderson and Roberts [1] demonstrate that, if the plaintiff is assumed to invest and reinvest exclusively in short-term government securities, the after-tax relationship between interest rates and growth rates in earnings is stable both over time and across occupations. The roll-over investment approach in short-term securities allows the interest rate earned on the award to vary over the period of loss (with the growth rate in earnings) in response to unexpected changes in the rate of price inflation and/or other economic variables. Anderson and Roberts conclude that a benchmark of -0.5 percent for the after-tax net discount rate (i.e., the relative difference between after-tax interest rates and growth rates in after-tax earnings) would have historically produced reasonably accurate awards for alternative industry wage series across time.

(1) The Supreme Court of the United States [17] recently ruled that awards for lost earnings should be intended to replicate after-tax earnings and should reflect the fact that interest income is subject to federal income taxes. The Court also noted that previous studies regarding the magnitude of the net discount rate for lost earnings are inadequate because they do not investigate the stability of the net discount rate across different occupations.

Although the volume of work reporting the relationships between interest rates and growth rates in earnings has been extensive, there has been a lack of published research regarding the relationships between after-tax interest rates and growth rates in the prices of different types of medical care. Moreover, the assessment of present value awards for future medical expenses involves issues that have not been addressed in the literature regarding the assessment of awards for lost earnings.

Issues in Assessing Medical Expenses

If the plaintiff is assumed to invest (and reinvest each year) in one-year Treasury notes and if required medical expenses are assumed to occur at the end of each year, then the present value of future medical expenses for a particular type of medical care may be expressed as follows:

PV = Summation of t from 1 to n X sub o pi of j from 1 to t (1 + g sub j) pi of j from 1 to t [1 + K sub j (1 - gamma subj)] where:

PV = the present value of future medical expenses for a specific type of

periodic medical care

N = number of years medical care is required

X sub o = present (or base year) dollar cost of medical care

G sub j = growth rate in the cost of medical care in year j

K sub j = before-tax rate of interest on one-year Treasury notes in year j

Gamma sub j = effective tax rate on interest income in year j. The numerators of equation (1) are the future medical expenses forecast for each year t and the denominators discount these amounts to present value using after-tax interest rates.

Equation (1) raises three interesting issues. First, since inflation is a significant component of both interest rates and the cost of goods and services such as medical care, changes in the annual rates of interest on one-year U.S. Treasury notes and changes in the annual growth rates in medical expenses will tend to be positively related over time. Similar relationships have been reported for interest rates and growth rates in earnings [1, 4, 8, 9]. As equation (1) indicates, similar increases or decreases in both the growth and interest rates tend to leave present value unaffected. One issue, therefore, is whether stable relationships exist between interest rates and growth rates in the prices of medical care that may be used in assessing present value awards. Second, Courts differ regarding the extent to which income taxes may be introduced into the present value assessments of future medical expenses. Some State Courts have ruled that income taxes must be excluded from the present value determination because future tax liabilities are too speculative [7]. Other Courts, including the Federal Supreme Court, have stated that present value assessments must be on an after-tax basis [7, 22]. Moreover, the extent to which medical expenses are tax deductible depends on whether the jury allocates part of the award to cover future medical expenses. If part of the award is allocated as a prepayment of future medical expenses, no deduction is allowed until medical expenses exceed this specified portion of the award [23]. If the jury does not specifically allocate a portion of the award to compensate for future medical costs, all future medical expenses may be applied to reduce future tax liabilities [21].

Thus, the tax issue centers on the present value effects resulting from alternative specifications of the taxability of interest income and the deductibility of medical expenses. The impact on present value of discounting future medical expenses with non-taxable municipal bond rates or after-tax Treasury rates, rather than pre-tax Treasury rates, is often substantial.(2) For those cases in which medical expenses are deductible, moreover, there may be many years in which deductible expenses exceed interest income earned on the award and the excess may be deducted against other earned income. Third, equation (1) represents the present value of only one element of medical care expenses and does not indicate how different types of medical expenses (and perhaps lost earnings) should be aggregated to determine the total present value award. Assessing the present value of each component of medical care expenses individually and then aggregating poses a problem because the appropriate tax rate applicable to interest income is dependent on the total present value award. Additionally, aggregating base-year medical expenses and then projecting total future losses introduces a weighting bias because historically the growth rates in the prices of different types of medical care have differed substantially.

Data and Methodology

The data used in this study encompassed the period from 1952 through 1985 and include the annual yields on one-year Treasury notes for January of each year [26], the annual effective income tax rates by income classifications [25], and the annual growth rates in the seven different medical care price indexes for which annual observations are available over the study period [4]. The seven prices index are Medical Care (MC), Medical Care Commodities (MMC), Medical Care Services (MCS), Prescription Drugs (PD), Physicians' Services (PS), Dental Services (DS) and Hospital Rooms (HR).

(2) E.g., a pre-tax interest rate of 8.00 percent and a tax rate of 15.00 percent imply an after-tax interest rate of 6.80 percent. Assuming a growth rate in medical expenses of 8.00 percent and 30 years of loss, the after-tax interest rate yields a present value 19.47 percent larger than the pre-tax interest rate.

The relationships between interest rates and growth rates in the prices of different types of medical care were evaluated by reformulating equation (1) as an annuity: PV = X sub 0 summation of t from 1 to N pi of j from

1 to t (1 + g sub j) / [1 + k sub j (1 - gamma sub j)]

= X sub 0 summation of t from 1 to N pi of j

from 1 to t 1 / (1 + d sub j)

= X sub 0 summation of t from 1 to N 1 /

(1 + d) raised to t Where: d sub j = k sub j (1-gamma sub j)- g sub j /

(1 + g sub j) where d, which will be referred to as the "net discount rate," is a complex averaging function of the annual interest rates, growth rates in medical costs, and income tax rates in equation (1).

Equation (3) indicates that the present value of future periodic medical expenses for a particular type of medical care may be computed as an annuity with N payments equal to medical expenses in the base year. The future payments are discounted to present value using a net discount rate (d) based on the relative differences for each year of loss between the after-tax interest rates on one-year Treasury notes and the annual growth rates in the price of this type of medical care.

If the one-year interest rates and the annual growth rates in medical care prices are positively correlated over time, then the net discount rates consistent with present value awards allowing the replication over time of actual medical expenses should be relatively stable over different periods of loss. For example, periods of loss with higher price inflation rates should be associated with both higher interest rates and larger rates of increases in medical costs, leaving the net discount rate (based on the relative differences between annual interest and growth rates) unaffected.

Medical cost net discount rates were determined using historical annual interest rates, annual growth rates in medical care prices and annual effective income tax rates in a computer program that solves for PV in equation (1) for different types of medical care, for alternative tax treatments of interest income and medical expenses, for different periods of loss and for varying levels of base year medical expense. Each present value solution to equation (1), along with the corresponding number of years of loss and base year medical expense, were then used to solve equation (3) for the net discount rate (d).

An Example

The present value assessment of medical expenses based on historical data is illustrated in Table 1 for three alternative assumptions regarding taxes: (1) there are no taxes, (2) interest income is taxable and none of the award is allocated as a prepayment of future medical expenses, thus all future medical expenses are tax deductible, and (3) interest income is taxable and that portion of the award for future medical expenses is allocated, thus medical expenses are not deductible until the cumulative value of future medical costs exceeds the allocated amount.

Medical expenses are listed in column (1) assuming that the plaintiff is injured on the last day of 1965 and incurs medical expenses at the end of each of the next 20 years equal to the aggregate price index for medical care multiplied by 100. Thus medical expenses are assumed to grow at the same rate as does the medical care price index.

Present value is determined recursively for each of the three tax scenarios by computing yearly present values from the last year of loss (1985) to the first year (1966). The investment principals required at the beginning of each year to allow replication of medical expenses for each of the remaining years of loss are listed in columns (3), (5) and (10). These principal amounts are calculated using the interest rates listed in column (2) available at the beginning of each year on one-year Treasury notes.

The allowable tax deductions for each year's medical expenses for the nonallocated and allocated award examples are listed in columns (7) and (12), respectively.(3) For those years in which medical expense deductions are allowed, only those expenses in excess of 7.5 percent of interest income, listed in columns (6) and (11), are deducted.(4) The income taxes paid on interest income are listed in columns (8) and (13) and are computed by applying each year's average effective tax rate for the appropriate income classification.(5) Deductible medical expenses in excess of interest income are labeled "residual deductions" and are reported in columns (9) and (14). These residuals may have value if they can be used to further reduce tax obligations on other income (e.g., spousal income, other investment income, etc.).

The present money values (at the end of 1965) for the three tax alternatives (no tax, nonallocated, and allocated), that would allow the plaintiff to adopt a rollover investment approach in one-year Treasury notes, pay all assumed income taxes on interest income and exactly reproduce medical expenses are $190,122, $190,485, and $201,453, respectively. These amounts represent the solutions to equation (1) for the varying tax assumptions. Substituting these present value amounts and base year medical expenses of $8,950 (the price index for medical care was 89.5 in 1965) into equation (2) for 20 years of loss yields net discount rates of -0.57 percent, -0.59 percent, and -1.10 percent, respectively.

(3) Prepaid medical expenses are not tax deductible [15]. If a portion of the present value award is allocated as a prepayment of future medical expenses, medical expenses are not deductible until their cumulative total exceeds the amount of the prepayment [23]. Thus, in column (12) of Table 1, the tax deduction for medical expenses is zero until total medical expenses exceed the allocated amount of $201,453.

(4) Current tax law generally allows an itemized deduction for medical expenses in excess of 7.5 percent of adjusted gross income. While this rate has varied, the variations over the study period from 1952 through 1985 are relatively small and would not have a significant impact on the net discount rates for medical expenses. Thus the current rate of 7.5 percent was used in deriving the net discount rates reported throughout the study. The negligible effect on the after-tax net discount rates for medical expenses of relatively small variations in the 7.5 percent rate is discussed in greater detail in the next section.

(5) Effective tax rates in each year are based on the historical annual effective tax rates reported in the Statistics of Income [25] by respective income class. Income to the individual is assumed throughout this analysis to accrue entirely from interest earned on the award.

These net discount rates indicate that for each of the alternative tax assumptions, the average annual after-tax interest rate (weighted by the principal amount invested each year) earned by the plaintiff over the period of loss was less than the average annual growth rate in the medical care price index.

The present values for the nonallocated and allocated award examples, however, assume that the residual medical expense tax deductions are not used as a tax shelter for other income (e.g., other plaintiff's earnings, interest income on an award for lost earnings, spousal earnings, investment income, etc.). The tax benefits of the residuals can be substantial. In the examples in Table 1, the value of the residuals at the beginning of 1966 [discounted to present value using the before-tax riskfree interest rates in column (2)] is $62,083 for the nonallocated award and $34,711 for the allocated award.(6)

Results of Study

The time series means and standard deviations of the net discount rates across successive periods of loss from 1952 through 1985 are presented in Table 2 for both the nonallocated and allocated award assumptions, for each of the seven price indices and for varying numbers of years of loss.(7) For example, the study period encompasses 20 successive 15 years periods that yield 20 observations of the net discount rate for 15 years of loss. The mean and standard deviation of these 20 observations for the price index for physicians' services (PS) are -0.38 and 0.43 percent for the nonallocated award.

The results presented in Table 2 are based on the assumptions that medical expenses in each year of loss are equal to the historical medical price index multiplied by 100 and that medical expense deductions are allowed for allocated or nonallocated awards on the basis of the currently prevailing (1988) tax rules regarding the deductibility of medical costs in excess of 7.5 percent of adjusted gross income. The historical net discount rates, however, are not very sensitive to changes in these assumptions.(8)

(6) Note, however, that the medical expense tax deduction residuals decrease as other income is increased because only medical expenses in excess of 7.5 percent of total income may be deducted under current tax laws.

(7) The level of aggregation of the seven price indices is also indicated in Table 2. For example, the indices for physicians' services, dental services and hospital rooms are included in the medical care services index. The Bureau of Labor Statistics has recently begun to report less aggregated medical care indices. For a more comprehensive list of indices and their level of aggregation, see [4].

(8) For example, the time series means for the net discount rates for the medical care index listed in Table 2 for nonallocated awards are -0.50 and -0.28 percent for ten and 25 years of loss. If medical expenses are assumed to equal the price index multiplied by 25 (rather than 100) these avarages net discount rates -0.49 and -0.27 perecnt, respectively. Alternatively if the portion of interest income subtracted from medical expeses to determine tax deductions is assumed to equal 3.0 percent (rather than 7.5 percent), these average net discount rates are -0.37 and -0.36 percent respectively.

The net discount rates for the allocated award are smaller than the corresponding net discount rates for the nonallocated award. If the award is allocated, a larger present value award is required so that the plaintiff can pay the additional tax burden on interest income that results because prepaid medical expenses are not tax deductible. For example, for medical care services (MCS) for 25 years of loss the net discount rates for the nonallocated and allocated awards are -0.88 percent and -1.24 percent, respectively. These rates imply that the present value award is approximately 5 percent larger when the award is allocated.

Table 2 indicates that the net discount rates for individual types of medical expense have been relatively stable over the study period. For example, assuming a nonallocated award, a one standard deviation error in the net discount rate for prescription drugs (PD) would result in an error in present value of approximately 7 percent for five years of loss and about 10 percent for 15 or 25 years of loss. A one standard deviation error in the net discount rate for dental services (DS) would result in errors in present value of less than 3 percent for 15 and 25 years of loss.

The net discount rates have varied substantially, however, across different types of medical expenses. For example, assuming a nonallocated award, computing the present value for prescription drugs (PD) for 25 years of loss using the average net discount rate for hospital rooms (HR), rather than the average net discount rate for prescription drugs, would result in an overstatement of 173 percent.

The time series stability and cross-sectional variability of the net discount rate is further illustrated in Figures 1 and 2, where the net discount rates (for the nonallocated award) for successive 15 year periods of loss are plotted for each of the seven medical price indices. These rates are plotted so that they correspond to the first year that medical expenses are incurred. The net discount rates for dental services (DS) and physicians' services (PS) are consistent with previously published results regarding net discount rates for assessing lost earnings (1), particularly if they are adjusted for the difference in the tax treatment of interest income. The net discount rates for prescription drugs (PD) are relatively high which indicates that the growth rates in this price index are substantially lower than interest rates. In contrast, the net discount rates for hospital rooms (HR) are relatively low, because the growth rates in this price index are substantially higher than after-tax interest rates.

The variance in the net discount rates across individual medical price indices portends the problem of inconsistent aggregation. Table 3 reports the percentage differences in present values which are computed using the average net discount rates for the aggregate medical care index rather than the average net discount rates for the individual elements of medical care (as reported in Table 2). Applying the net discount rate for the aggregate medical care index can lead to significant errors in present value if the plaintiff's medical care requirements are not consistent with the weights underlying the aggregate index.

The net discount rates for the "no tax" assumptions are not presented in Table 2, because they are virtually identical with the net discount rates for the nonallocated award. This result emanates from the fact that for the nonallocated award, for almost all cases examined, the medical expense tax deduction exceeded taxable interest income in every year of loss. This analysis, however, does not reflect the potential total value of each year's tax deduction for medical expenses. In most years the medical tax deduction exceeded earned interest income by a substantial amount [e.g., see column (9) of Table 1].

The present value of the tax deduction residuals were computed for each period of loss for each medical cost series using the interest rates on one-year Treasury notes. For nonallocated and allocated awards, respectively, the present values of the residuals as percentages of the present values of medical expenses ranged from 65 to 95 and five to 20 percent for five years of loss, 55 to 85 and ten to 20 percent for ten years of loss, 40 to 80 and 12 to 18 percent for 15 years of loss, 30 to 70 and 15 to 20 percent for 20 years of loss, and 20 to 55 and 15 to 18 percent for 25 years of loss.

Conclusions

Exact present value awards for medical costs as reflected in dollar multiples of seven indices have been computed for the allocated, nonallocated, and no-tax specifications for the period 1952 through 1985. The awards reflected the changing levels of medical costs over time and the interest rates that prevailed over this period. Taxes and interest earned from investing in one-year Treasury notes were computed according to the three alternative tax treatments of medical expenses and their tax deductibility against earned income. The results of these analyses for five, ten, 15, 20 and 25 years of loss over volatile economic periods of time showed relatively stable relationships between growth rates in medical costs and after-tax interest rates earned.

For each alternative specification of taxation the formulation of awards in terms of an average net discount rate revealed that present value determinations were possible in the presence of unpredictable interest rates and unpredictable medical cost growth rates. Factors such as unanticipated inflation that resulted in rising medical costs also resulted in rising interest rates. The net effect left the present value award determination relatively unchanged. Knowledge of the base year of medical costs and the net discount rate would have allowed reasonably accurate assessment of these present value awards for each medical cost series when formulated as a simple annuity. Using the average derived net discount rate for the specific medical cost series generally produced present value award estimates within 5 to 10 percent of the present value award needed to replicate after-tax losses.

The net discount rates, although relatively stable over time for each index, varied dramatically across the different types of medical care. This cross-sectional variability suggests that the common practice of aggregating base year medical costs for different types of medical care before assessing a present value for total medical expenses may introduce substantial bias. Even if the future relationship between the growth in medical costs and the level of interest earned is consistent with historical experience, the implicit weighting in the aggregation of the broad index may differ significantly from the requirements of the specific case. More accurate awards would have been attained if the individual components of future medical costs had been projected using growth rates consistent with the historical net rates before aggregating and discounting.

In virtually all of the nonallocated present value awards computed, there was little or no tax obligation on the interest earned over the period of loss. Tax deductions for medical expenses generally exceeded the interest earned for each year of loss. The deductions in excess of interest income proved to be substantial in virtually every present value computation. These medical cost tax deduction residuals could be used to reduce the tax liability on interest earned on the award for lost earnings. Integrating the tax deductibility of medical expenses with the lost earnings analysis will produce lower present value assessments for lost earnings. The additional tax liability on future interest earned in the allocated awards resulted in lower net discount rates and lower cumulative present values of tax deduction residuals. However, the differences were systematic and the general relationship of the nonallocated awards prevailed. Any future movement by the court or the legislators to allocate awards for medical cost will necessitate larger present value payments to plaintiffs to compensate for the future tax liability on interest income.

The common practice of discounting future medical expenses to present value using after-tax interest rates on Treasury securities or rates on tax-exempt municipal bonds without consideration of the medical cost tax deductions produces biased awards that are substantially inflated. For example, if the before-tax interest rate on Treasury bonds is 10 percent and if medical expense tax deductions are large enough so that no taxes are paid on interest income, then discounting 25 years of medical expenses using an after-tax or tax-exempt rate of 8 or 9 percent will produce overstatements in the present value award of approximately 28 and 13 percent, respectively. From the perspective of the historical relationship between medical costs and U.S. Treasury short-term, after-tax interest rates, the concept of making the plaintiff economically whole mandates the ex ante determination of whether the award will be allocated or nonallocated.

TABLE : Examples of Present Value Assessments of Medical Expenses with Alternative Tax Treatments

TABLE : Time Series Means and Standard Deviations of Net Discount Rates for Nonallocated (NA) and Allocated (A) Awards for Different Components of Medical Care with Various Periods of Loss from 1952 through 1985 (in percentages)

TABLE : Percentage Differences in Present Value From Using the Net Discount Rate for Aggregate Medical Care Rather Than the Net Discount Rates for the Individual Components of Medical Care
COPYRIGHT 1989 American Risk and Insurance Association, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Author:Anderson, Gary A.; Roberts, David L.
Publication:Journal of Risk and Insurance
Date:Jun 1, 1989
Words:4986
Previous Article:The optimal investment strategy through variable universal life insurance.
Next Article:Asymmetric information, captive insurers' formation, and managers' welfare gain.
Topics:

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters