For merger & acquisition (M&A) transactions involving healthcare entities or physician practices, both parties in the transaction face the issue of how to best handle “tailing out”—or extending coverage—on the claims-made malpractice program. Most medical malpractice (med mal) insurance is written on “claims made” coverage forms, meaning the policy only responds to claims that are: 1) made during the policy period; and 2) for occurrences that happen after the retroactive date (claims cannot be made for events that happened prior to this date). Because it often takes many years for all the claims associated with activities during a given policy term to be reported, the premium and exposures in the early years of a med mal program are usually less than in a mature one.
Nose Versus Tail
To limit their liability for the prior acts of the other party (the “seller”), the buyer in the M&A transaction has two options: 1) “buy nose,” meaning continue the retroactive date from the prior claims-made policy on the new coverage; or 2) “tail out” the prior coverage. This entails buying an extended reporting period to keep all liability prior to the M&A purchase date with the prior carrier, and purchasing a new first-year, claims-made policy with a retro date that matches the purchase date. Of course, in comparison to option 2, option 1 increases the buyer’s liabilities. However, buyers do sometimes select option 1 because the cost for tailing out the prior coverage, plus the cost of the new policy, exceeds that of simply retaining the retro date.
In Comes the Standalone Tail
While sometimes less expensive in initial premium dollars, the increased risks associated with taking on liabilities from a time before the buyer had any knowledge of occurrences or control over business practices and risk management can come back to haunt them. If nothing else, there is increased volatility from the unknown assumed liabilities. This can spoil anticipated ROI from the M&A transaction by exceeding the liability estimates that were determined during the diligence process. This is why our preferred approach when representing the buyer is to go with option 2—start fresh by tailing out the prior coverage.
Our recommended approach is undeniably safer, but as described above, has often been more expensive, which subsequently leads to a judgment call for the parties involved. The good news: the current market for med mal insurance is very buyer-friendly as carriers price aggressively to retain their share of a shrinking pool of buyers in today’s high-volume M&A environment. This is due to the merging of physician groups and more hospitals or health plans employing physicians (versus contracting with them). A favorable byproduct of this dynamic is the emergence of “standalone tail” markets. These are programs where a new carrier buys out the tail obligations of the prior policy, whether they insure the go-forward program or not.
Claim Development Patterns Support Our Recommended Approach
Stand-alone tail products work both for the insureds and for the carriers because it offers an option to avoid the price inefficiency that comes from the in-place program’s tail premium being calculated as a multiple of the existing program’s mature premium, and instead price the actual remaining exposure which takes a number of years to fully develop.
For example, the following represents the industry norm in claims development on an incurred basis. The percentages represent the ultimate claims costs from occurrences within the policy period that are incurred (not necessarily paid) by the end of each year (Incurred = Claims Paid + Reserves).
- Year 1 – 25%
- Year 2 – 39%
- Year 3 – 31%
- Year 4 – 4%
- Year 5 – 1%
The sum of this is 100% of a mature premium. This is why first-year, claims-made policies will “step up” and cost more at renewal, and will continue to develop upwards in premium until Year 3 or 5 depending on the carrier. At that point, the premium will be “mature claims made” or roughly equivalent to what “occurrence” coverage would cost.
Based on this time-tested theory, the inverse would hold true as a program tails out per the following expected payout pattern, post claims-made program expiration:
- Year 1 – need to charge 39% + 31% + 4% + 1% = 75% (the remaining exposure)
- Year 2 – need to charge 31% + 4% + 1% = 36%
- Year 3 – 5%
- Year 4 – 1%
- Year 5 – nothing
Total of .75 + .36 + .05 + .01 = 1.71,or 171% of the mature premium.
Compare this with traditional tail options of 200% to 300% of mature premium and you understand why, assuming the mature premium was “right,” that a standalone tail program that more closely matches the actual liability is an option that should be considered in M&A situations involving medical providers.