Model Variances in Assessing the Present Value of Future Medical Care

Journal of Legal Economics, Aug 2008 by Anderson, Gary A

Abstract This research investigates four alternative models for computing the present value of future medical care and illustrates the valuation differences among the alternatives. The four models are the life expectancy model, the expected med cost model, the expected present value model, and the no tax expected med cost model. Models 1 through 3 integrate tax liability on the basis of an allocated award. Valuation comparisons among the models are presented for variations across the most critical valuation parameters including, age, base level of medical care, and real future medical care growth rates. Results show only modest differences, less than 2.0%, across the first three models when the med cost growth rate approaches the before tax interest rate for all age and base level med care comparisons. Differences among models 1 to 3 increase as the net before tax discount rate departs from approximately zero. Differences of 5% to 8% result with approximate minus one and minus two net discount rates, respectively. At a plus one approximate net discount rate, the differences among models one to three are less than 2%. Omission of taxes in model 4 results in substantially lower present values with the differences increasing as the years of loss and the base level medical care increase.

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Introduction

For severely injured parties, future medical care often constitutes the greatest component of economic loss in a personal injury case. Catastrophic injuries often result in life care plans projecting future medical care needs in the hundreds of thousands to millions of dollars. The economist's task in assessing the present value of future medical care requires integration of the elements of projected future medical care needs with projected rates of growth, discount rates, tax liabilities on interest to be received on the invested award, and statistics of mortality. There are three alternative models for the integration of mortality statistics into the valuation process. These models are the Life Expectancy Model, the Expected Future Medical Care Model, and the Expected Present Value Model. This is the first research to introduce the Expected Present Value Model. The literature regarding the modeling of the present value of medical care has been limited to the Life Expectancy and the Expected Future Medical Care Models. Slesnick was one of the first to introduce some of the complexities of valuing medical care but did not address the unique IRS rulings regarding tax effects on the valuation. Anderson and Roberts (1989), Syderhoud and Chun (1996), and Ireland (1989) introduce the unique tax modeling issues of medical care, but are limited in scope to single illustrations and general discussions of the structure of the medical cost present value modeling.

In the sections to follow these models are presented along with a model of losses without taxes. Numerical illustrations of differences among the models are presented for variations across the valuation parameters, number of years of loss (age of the injured party), annual base level of medical care needs, and growth rate of future medical care. With the exception of the no tax analysis, all tax liabilities are integrated assuming that medical care is identified with specificity, i.e., an IRS allocated award. The paper concludes with a summary of findings.

Present Value Models of Future Medical Care

In many cases a life-care plan defines for the economist the base medical care costs, frequency, and needs. The economist integrates growth rates, mortality statistics, and tax liabilities on interest to be received on the invested award in computing the present value of future medical care. The two most frequently employed methods of valuation are the Life Expectancy and the Expected Medical Cost Present Value Models. The Life Expectancy Model, Model 1, front loads future medical care costs into the years of remaining life expectancy by weighting each year's future medical care with probability one to the period of life expectancy. The Expected Medical Cost Present Value, Model 2, spreads the projected med costs over the prospective remaining years of life, assumed here to age 100, by weighting each year's future medical care costs by the probability of surviving to that year. When the discount rate equals the projected growth rate, valuations from the two models are identical. Front loading medical costs in Model 1 will result in smaller (larger) present values than Model 2 when the growth rate is greater (less) than the discount rate. Model 3 is the Expected Present Value Model of future medical care. This Model differs from Model 2 in that the present values of alternative years of survival are weighted by the probabilities of death in each future year. For example, if the injured party is age 70, there are 30 possible present value series associated with living to age 71, 72, 73, etc. out to age 100. This model is identical to Model 2 only if the discount rates are equal for the two models. Since discount rates are the after tax rates for each future year, there is little reason to assume equality of discount rates across the two models. The final model presented in this research is the No Tax Expected Medical Cost Present Value Model, Model 4. This model is identical to Model 2 with the exception that future expected med costs are discounted at the before tax discount rate instead of the after tax discount rate. Model 4 reflects valuations in those states that preclude testimony regarding taxes on any of the economic elements of loss. Exclusion of taxes increases the discount rate and therefore produces the lowest present values. The differences between models 2 and 4 are the present values of the future tax liabilities on interest to be earned on the invested award in the future. In all the illustrations to follow, it is assumed that the injured party is filing jointly, taking two personal exemptions, and has itemized deductions excluding future medical care that equals the joint filing standard deduction. Future medical care tax write-offs are computed on the assumption that future medical care write-offs are excluded until the future time at which future cumulative medical care exceeds the present value award, i.e., the present value award is an IRS allocated award. Interest earned on the invested award is assumed to be the only source of future taxable income.