CHAPTER SEVEN - PRICING AND ADMINISTRATION

 

A detailed explanation of the actuarial process in determining the premium is outside the scope of this text, but a basic understanding as to how rates are determined should be of value to anyone representing a Disability Income insurance product.

 

Premiums for health insurance products, both individual and group, are affected by many factors, principally morbidity rates, commissions and other provider expenses, interest, expenses and persistency (lapse rates).  The underwriting philosophy of a company and the claims techniques and administration policy can affect the pricing also.  A company with liberal underwriting practices will have a different claims ratio – hence different premiums – than a company with a very conservative underwriting philosophy.

 

Other areas not so apparent are such things as the cost of medical care in the area, and the impact of various regulations can have considerable impact.  Many states are highly consumer-oriented and have liberal provisions and additional benefits in their requirements for policy approval, but –someone has to pay for these benefits and provisions, which will be reflected in the premiums. 

 

Rating for health insurance products is very difficult but the insurer must estimate the future net annual claim costs of the products it offers as the premiums must reflect the risk that is involved. 

 

The key words for health insurance premiums are adequate, reasonable and equitable.  Insureds are categorized according to risk and these three criteria must be met for all classes.  Classification of insureds depends upon the factors that have a direct impact on claims experience, such as age, sex, geographic area and occupation, plus any restraints because of legalities and competitors.

 

As discussed earlier, if everyone were charged the same premium, adverse selection would be present as those in poor health would purchase the plan, but those in excellent health would probably not as they could find it less expensive elsewhere - or they are willing to self-insure.  This would then leave a body of poor risks at inadequate premiums, and everyone knows where it goes from there.  There are some limitations on placing risks into certain categories as the number of rating classes would be limited by the administrative expense of handling so many classifications, and further, there would not be enough policies in each categories to validate the actuarial studies.  In other words, there would not be the necessary spread of risk in each category.

 

Competition is always around and can be counted upon to help keep premiums low, or at least with reason as to the benefit involved.  Individual health insurance rates must be filed and approved in most states, as are group rates in a few jurisdictions also.

 

The most difficult criteria to meet satisfactorily, is the adequacy of the rates.  When a new product is introduced, there almost always is a safety factor built into the premiums for unexpected claims and the premiums are therefore higher than those for policies with substantial experience.  Insurers continually test their rates by running studies using various assumptions.

 

DETERMINING ANNUAL CLAIM COSTS FOR DISABILITY INCOME POLICIES

 

The annual claim costs that are used in premium calculation for a disability income benefit varies considerably by occupation class.  The following table shows the annual claim costs for one type of Disability Income insurance policy.  As explained below, the costs vary according to age, sex, occupation class, elimination period and maximum duration.  It should be pointed out that if the elimination period and the maximum duration of benefits are different for sickness than for accident benefits, separate claim costs will have to be developed taking each into consideration.

 

The following statistics are derived from the Society of Actuaries publication, 1998, and are used for illustrative purposes only.  These annual claim costs are for $100 of monthly disability income benefit with a seven-day elimination period and reflects experience for years 1986-1991.  These statistics use basically two occupational classes, white-collar jobs and blue-collar jobs.

                             

 

 

MEASURING MORBIDITY

In determining a premium, the first step is to provide a measure of the expected net annual claim cost per policy in an established line of business.  In order to predict future claims costs, the best source of this information is from the insurer’s own files, if they have been in business for a while.  Otherwise, the Society of Actuaries publishes morbidity tables for this purpose as well as studies by other insurance industry organizations.  These studies analyze claim costs for various types of benefits.

 

There are only a few Disability Income insurance companies that are able to do their pricing based upon their own experience.  The NAIC publishes public disability morbidity tables, and the Society of Actuaries publishes annual updates on disability experience.  The final analysis, of course, must come from the actuary developing the product and their interpretation as to the value of the various sources of information available.

 

As in any technical determination in insurance, a formula is used to determine the annual claims cost.  This is based upon a “Unit Benefit Cost,” which is the frequency of claims multiplied by the amount of the amount of the average claim.  The net annual claims cost is the unit benefit cost by the benefit amount.  In Disability Income insurance, the unit of exposure would be $1 of monthly benefit amount. 

 

CONTINUANCE TABLES

 

The expected claim frequency amount persons insured and the average claim value are important determinations that must be made by the actuaries.  However, since an elimination period is used in Disability Income insurance, there would be variance of claims costs based on the elimination period.  The actuary then develops a “Continuance Table” which is the probability of claims continuing for various durations or amounts.

 

The elimination period has a very dramatic effect on rates, as illustrated in the following table:

Probability of Continuation of Disability per 10,000 disabled lives or age 40, adult males

G Probability of Continuance                            Duration of Disability

 

NET LEVEL PREMIUMS

 

The net level premium for a Disability Income insurance policy (or Long Term Care Insurance) is the level annual payment needed to pay benefits (provided the claims predictions are exactly the same as the average claim amounts assumed and the frequency of claim rates as derived from morbidity tables used), if the lapse and mortality assumptions on the persons insured are the same as that assumed lapse and mortality rate, and if the rate of interest is the same as that assumed in the rate basis.  The formula to determine net level premiums is as follows:

 

Net Level Premium is:

                                           Present Value of Future Net Annual Claim Costs                     .

                              Present value of a life annuity due of 1 for the premium paying period

 

The calculation of the Net Level Premium is only of interest to actuaries and insurance accountants to some degree.  It never hurts to be familiar with the technical end of any product represented as when premium rates are increased or benefits added or deleted from policies, there can be some degree of intellectual understanding.

 

LOSS RATIO

 

Loss ratio is another term that is “thrown about” and particularly in health insurance.  If one has to explain why premiums are higher for one class of insured than for another class, or if there is a premium increase on the same policy form, the theory usually is that it is because the “loss ratio” is higher, or in case of an increase, higher than expected. 

 

Loss ratio is actually a method of establishing the level of morbidity costs based upon the ratio of claims incurred to premiums earned.  Really quite simple in concept.

 

There are two types of loss ratios, permissible loss ratio and incurred loss ratio,

 

Permissible loss ratio is the portion of each premium dollar that is used to pay claims.  The remainder of the premiums is assumed to pay taxes, expenses and profits.  Another way to put it is that the permissible loss ratio is the expected loss ratio.

 

Incurred loss ratio is the portion of each premium dollar that is actually used to pay claims.

 

Therefore, if the permissible loss ratio is compared to the incurred loss ratio, the result will be the percentage that is necessary to bring the pricing in line with the experience. 

 

GROSS PREMIUMS

 

The Gross Premiums can be simply explained as the premium that must provide for not only benefits to be paid (net level premium), but also for expenses, taxes, and funds held for contingency purposes in case claims and expenses are higher than expected.  They are usually computed on the assumption that they will be paid annually, although premiums can be paid on other basis.

 

INGREDIENTS THAT AFFECT PREMIUM CALCULATION

 

Premium rates for Disability Income insurance benefits consist of morbidity, provider payment arrangements, expenses, taxes, persistency, interest and profit/contingency margins. 

 

MORBIDITY

 

For comparison purposes, in calculating premiums for life insurance the actuaries only have to consider the number of deaths during a year compared with the total number of persons exposed in the same class.  For Disability Income insurance, however, in measuring morbidity the annual claim cost for a given age/sex/occupational class is, as described earlier, the annual frequency of the disability and the average claim when the disability occurs.

 

Generally, morbidity tables used in Disability Income insurance for benefits, exclude the experience during the calendar year in which the policy was issued.  There is not the importance of a “select” period (the period of time that it takes a newly underwritten insured to reach the experience of all of the insureds), as there is in life insurance. 

 

Disability Income insurance has rather unique morbidity statistics.  For instance, there appears to be considerable adverse selection by those who apply for Disability Income policies with short elimination periods and long maximum-durations.  Applicants who purchase insurance in the 20-30 age ranges, develop a higher level of morbidity after age 50, then those who become insured after age 50.  To further complicate it for the actuaries, experience varies considerably among various benefits.

 

PAYMENT OF PROVIDERS

 

Premium rates for HMOs and for other medical care organizations are affected by the degree to which the providers share in the cost. This is not as important a factor as for medical insurance, but could be a factor if the treating physician for the disability is a member of a provider organization.

 

EXPENSES

 

Expense assumptions used in premium calculation for Disability Income insurance include premium taxes, agents’ commissions, policy issue costs, underwriting costs, claim costs, and investigation/legal costs.  These expenses are much higher the first year (administration-underwriting-issue costs plus the higher first year commissions), and are relatively constant after the first year – except for inflation, of course.

 

PERSISTENCY RATE

 

Persistency is the length of time that a policy stays on the books (in force).  It is expressed as a ratio of the number of policies that continue coverage on the date of premium due, to the number of policies in force as of the previous policy due date.  Persistency improves with policy duration, and after, for instance, five years; the persistency rate is usually in the 90 percentile with many types of policies.

 

Persistency is important in health insurance, as expenses are higher in the first year as stated above, plus, claim ratios in health insurance increase as the age of the insured increases.

 

INTEREST

 

While low interest rates are good for many industries, it is a double-edged sword for insurance, as premiums are based upon assumed interest on the investments of the insurance company.  If interest is higher than assumed, benefits can be increased, better and less expensive policies can be introduced, and dividends are paid (if mutual company).  On the other hand, as in today’s economic climate, when interest rates are at a historic low, the insurers are not making the money on their products that they had assumed because of the difference in the assumed interest rate and the actual interest rate being collected.  With the present interest rates, many companies have had to divest themselves of investments in order to meet their profit objectives and pay claims. 

 

With Disability Income insurance, interest is very important to consider the interest in measuring the average claim cost and the value of the disability annuity can be significantly reduced because of the interest discount.

 

NOTE:  Throughout this discussion “disability annuity” or “claims annuity,” the “annuity” refers to the amount that must be paid out for a specified period of time.  In essence the insurer creates an annuity that pays out the monthly income payments at time of claim, using annuity statistics and cost of money, etc. 

 

 

PROFITS/CONTINGENCY ASSUMPTIONS

 

If the premium-rate calculations do not assume a profit and a reserve for contingency, then there will be no profits.  There are several methods of producing these assumptions, one of the simplest is to calculate the premium without the profit/contingency assumption, and then add a certain percentage of the premium to the premium for this purpose. 

 

MISCELLANEOUS PREMIUM VARIABLES

 

Changing, adjusting and monitoring costs are very important for Disability Income insurance because under a noncancellable policy, the insurer is in effect guaranteeing the premium for the life of the policy

 

If the policy is guaranteed or conditionally renewable Disability Income insurance policy, the insurer may raise or adjust the premium in certain circumstances.  If the experience of an entire block of policies experiences higher claims costs than assumed, the insurer can raise the premiums on the entire block of policies – but not separately for individual policies.

 

One of the difficulties in creating a premium that meets assumptions is that the inability to work because of the result of sickness or injury, is subjective and involves an attitude in addition to a physical or mental impairment.  Therefore, many factors come into play at time of claim – such as the level of unemployment, individual’s work ethics, the attitude of the insured in respect to retirement, attitudes of physicians who certify the disability, and last but not least, the attitude of the insurance company. 

 

In order to compensate for these variable, the underwriters perform their tasks very carefully, and use various risk classifications as discussed earlier, such as Age, Sex, Occupation, Geographical Area, Elimination Period, and other factors, such as smoking, lifestyle, etc.

 

FINAL DETERMINATION

 

Even though the calculation of the premium may appear complex, there are several other factors that must be taken into consideration that are beyond the scope of this text.  However, one of the most important factors is simply that of actuarial judgement.  Actuaries may voice this factor in different ways, but simply put, after the premiums have been determined, they look at it and ask if it makes sense and will it do the job intended, and further, how does it stand up to competition. 

 

There have been more than a few instances where an actuarial department has slaved to develop a new product, and then when it is announced, discover that another company offers a similar or nearly-the-same product, but at lower rates and/or higher commissions.  This is called, “Back to the drawing board!”

 

While agents certainly are not required to understand the entire premium-making and/or product development process, it is important to note that new products are almost always a result of a request of the marketing department and agents’ requests.  Then once the product is introduced, it is the marketing department and agents who really determine whether the product performs as intended.  Insurance company files are full of policy forms and rates of products that the agents could not or would not sell.

 

HEALTH INSURANCE RESERVES

 

It is necessary, in a business sense and also legally, that proper provisions be made in the liabilities of the insurer to make sure that there are sufficient funds to be able to honor all policyholder obligations.  This is accomplished by setting up liability accounts for both present and future claims.  The funds come from premiums collected and are held as claims against the assets of the company.  The technical word for these funds are Reserves - used to pay future claims and present obligations.

 

This is a technical aspect of Disability Income insurance and actual amount of reserves are established using actuarial studies, statistics and formulae that are (way) beyond the scope of this discussion.  However, it is a very important financial feature of the policy and one should at least be familiar with the terminology. 

 

Reserves (for all health insurance products) consist of three types:

1. Policy reserves which are those reserves necessary for the company to meet all of its contract obligations and can be simply defined as the present value of future claims.

 

1. Claim reserves and liabilities basically are those that cover claims that are incurred but not as yet paid.

 

1. Expense liabilities are technical reserves that are used to pay loss adjustment expenses and taxes that the company must pay and that have accrued prior to the filing of an annual financial statement.

 

ANNUAL STATEMENT

 

The preparation and the contents of the NAIC Annual Statement is rather complicated and is performed by actuaries.  The accuracy of the numbers contained in the annual statement are attested to by other actuaries typically, and it must be audited by an independent accounting firm.  It is a form that is filed with the Department of Insurance and is required to be filed by all insurers who are licensed to write business in that state.

 

The annual statement consists primarily of the balance sheet and the summary of operations.  For the purpose of this discussion, only some of those items appearing on the balance sheet are of interest.  The final accounting of the balance sheet is

                              Assets = Liabilities + (Capital Stock + Surplus)

 

An example of the financial categories on an Annual Statement of Financial Condition of an insurer as of December 31 of each year: 

 

 

UNEARNED PREMIUM RESERVES

 

Technically, the unearned premium reserve for individual coverage is the pro-rata portion of the policies’ gross premium, from the time period from when the statement is filed (Dec. 31, of previous year) to end of the time period for which policy premiums have been paid on the policy, regardless of any policy renewal provisions.  Perhaps it can be more easily understood by simply using the name of the reserves “Unearned Premium” – the premiums that have been paid to the insurance company for coverage that it has not as yet afforded the policyholder.  If the premiums paid on a policy on an annual basis, for instance, is $100, but the policy was dated July 1, then only half of the premium is earned at the end of the year. (The remainder will be earned at the rate of 1/12 each month, until July 1 of the next years, etc.,)

 

POLICY RESERVES FOR LONG-TERM HEALTH INSURANCE

 

Special reserves must be set up for individual disability policies (and Long Term Care insurance and hospital benefits policies) as they are priced on a level annual premium basis and may (or may not) offer premium guarantees for a number of years.  Disability Income insurance is usually only issued to age 65 and the premium is level until that age.  But since morbidity (chance of claims) increases with age, the premiums are, in effect, an overcharge of anticipated claims at the younger ages and an underpayment in later years – similar to the premiums of whole life insurance policies.  This reserve is eventually used up by the passage of time until it reaches zero at expiration date (age 65 usually).

 

Also similar to life insurance, for policies of this type (noncancellable and guaranteed-renewable) the NAIC allows the company to post “zero” reserves for the policies first two years.  The minimum standard for the valuation of disability income policies is the 1987 Commissioners Group Disability Tables.  The Departments of Insurance dictate which morbidity and mortality tables must be used, etc., by the actuaries in determining this reserve.

 

CLAIM RESERVES

 

Claim reserves are amounts that the insurer expects to pay (in the future) for claims that have been incurred prior to the date of the Annual Statement, and have not been paid in full.  Since claims in Disability Income insurance tend to be of Long-term duration, these reserves are particularly important. 

 

There are several different and technical methods of assuming the claims amounts that are outstanding but not paid in full.  Claim reserves pertain only to payments in the future that are not certain.   Claim “liabilities” on the other hand, are items due, unpaid claims and claims that are in the process of being settled.  Reserves must use actuarial assumptions, which are not needed to record liabilities.

 

RESERVE FOR AMOUNTS NOT YET DUE ON CLAIMS

 

The first part of this reserve is for amounts of payments that the insurer would not be required to pay if the insured were to recover from a covered disability at the end of the year.  While this part of the reserves is for future unaccrued payment, the second part refers to unreported claims.

 

The reserve liability for disabled lives is particularly technical and complex in Disability Income insurance.  For example, the rate of recovery from a claim decreases with the length of time the insured is disabled, the value of the claim annuity for a long-duration benefit period increases for a certain period of time, and then decreases to the end of the benefit period.  As one can imagine, in order to establish these reserves, each individual claim must be analyzed as to the date of the claim incurred, the age of the insured at time of disability, length of time that the insured has been disabled, and the number of years of benefit still remaining.  This is necessary in order to establish the necessary claim annuity factor to the monthly benefit amount. 

 

LIABILITY FOR CLAIMS DUE AND UNPAID

 

This is usually a small amount that represents claims that are approved but not yet paid.

 

LIABILITY FOR CLAIMS IN THE COURSE OF SETTLEMENT

 

This represents those situations where a claim has been filed, but final determination has not been made and the insurer is awaiting proof of claim or other such documentation before a claims determination can be made.

 

LIABILITY FOR CLAIMS INCURRED BUT NOT REPORTED

 

In many situations, the insurer was not aware of a claim at the time the Annual Statement was filed because the insurer had not been so notified.  Usually this is an estimation based upon the volume of business inforce or premiums earned on that business.

 

LIABILITY FOR EXPENSES

 

The insurer must estimate the amount of claim expenses that will be paid on any unpaid loss at time of Annual Statement.  Generally this is determined as a function of the average amount of claims paid and applied to the unpaid loss.

 

OTHER RESERVES

 

Group Reserves and Liabilities are usually smaller as premiums are collected on a monthly basis and the company reserves the right to change the premiums on anniversary date.  Otherwise, the reserves and liabilities will generally be the same as for individual.

 

Liability for Dividends Payable must be establish if there are participating Disability Income insurance policies, and therefore there must be a liability established to pay the dividends that will be paid after the Annual Statement date.

 

Contingency Reserves are often established and are voluntary reserves in case the claims cost increase because of the trend of claims or an unexpected event.  Contingency reserves are often required for group health business.

 

STUDY QUESTIONS

 

1.  Health insurance premiums should NOT be

      A.  adequate.

      B.  unreasonable.

      C.  reasonable.

      D.  equitable.

 

2.  If every insured were to be charged the same premium, the healthier ones would be most likely to stay and the unhealthy ones would stay.  This is called an example of

      A.  anti-selection against the company.

      B.  morbidity fluctuations.

      C.  presumptive forecasting.

      D.  inverse selection.

 

3.  When pricing an insurance product, the most difficult criteria to meet satisfactorily is

      A.  actuarial costs.

      B.  competition.

      C.  adequacy of the rates.

      D.  the commission schedules.

 

4.  The first step in determining a premium is

      A.  to see what competitors are offering.

      B.  to ask the insurance department how high the premiums can go and still be approved.

      C.  to provide a measure of the expected net annual claim cost per policy.

      D.  to receive approval from the Society of Actuaries.

 

5.  The chart which shows the probability of claim continuance for various durations or amounts

      A.  is the net level premium chart.

      B.  is a mortality table.

      C.  is a morbidity table.

      D.  would be a continuance table.

 

6.  The level of morbidity costs based upon the ratio of claims incurred to premiums earned, is

      A.  the loss ratio.

      B.  persistency tables.

      C.  administrative percentages.

      D.  used to determine life insurance premiums.

 

7.  Funds for health insurance reserves for present and future claims, come from

      A.  stockholder assessments.

      B.  premiums collected and held as claims against assets of the company.

      C.  the Federal Health and Security Agency.

      D.  only reinsurers.

 

8.  If a policy is issued in July and annual premiums are collected, the premiums for July are considered as having been earned by the company as the company provided the contractual coverage.  The remainder of the annual premiums (11/12) are considered as

      A.  commission advances.

      B.  a reserve for amounts that are not yet due on claims.

      C.  the unearned premium reserve.

      D.  reserve for fluctuation of expenses.

 

9.  Claims reserves are payments in the future that are not certain and requires actuarial assumptions.  Items that are due, unpaid claims and claims in the process of being settled do not require actuarial assumptions, and are called

      A.  Liabilities.

      B.  Assets.

      C.  Probable reserves.

      D.  Surplus.

 

10.  An insurer introduces a new type of Disability Income insurance which is sold on a group basis.  The plan is introduced principally because of market share protection, and the actuaries are emphatic that there really is not enough data available to price the product correctly, but indications are that the claims ratio may increase.  What could an insurer reasonably do financially?

A.  Get special approval from the department of insurance whereas if there were excess claims, the state insolvency fund would cover any losses.

B.  Make plans to move their home office to another state where they could reincorporate if the claims got too bad.

C.  They could transfer their block of business to an off-shore subsidiary.

D.  They should establish contingency reserves (which probably would be required anyway since it is group business).

 

ANSWERS TO STUDY QUESTIONS

1B    2A    3C    4C    5D    6A    7B    8C    9A    10D