GHC 819-18: Practices for Preparing Health Contract Reserves Flashcards
Introduction
- Common practices provided by American Academy of Actuaries’ Health Practice Financial Reporting Committee (HPFRC)
- Statutory Accounting Principles (SAP) – refers to SSAP 54
- Generally Accepted Accounting Principles (GAAP) – refers to FAS 60
a. ASC 944 superseded FAS 60, but article still uses FAS 60
b. Some HMOs and other organizations (e.g. Blue Cross Blue Shield) fall under ASC 954 - Contract reserve – excess of present value of future policy claims over present value of future net
premiums
- a.k.a. policy reserves or additional reserves
- Sometimes called “active life reserves”, but this article uses active life reserves = contract reserves + unearned premium reserve for a policy
Purpose of Contract Reserves
- Matching future revenue with future costs
- Mismatch when PV (Future Net Premiums) < PV (Future Claims)
- Contract reserves – represent portion of current and past premiums needed to pre-fund future increases in claims
- Solvency perspective – without contract reserves, insurer’s net worth would be overstated
- Would report excessive profits in early years and excessive losses in later years
Main GAAP and SAP Guidance on Contract Reserves and Differences Between Bases
1. GAAP (FAS 60)
a. Classifies liabilities by duration
- Short duration
i. Insurer can cancel contract or adjust premiums or level of benefits
ii. Regulation interpreted so that insurers cannot establish liability for future policy benefits
- Long duration
i. Insurer can’t make unilateral changes
ii. Noncancelable, guaranteed renewable or collectively renewable contracts are considered long duration
iii. Insurer establishes liability for future policy benefits (“benefit reserves”)
b. Doesn’t prescribe methodologies or assumptions
c. FAS 60 Guidance
(1) Assumptions should include provision for adverse deviation (PAD or PfAD)
- Increase the policy reserve
(2) Assumptions used when policy first recognized continue to be used
- Except when premium deficiency exists – then original assumptions are unlocked and replaced with current assumptions
- Known as the “lock-in principle”
2. SAP (SSAP 54)
a. Doesn’t define short or long duration. Instead simply classifies as Life, Accident and Health, Property and Casualty, and Deposit-Type
b. Policy reserves include unearned premium reserves and contract reserves
c. Provides minimum reserve standards
d. Contract reserves required for Accident and Health contracts with level premiums and contracts where PV (future benefits) > PV (future premiums)
- Exceptions:
(1) Not required if contracts cannot be continued one year from issue or
(2) Rates for a particular block are determined so that each year’s premium covers that year’s cost (i.e. no pre-funding)
- Insurers right to increase premiums or decline renewal doesn’t matter (as it does in GAAP)
e. Appendix A-010 of SSAP 54 – prescribes methodologies and assumptions for minimum reserves
- Can use alternative methods if shown to be greater than minimum
- Assumptions prescribed for mortality, morbidity, termination rates and interest rates
- Conservatism used in assumptions
* Contract reserves under SAP will differ from GAAP (GAAP has more freedom)
f. Doesn’t address “lock-in principle”, but assumptions generally remain unchanged after policy issuance
Types of Health Insurance Products Typically Requiring Contract Reserves
- Issue age premium structure (level premiums based on age at issue) with increasing future claims
a. Individual disability, Long-term care, Medicare supplement, Specified disease (cancer) - Products where underwriting selection creates mismatch in future claims and premiums
a. Individual major medical - Attained age products if future premium increases don’t match future claim increases
- Since GAAP only allows reserves on long duration products, this classification can be interpreted in different ways
a. Some insurers classify group Long-term Disability as long duration
- Allows deferred acquisition costs to be amortized over longer period
b. Could argue that small group medical is long duration, since insurer can’t unilaterally not renew the contracts
Appropriate SAP or GAAP Contract Reserve Assumptions
1. SAP
a. Use sound value of liabilities to come up with contract reserves
b. Reserves should be appropriate under moderately adverse conditions, but not be excessive
- Include provisions for adverse deviation
c. SAP reserves usually greater than best estimate reserves
- Rely on own experience or industry for best estimate reserves
2. GAAP
a. Liability uses methods and assumptions applicable at time insurance contracts are made
- Also include provision for risk of adverse deviation
b. No prescribed assumptions
- Best estimate basis (least conservative) – GAAP (middle) – SAP (most conservative)
- Assumptions used for premium development may be used
i. Must consider any changes since the premiums were originally established
ii. More common for actuaries to change interest rate or persistency
iii. Less common to change mortality or morbidity
- ASOP 42 – discusses contract reserve assumptions
Contract Reserve Methods Under SAP and GAAP
1. SAP
a. 2 year full preliminary term method for most benefits
- Exception:
(1) LTC – 1 year full preliminary term and
(2) Return of Premium benefits – 1 year or 2 year full prelim. term (1 yr if benefits are provided before 20th anniversary)
b. Allows for reduced reserves in initial 2 years of policy to limit surplus from acquisition costs
c. This is a minimum standard
- Many carriers use a reduced preliminary term or net level premium method (when product has minimal acquisition costs)
i. Matches premiums more effectively with expenses
2. GAAP
a. Net level premium method
- With deferral of acquisition costs
3. GAAP and SAP – if contract reserves are deficient, additional reserves required (determined by gross premium valuation)
Tax Deductibility of Contract Reserves
- Contract reserves are tax deductible if contract is noncancelable or guaranteed renewable
a. Tax reserves calculated using 2 year full preliminary term (1 year for LTC)
i. Prescribed assumptions for mortality, morbidity, interest and lapsation
b. Premium deficiency reserves are not tax deductible
Unlocking GAAP Assumptions
- Original assumptions used unless they are unlocked
- Situations Where GAAP Assumptions May Be Unlocked
o 1. Premium deficiency (shown by gross premium valuation) o 2. Pattern of profits followed by losses (shown in projection) o 3. Internal replacement occurs
Unlocking GAAP Assumptions When There is Premium Deficiency
- Recognizing premium deficiency
a. Write off DAC or increase reserves (uses best estimate assumptions) - New assumptions are now locked-in
- GAAP doesn’t specify order or writing off DAC or increasing reserves
a. For short duration, GAAP says unamortized acquisition costs are first recognized, then liability accrued - Best estimate assumptions used in Gross Premium Valuation (GPV)
Establishing Contract Reserves When There is Changing Benefit or Premium Pattern
Methods of Modifying Reserve Factors
1. Do nothing Approach
2. Proportional Approach
3. Benefit rider approach
4. New Factor Approach
5. Assume Benefits increase initially Approach
6. Loss Ratio Approach
- Contract reserves usually determined at issue assuming level premiums and increases in benefits for only aging and medical trend, if any
- SAP – inflationary increases
a. Reserve factors should recognize anticipated increase in benefit costs from aging and can also consider inflation, changes in utilization, etc - Methods for Modifying Reserve Factors
a. Do Nothing Approach
- No adjustments. Use if company has pattern of increasing their rates when future benefits increase
b. Proportional Approach
- Each year multiply contract reserve by cumulative inflationary factor for cost increases
c. Benefit Rider Approach
- Each year new set of contract reserve factors and add to prior year factors
d. New Factor Approach
- Each year completely new set of factors
- Not appropriate for GAAP (due to lock-in principle)
e. Assume Benefits Increase Initially Approach
- Assume pattern of future benefit increases at issue
f. Loss Ratio Approach
- Project a target loss ratio
- Reserve is retrospective difference between expected claims and actual claims
- Not often used for SAP
How Gross Premium Valuations and Contract Reserves Interact
1. GPV compares PV Future Claims, Expenses and Ending Reserves to PV Future Premiums and Current Reserves
2. SAP
a. This is ultimate measure of reserve adequacy
b. Extra reserves are needed if there is any inadequacy
3. Taxability
a. Some companies perform GPV prior to premium deficiency testing
- GPV related extra reserve is tax deductible
- Premium deficiency reserve is NOT tax deductible
Comparison of GAAP Loss Recognition Testing and GAAP DAC Recoverability Testing
1. Recoverability Testing
a. First contract year
b. Applies to all new business
c. Tests for premium deficiency
d. GAAP assumptions
e. Includes PAD
- If test fails, test is performed again without PAD
- If test fails without PAD, adjustments are made to DAC and reserves
2. Loss Recognition Testing
a. Any time
b. Done whenever actual experience materially deviates unfavorably
c. Applies to all business in force
d. Testing done without PAD
How to Perform GAAP Recoverability Testing and Loss Recognition Testing
1. Both tests compare net liability position to minimum liability derived from GPV testing
a. GPV = PV (Remaining Benefits and Expenses) – PV (Remaining Gross Premiums)
- Uses best estimate assumptions
b. Probable loss exists if net liability is less than GPV
- Reduce DAC or increase GAAP benefit reserves
2. Contracts are grouped consistent with how company acquires, services, and measures contracts
a. Companies can choose the groupings, but must be consistent in future testing
b. Higher level of aggregation gives more opportunity to use sufficiencies to offset deficiencies
Comparison of SAP Gross Premium Valuation Test to GAAP Loss Recognition Testing
1. SAP – GPV
a. Done when a significant doubt exists about reserve adequacy for major block of business or company as a whole
b. Immediate loss recognition and reserves restored to adequate level
c. Aggregate all contracts in a given line of business or for company as a whole
2. Areas of Differences between SAP GPV and GAAP Loss Recognition Testing
a. Timing of Tests
- SAP – only when there is a concern of adequacy
- GAAP – performed as a regular course of business
- May be situation where SAP is fine (because it is conservative) but GAAP is deficient
b. Grouping
- SAP – aggregate level or company level
- GAAP – consistent with how products are acquired, serviced and measured
- Not a huge difference, but wide variety of interpretations
c. Treatment of Expenses
- SAP – includes all expenses
- GAAP – only settlement and maintenance costs
d. Conservatism
- SAP – produce adequate reserve under moderately adverse experience
- GAAP – expectation of ultimate outcomes
- May assume future morbidity and rate increases, while SAP usually doesn’t
GAAP - Determininng Profits Followed by Losses
- Require period-by-period projections
- Common for products to show losses followed by profits (reflects acquisition costs)
- Products showing profits followed by losses require special treatment to strengthen reserves
a. Even if not deficient in aggregate
b. Liability increased by amount necessary to offset losses that would be recognized in later years
c. Relevant for scenarios where gross premium rates are increased on guaranteed renewable products (originally priced with level premium assumption)
- E.g. Long-term care - Some companies assumed premium rate increase event allowed unlocking of assumptions
a. Guidance from 2008 clarified that this is not the case
