Group Chap 26: Experience Rating and Funding Methods Flashcards
Introduction
1. Rating formulas – enable underwriters to estimate expected claim costs of any policyholder
a. Rates from formula can be “manual” (from a rating manual) or “community” (based on average rates over insurer’s portfolio)
b. Weakness – unable to account for correlation between successive policy periods
2. Experience rating – policyholder’s expected claim costs are estimated using actual past claims
a. Accounts for correlation effects
b. Implicitly accounts for employee demographics, occupations and locations, and other factors not in manual rating formulas like employee lifestyle, turnover rates, average income and other factors
3. Actual claim costs reflect prior enrollment and prior plan designs
a. Manual rate based on enrollment and plan design for future period, so it may be used to estimate effect of changes on experience rates
4. Experience rating can be prospective, retrospective or both
a. Prospective – estimation of future expected claim costs using actual past claim costs
b. Retrospective – evaluation and measurement of financial experience of past period (policy period)
▪ Supports contractual arrangements such as experience refunds or policyholder dividends where policyholder can benefit from favorable experience
5. Use of judgement in rate setting is important but beyond scope of this chapter
Experience Rating Context and Background
1. Group policyholders – seek quality coverage at reasonable cost that enables them to attract and retain productive work force
a. Many groups believe their costs will be lower than average, so they expect a rate based on their own experience would be lower than a manual rate
b. Experience rates add transparency to pricing process
2. Group insurers – seek to offer coverage at most accurate rate possible
a. Minimizes insurer’s exposure to risk of antiselection and allows them to be competitive (don’t want to be too high or too low)
3. Key Elements to Identify in Group Experience Rating:
a. Group size where group’s actual claim costs offer little information to estimate their future periods (i.e. insurer will use rating manual or community rates only)
b. Group size where group’s actual claim costs are demonstrably more accurate than rating manual (insurer will use experience, and only use manual where necessary for estimating effects of changes)
▪ Between group sizes 1 and 2, many insurers use a weighted average of experience and manual rates
▪ Credibility factor – weight applied to group’s experience rate, between 0-100%
* Setting this factor is a balance of theoretical and practical considerations
Considerations entering into Choice of Credibility Levels
- Theoretical Considerations
- Practical Considerations
1. Theoretical Considerations
Theoretical considerations entering into choice of credibility levels for experience rating:
a. Coverages with low frequency of claim are more volatile and will require a larger exposure base for a given credibility level
b. Coverages with widely varying claim sizes will tend to be more volatile
c. Statistical confidence interval chosen by the insurer
d. Portion of experience due to statistical fluctuation has historically been treated as varying inversely to the square root of the number of claims or exposed lives
e. Development of credibility factors requires recognition of non-zero correlation between experience period and projection period (not stochastically independent for most coverages)
f. Typical measure of credibility is number of lives covered, but covering a longer period rather than more lives may be appropriate if claims are independent
2. Practical Considerations
Practical considerations entering into choice of credibility levels for experience rating:
a. Regulatory restrictions on experience rating for certain group sizes
b. Competitive pressures
c. Administrative and managerial units within the company and their ability to cope with experience rating
d. Trade-off between the added cost of applying experience rating and the resulting gains in volume and quality of new business
e. Effect on existing business of change in credibility
f. Management philosophy regarding experience rating
g. Need to be internally self-consistent between classes of business
Prospective Experience Rating
- Deelopment of Claim Experience
- Adjustment to reduce effect of Random Variations
- After Pooling
- Final Adjustments
- Setting Pooling Charges
- Small Group Considerations
1. Actuary’s role to create insurer’s experience rating plan (along with underwriting collaboration), establish methods to evaluate prior experience and set prospective rates
2. Development of Claim Experience
a. Individual specific conditions not commonly examined for large groups
b. First step – develop estimate of incurred claims (all claims incurred during experience period, regardless of when they are paid)
c. Claim data starts with dollar amount of claims paid over experience year
d. Adjustments and calculations to claim experience must be made for:
▪ Incurred but unpaid claims
▪ Extrapolating rates for a full year from a partial year’s experience
* Necessary because new premium rate will be needed before year is complete
e. Incurred claims = Paid Claims + Ending reserve – Starting reserve
- Incurred claims = Paid Claims + Change in reserve
3. Adjustments to Reduce Effects of Random Variation
a. Insurer will apply techniques to dampen random statistical fluctuations on experience
▪ Idea is to develop premium rates to be charged for the future (with prospective rating)
b. Catastrophic claim pooling
▪ Forgiveness of some or all of exceptionally high claims on individuals within the group
* Claims often called “catastrophic”, “stop-loss” or “shock” claims
▪ In return, an average charge (pooling charge) is made to all groups participating in this feature
▪ Over time, the pooling charge included in the experience of all groups must be large enough to equal the average cost of claim modifications made through the pooling process
▪ Claim Distribution (see graphs in source material for additional detail)
* High probability of small claims and low probability of large claims (high on the left side of the graph and then very long right tail when graphing Claim Size vs Frequency)
* Aggregate claims are the distribution of the sum of individual claims
c. Skew of aggregate graph changes with size of group
▪ As group size increases, distribution has lower variance and is less skewed (becomes nearly normally distributed, though right tail is slightly longer than left tail)
d. Specific stop loss (catastrophic claim limit) reduces skewness of aggregate claims distribution
e. Loss ratio/rate increase limits
▪ Puts an upper limit on the loss ratio used in setting future rates
▪ This is equivalent to
(1) Setting an upper limit on the percentage rate increase which a group will be charged
(2) Setting an upper limit on the aggregate claim dollars a group will be charged (aggregate stop-loss)
(3) Lost income must be recouped through an average charge over all groups
f. Credibility Weighting
▪ Benefit of credibility weighting experience with manual rates – estimates of claim costs are more accurate than estimates from experience or manual rates alone
▪ Credibility Weighted Expected Incurred Claims = C * Experience Based Expected Incurred Claims + (1-C) * Manual Based Expected Incurred Claims
* C = credibility factor
g. Multi-year averaging
▪ Combines several years of experience to smooth out fluctuations in a single year
▪ Weighted average that usually gives greatest weight to most recent year
▪ For example:
* Pooled loss ratio in year Z = (5 * LR in year Z + 3 * LR in Z-1 + 1 * LR in Z-2)/9
▪ Avoid using when there is high turnover in the group or any other dramatic population changes in the group
▪ Adjust loss ratios by year to reflect consistent treatment of ACA taxes and fees
h. Combination methods–many of the methods can be used together
▪ E.g. catastrophic claims pooling applied before taking multi-year average of claims
4. After Pooling
a. Rate Basis Considerations
▪ “Charged claims” – result of pooling process results in charged claims
▪ Must look at exposure base – premium or number of people covered (employees, members, etc)
▪ Unit cost – derived with ratio of claims and exposure on a consistent basis
* Form starting point for projected unit costs
* Must make sure mix of business in historical period is representative of mix in projected period
b. Trend
▪ The next step is the translation of historical experience to expected future experience
▪ Involves trending to account for changes over time
▪ Factors which have an impact on the expected costs in prospective rating period include:
* Changes in government programs
* Secular or cyclic trends in rates of disablement or length of disability
* Mortality trends
* Utilization or cost trends in medical trend (including changes in provider agreements, pandemics, benefit design)
* Changes in demographic characteristics
* Changes in benefits in the plan
* Antiselection opportunities by insured
* Changes in insured, economic, or financial environment
▪ Trending typically occurs from the midpoint of the experience period to the midpoint of the projection period, but this may not always be true
* Consider case where group grew rapidly during experience period
* Average exposure may be beyond the midpoint of the experience period
c. Non-Claim Costs
▪ Gross premiums – premiums actually charged, must account for expected claims and a number of other items (“loadings”)
* Called “retention” of the insurer
▪ Common Retention Items for Insurers
* Expense loadings and ACA fees
* Deficit recovery charge
- If policyholder has incurred losses in prior years that have not been recovered, insurer may build in to recoup past losses
* Termination risk charge
- If a policyholder in a deficit terminates its contract, the insurer has no means to recover losses
- For this reason, the termination risk charge is made in advance on all policyholders
* Pooling charges – generally shown in the development of premium
* Profit charge (aka contribution to free reserves) – this item is often built into other assumptions rather than broken out separately
* Investment income
* Explicit margin – comfort factor built into rates
d. Risks associated with rate guarantees
▪ Misestimation risk – since insurer is locked into rates for a longer period, impact of Misestimation of costs is greater than for a one-year contract
▪ Trend risk – if claims are greater than expected, effect will be magnified over time, and there is more risk for inaccuracy due to changing conditions
**5. Final Adjustments **
a. The insurer may wish to make an adjustment for reasons that have nothing to do with premium adequacy (e.g. a politically sensitive policyholder)
6. Setting Pooling Charges
a. Insurers assume underlying manual rates represent the aggregate experience of the group pool
b. If pooled or manual level of claims correctly set at average level, the aggregate result of applying a pooling formula to all groups will not change the total pre-pooling incurred claims
c. Pool averages – only non-credible portion of claims is pooled, so only this portion is the pool that is averaged
d. Avg non-credible claims different than credible avg claims – due to combination of 1) insurer’s experience that is biased to higher or lower claim levels by size of group and 2) credibility formula that varies by size of group
7. Small group considerations
a. Use of prospective experience for small groups presents unique set of problems
b. Definition of “small” depends on coverage and state
▪ For medical, usually 50 employees or under
▪ For life and AD&D, usually 500 employees or under
o Effective January 2014, small group medical coverage is community rated, eliminating experience
rating in this market
Retrospective Experience Rating
- The Retrospective Process and Its Characteristics
a. Reflecting claim levels from group’s own characteristics (prospective experience rating) has become common
b. Also common to give group the financial benefit of good experience and hold them accountable for adverse experience (retrospective experience rating)
▪ Excess of good experience can be accumulated in an account or refunded
* If accumulated – usually called premium stabilization reserve, claim fluctuation reserve, or contingency reserve
* If refunded – called dividend, experience refund or surplus share
2. Typical Experience Refund Formula
a. Formula balance = Prior formula balance carried forward + premium + investment earnings on money held – claims charged – expenses charged – risk charge – premium stabilization reserve addition – profit
3. Prior Formula Balance Carried Forward
a. If prior years balance has not been eliminated, remaining balance is carried forward
b. Negative balance can be eliminated with payment from policyholder or company writing off the balance
▪ Insurer’s hope is that negative is carried forward and offset by future positive surplus
4. Premiums
a. Simply premium paid, possibly adjusted for interest charges
5. Investment earnings on money held
a. Investment income held on claim reserves or prior year balance roll forwards must be considered
b. For coverages with significant balances, can be a significant source of income
6. Claims charged
a. Developed over several steps
b. Determine Historical Claims Experience
▪ Should be done on an incurred basis
▪ Doesn’t require measure of exposure (since no projection of results is needed)
▪ Retrospective claims usually done on aggregate basis
▪ Managed care coverages – cause unique considerations
▪ Reserves for retrospective calculations often include larger margins than prospective:
* Less competitive pressure with retrospective arrangements (policyholder benefits if price was too high)
* Conservatism with excess money being held will likely be released in future calculations (for continuing policyholders)
* Conservatism translates to added margin of comfort to insurer that policyholder claims can be paid out of historical premiums (for terminating policyholders)
c. Modifications to Claims Experience
▪ Specific stop-loss claims (or claims in excess of pooling threshold) are removed
▪ Incurred claims in excess of the aggregate stop-loss pooling level are removed from incurred claims
▪ Stop loss pooling charge is added back in
▪ Additional credibility pooling adjustments
▪ Add in excess claim cost for conversion privileges
d. Generic formula for charged claims is:
▪ Claims charged = Claims paid + Increase in claim reserves – Pooled claims + Pooling charges + Conversion charges + Claim margins
7. Expenses Charged
a. Expenses are generally allocated to lines of business
b. Usually broken out into detail such as commissions, premium taxes, conversion charges (if not included in claims charged), overhead, etc.
c. Often higher in first year than renewal years to reflect initial acquisition costs
d. Expenses for optional service such as a wellness program are typically separate and attributed only to policyholders choosing the service
8. Risk Charge
a. Generic term to cover charges for a multitude of risks
b. Usually charge is made to cover risk that the policyholder will leave insurer in a loss position
c. Should take into account expected variance of a group the policyholder’s size
9. Premium Stabilization Reserve Addition
a. Most carriers reduce their risk of being in a deficit position by accumulating a portion of
policyholder surplus in a reserve to offset experience fluctuations
10. Profit
a. Most carriers are reluctant to show an explicit profit charge on experience exhibits which are shown to policyholders
b. Profit margins are often built into other assumptions
c. For coverages subject to trend, contributions to surplus are required just to maintain capital position. Example:
▪ If insurer wants to maintain surplus level = 25% of prem,
▪ If trend is 10%
▪ Profit or contribution to surplus must be 10% * 25% just to maintain surplus position
11. Applicability
a. Group size
▪ A certain level of resources is needed to compile, analyze, and communicate experience specific to a policyholder
▪ Smaller group sizes may not be worth that investment and may also not have credible experience
▪ Prospective rather than retrospective rating is probably a better alternative in such situations
▪ Groups of 50 or fewer (for majority of states) with medical coverage, prospective and retrospective rating is not allowed with fully insured rates
b. Contract provisions regarding the funding arrangement
▪ The choice of funding methods will have an impact on whether retrospective formula will apply
c. Company policies and practices
▪ Nonprofit and mutual companies may limit use of refunds
d. Company financial situation
▪ Unless a refund formula is guaranteed, carrier’s financial health is an overriding factor in any refund situation
Special Funding Arrangements
- Traditional Fully Insured Plans
- Reserveless Plans
- Min. Premium Contracts
- Retrospective Premium Arrangement
- Self-Insured Plans
- Level-funded Contracts
- Stop-loss Contracts
- Final Considerations
1. Traditional Fully-Insured Plans
a. All cash paid out to insurer is treated as premium, and claims are paid by the insurer
b. Considerations in using this arrangement
▪ Insurer bears immediate risk of adverse experience
▪ Insureds have the security of the insurer being the claim guarantor
▪ Premium tax will be owed on money flowing to the insurer
▪ Contracts will be subject to state insurance laws (As opposed to ERISA laws)
▪ Fully insured plans subject to benefit mandates, premium taxes and ACA taxes and fees
2. Reserveless Plans
a. Insurer foregoes premium payments up to a specified level intended to equal part or all of the claim reserves in return for a promise by the policyholder that they will pay the needed amount upon termination
▪ Final premium is called “terminal” premium
▪ Also called “deferred premium” or “premium drag” plans
▪ Risk that policyholder will be unable to pay
b. Switching to reserveless plan provides only a one time premium reduction
▪ Renewal premiums likely substantially higher than those in first year
3. Minimum Premium Contracts
a. Similar to Reserveless Plan
b. Minimum premium rideris attached to a fully insured contract, which modifies the funding to have most or all of the claims portion of the premium be used to fund claims directly without becoming premiums
b. Policyholder deposits funds to an account as they are needed
c. Claims are paid from the fund, insurer is liable for claims above the expected amount
d. Arrangement is very similar to stop-loss coverage, but state premium tax is avoided (except in California)
4. Retrospective Premium Arrangements
a. The policyholder takes over some or all of the aggregate claim risk in exchange for reduced risk charges and lower up-front premiums
b. Example: A policyholder and carrier agree policyholder pay 90% of premium; if experience is worse than expected, additional premium is due, but experience is better than expected, a refund may be payable to policyholder
c. Retrospective premium arrangement may make it more difficult for carrier to accumulate a contingency reserve
5. Self-Insured Plans
a. Employer takes on the role as the primary risk taker
b. Claim payments and plan expenses are the responsibility of the employer
c. Normally funded through a trust
d. Usually accompanied by an administrative services only (ASO) agreement to handle enrollment, eligibility, claim adjudication, and other services
e. Any investment income on the trust assets is earned directly
f. Employer may purchase stop-loss coverage to protect against the risk of excess claims
g. Considerations in choosing this method
▪ Premium tax is avoided, and ACA insurer fee
▪ State or provincial mandates on insurance contracts will not apply, since there is no contract of insurance. Federal mandates do apply
▪ Employer’s plan becomes sole bearer of risk and must be able to absorb claim fluctuations
▪ Different coverages require varying degrees of experience to manage them
6. Level-Funded Contracts
a. Rapidly growing in popularity in small and mid-size market
b. Good for formerly fully funded insured employers moving to self-funding
c. Admin adjudicates and pays claims (even when not enough in account fund, as long as premium equivalents are paid up)
d. Reconciliation at end of year comparing incurred claims to expected amount
▪ If incurred claims lower than funded amount, sponsor has a surplus and receives an administrative credit for next year’s premium equivalent upon renewal
▪ If incurred claims are higher, stop loss carrier covers this under Aggregate Stop Loss
e. Level Funding Attractive to Small Employers:
▪ Employer pays a predictable, pre-determined monthly premium equivalent to claims administrator (includes claim payments, stop loss premium and admin fees)
▪ Downside exposure to high claims limited through stop loss
▪ Employers with good risk benefit from lower premium equivalents and retrospective refunds or surplus share
7. Stop-Loss Contracts
a. Used with self-insured plans to provide insurance of claims in excess of particular levels
b. Individual stop-loss (specific stop-loss) insures claims of individuals covered
c. Aggregate stop-loss covers the claims of the plan as a whole
d. Specific and aggregate options can be purchased separately or together
▪ When combined, individual coverage applies before aggregate coverage
e. Contract can be structured based on when claims are incurred or when they are paid
f. Stop loss insurer must consider that misestimation risk and leveraging on trends are magnified
g. Leveraging effect on trends can be amplified with stop-loss arrangements
8. Final Considerations
Choice of funding mechanism depends on:
▪ Effect on retention items (especially premium tax and risk charge)
▪ Federal and state regulations
▪ Employer’s risk tolerance levels
▪ Competitive landscape
▪ Insurer’s ability to unbundle aspects of the financial agreement
▪ Nature and size of the insurance risks assumed by each party
▪ Possible policyholder or insurer bias
