Individual Chap 5: Setting Premium Rates

Question 1

The Rate Setting Process

Answer 1

1. Depends whether rates are set:
(1) Based on direct, existing experience (called rerating)
(2) Based on fundamental pricing

2. Fundamental nature of process
(1) Measuring the past
(2) Adapting it to the future
(3) Using results to project the future to determine rate levels

3. Considerations
(1) The Market - how product is priced by competitors; can apply to rate guarantees, margins, rate structures, and prefunding

(2) Exisiting Products - if company already in marketplace, expectations by market will have an impact; Changing strategies will cause a distruption

(3) Distribution system - structure, compensation system

(4) Regulatory situation - How likely full needed rate increase will make it; explicit limitations on rates

(5) Strategic plan and profit goals - Pricing should contribute to company’s strategic goals

Question 2

Rate Structures Used Today

1. Allowable Rating Under ACA
2. Major Rate Structure Elements
   a. Age
   b. Duration
   c. Gender, Marital Status, Prenatal status
   d. Occupation
   e. Geographic Area
   f. Other Factors: Health Status, Past Claims

Answer 2

1. Community Rating
a. Many rating variables are knowingly ignored

b. Does allow rates to vary by geographic area, martial and parental status, and benefit plan

c. ACA imposed modified community rating for individual and small groups starting in 2014

d. Allowable Rating Variable Under ACA for Individual and Small Group
- Age (max 3:1 ratio)
- Tobacco (max 1.5:1 ratio)
- Area
- Family tiering/structure
- Plan (Benefits, cost sharing and network)

2. Predictive Models - future claim costs for individuals and groups based on claim history, drug use, or other information

3. Consumer data used in underwriting

4. Major rate structure elements
a. Age

• Attained Age Rating- rate function of age at renewal
• Entry age or issue age rating - rates reflect age at issue. Accompanied by “active life reserve”
• Uni-age rating - Most “community rate” structures are uni-age. Situation for antiselection. Uses average rate for the entire community group
• Medical and Medicare Supplement tend to use attained age rates - Impact of claim trend overshadows year-to-year increases
• Non-inflation sensitive coverages, prone to age-leveling premium structure - DI, LTC, and HIP sold on issue age basis
• Older ages tend to generate higher claim costs
• Morbidity by age for individual insurance flatter than that of large group insurance, where there is no individual underwriting
• Accidental Death coverage factors decrease above the younger ages
• ACA requires carriers to use prescribed age factors

b. **Duration **
- Age of the policy

• Durational Trends
  (1) Initial underwriting, causes policyholders at duration zero to be relatively healthy - Underwriting selection wears off by duration four to five for DI, year two for Med Supp, and year 10 for LTC
  (2) Cumulative antiselection
• Some medical carriers charge rates which explicitly vary by duration. Others close their blocks to further new issues - Both approaches not allowed by ACA for major medical starting in 2014
• Open blocks will not see dramatic impact of duration on results, but such forces are operating

c. Gender, Marital and Prenatal Status
- Unless prohibited by law (such as ACA’s new law), most coverages have rates by gender
(1) Exception is LTC - unisex rates due to market conditions
(2) Experience can also vary by marital status (LTC example)
- LTC Claim Cost - Female higher than male; costs increase with attained age
- DI Claim Cost - Female higher than male; costs increase with attained age, gap narrows in late 50s and 60s
- Individual CMM - Female higher than male until late 50’s; cost increase with age
- Married vs. Single Claim Costs - Single LTC higher than married; costs increase by duration
- Need to vary premium by how many people and whether they are adults or children - Some family policies don’t differentiate on how many children above some number

d. Occupation
- DI Carriers have different rates for different occupation classes

e. Geographic Area
- Two geographic locations are relevant: Location of issue and residence

• Either the state of issue or the state of residence can have jurisdiction over renewal rates
• Area of residence important for many coverages
  (1) For medical coverage, utilization and average costs vary from place to place
  (2) In addition, provider contracts may be concentrated in a geographic area
• LTC (higher availability of nursing homes cause utilization to be higher) & DI (varying legislation by state causes different claim costs)

f. Other Factors: Current health status, past claim history, smoking status, weight, presence of other coverages, situation-specific factors (such as whether policyholder converted from another plan)

Question 3

Fundamental Pricing

Answer 3

1. Using tables or claim costs developed through other sources
   - Useful when pricing a new benefit, or if experience is inappropriate or insufficient
2. Own experience preferrable to other sources, because it usually was underwritten in the same way
   - By same underwriting department, same network of providers, administered by same claim department, same network of producers came from similar pool of prospects

Question 4

Fundamental Pricing - Tabular Method

Answer 4

1. Used for long term, non-inflation sensitive products, like DI

2. For inflationary policies, the value of precise calculations disappears

3. Most common basis for pricing DI is 85 CIDA tables

4. Tabular approach depends on number of “claim states” (and their order)

5. Modeling technique is a deterministic
- Policy with probabilities of claim at each duration, multiplied by cost of that claim
- Sum of all such product is claim cost or net premium

6. For other coverages, not publicly available tables; insurance companies create their own claim costs
- Modal premiums - premiums paid other than annually

• Modal lapse rates
• Exposure calculations - various elements expressed as a function earned premium, written premium, received premium, incurred claims, paid claims, reserves, number of policies, face amount
• Additional benefits - e.g. benefit that automatically increases payments by 3% per year, to address inflation
• Interest
  i. Varying the interest rate assumed in the future
  ii. Testing alternative interest rate scenarios
  iii. Treating interest as stochastic variable
  iv. Often simplified to single rate for each year, or rate for all years
• Multiple decrements
  i. LTC might have no care, home health care, assisted living, and nursing home
  ii. DI might involve full disability, partial disability, and residual disability

7. Techniques to model benefits
- Monte Carlo simulations path based on random numbers applied to probabilities
- Markov processes (linear algebra to model claimants’ states over time)
- Classical multiple, contingent decrement actuarial commutation functions

Question 5

Fundamental Pricing - Buildup and Density Function

Answer 5

1. For inflation-sensitive products

2. Buildups
a. Sum of a number of pieces, each of which has its own benefit calculated

b. Also known as “cost model” method

c. Each category has its own claim cost calculation - product of claim frequency times average cost per service

d. (Frequency of service) x (copay amount) = (reduction in claim cost)

e. Often secondary calculation because change in benefit or copay impacts the behavior of insureds

f. May even be tetiary effects

g. Often units in these calculations are “pmpm”

3. Density Functions
a. Claim distribution function usually described discretely

b. In contrast to buildup approach, density functions describe total claim of an individual in a year
- No calculations of cost of component benefits

c. Sometimes called continuance or continuation function. Where size of a claim is the number of days of claim times the amount per day; curve measures how long rhe claim continues

d. Useful when calculating impact of deductibles, OOP limits, which don’t depend on particular service provided

e. Difficult to deal with copays
- A claimant with $1,000 in total expenses might have no office visists or he might have entire $1,000 composed of office visits
- Preferable to reflect “what would have happened if $10 copay had been in effect,” and develop a density function from that
- Approximated by expected value of copay using build-up approach, and then allocating over the whole curve
- Another approximation might be to interpolate between two curves - one with office visit benefits, the other without

4. Combining Buildup and Density in PPOs and Hybrid Plans
a. In-network benefits have copays

b. Out-of-network benefits have deductibles and coinsurance

c. Claims in each depend on
- The financial incentives
- Availability and quality of in-network providers

d. Average charge levels differ between in-network and out-of-network

e. Separately calculate in-network claim costs (using buildup) and out-of-network (using density) then combine as a weighted average

f. “Hybrid” plan designs combining copays and global deductible, coinsurance and out of pocket maximum have become common
- Need careful combination of both approaches to value these benefits

g. ACA mandates have led to further complications
- Plans have single overall OOP maximum for in-network, not to exceed statutory level - All cost sharing accumulates to this maximum

• Must carve out preventive services from certain calculations because they don’t allow any copay
• Actuarial Value Calculator - published by federal government to estimate actuarial value of each major medical plan

h. New approach possible due to advances in computing - take large claim database with service categories and re-adjudicate based on new plan design
- Helps model complex plan elements piece by piece

Question 6

Fundamental Pricing - Simulation

Answer 6

1. Another pricing approach is stochastic based on Monte Carlo simulations

2. Future claim level can be considered a random fluctuation from the average claim level
- Improved by applying correlation values dependent on prior claim experience

3. Process
- 1. Develop “expected” value based on whole block’s experience
- 2. Expected value modified for information about the individual
- 3. Simulate random statistical fluctation

4. Statistical fluctuations because:
   - Block no infinite in size (“statistical fluctuation”)
   - We cannot unerringly predict block’s future cost, regardless of size. (“historical fluctuation”)
5. Calibrate model to match actual historical experience
6. “New business module” needed to generate new issues and predic their results
7. Advantage of stochastic method is that it examines whole distribution of future results, over the whole portfolio
   - Allows behavior to be modeled on a policy-by-policy basis
   - Other methods based calculations on average expected rather than whole distribution of results
8. Method lets us develop extensive relationships between model values. Take non-linear relationships into account

Question 7

Rerating

Step 1: Gather Experience
Step 2: Restate Experience
Step 3: Project Past Results into the Future
Step 4: Compare projection against Desired Results
Step 5: Apply Regulatory and Management Adjustments

Answer 7

Step 1: Gather Experience
a. Preferable data - Incurred claims and earned premium rather than paid claims and premiums received

b. Matches claim experience to exposure

c. Use runout claim experience rather than financial basis
- Financial basis incurred claims are (Paid claims) + (Ending Claim Reserve) - (Beginning Claim Reserve)
- Understatement of prior year’s reserves make current period’s incurred claims appear higher

d. Runout based incurred claims allocate corrections to prior reserve estimates, restating prior reserves to current estimate

e. For a long term coverages, if actual experience equals expected, the difference between this year’s reserve and next year’s is claim payments plus interest earned on remaining reserve

f. Reliability of the data should be assessed
- Actual-to-expected (A:E) analysis across variables is method for adjusting rates slopes and subsidies
- Multivariate logistic regression, to derive information about the nature of the data

Step 2: Restate Experience
a. Either
- Do analysis and then adjust for relationship between average rates in experience period and current rate level
- Adjust past experience to be on current rate level, and do analysis with respect to current rates

b. Effective dates of rate changes during experience period
- Depends whether increases were applied on policy anniversaries, on renewal dates, or on a common date for all policies

c. Policy Reserve Considerations
- Medical rerating is done in absence of policy reserves

• DI and LTC - carry substantial policy reserves
• Inappropriate to compare actual loss ratio without policy reserves against expected lifetime loss ratio (implicitly on a “with policy reserves” basis)
• Make interest adjustment in loss ratio calculation, and include change in policy reserves in numerator as though they were incurred claims, to achieve actual loss ratio “with policy reserve” exactly equal to expected loss
• Net level premium constant over life of the policy and equals gross level premium times anticipated lifetime loss ratio
• In A:E analysis, do it either with or without policy reserves. If done with them, important that loss ratios be interest-adjusted
• Additional morbidity recognized at time of rate increase, treated as though a separate benefit
• Separate stream of policy reserve factor calculated and added to reserve factors already calculated

Step 3: Project Past Results to the Future
a. Taking into account every element that might cause future experience to differ from past

b. Changes in the covered population
- If popultion changes are for characteristics included in rating variables, then we needn’t make any adjustment
- Factors that aren’t in rating structure have potential to cause problems

c. **Changes in Duration **
- Analyze experience durationally
- Track how much business is in each duration

d. **Changes in claim costs **
- Claim frequency can change over time. Reflect evolution of medical care toward more cost-effective delivery

• Other element that changes over time is average claim size
• Evolution of care management causes low cost inpatient stays to be done on outpatient basis
  i. Raises average cost of inpatient stays while lowers frequency
  ii. Procedures that used to be done inpatient have higher cost than average outpatient while also increasing frequency
  iii. Changes in average cost are termed “intensity” changes

e. Leveraging
- Fixed deductibles, copays, and out of pocket limits cause leveraging
i. Claims costs increases while deductibles or other parameters remain constant from year to year
- Results in claim costs increasing at a higher rate than underlying costs

f. Healthcare reform items
- Must account for three risk mitigation programs: Risk Adjustment, Transitional Reinsurance, Transitional Risk Corridors

• Unique Challenges in Pricing due to ACA Risk Mitigation Programs
  i. Risk Adjustments - must estimate market-wide risk scores and insurer’s own risk score
  ii. Reinsurance - uncertain if money collected to fund the program will be adequate for claims
  iii. Risk Corridor - program depends on results of risk adjustment and reinsurance programs
  iv. Government has made repeated changes to these programs, even after rates are set

g. Other Changes
- Changes in how risks are selected or renewed
i. Company’s renewal business might be “cannibalized” by reunderwriting existing policyholders into new policies
ii. Changes in underwriting
iii. Sudden increase in lapse rates, possible indicating higher than market rates on healthy lives
- Changes in policy provisions, business operations, premium and benefit levels, utilization and cost of services, administrative and care delivery system

Step 4: Compare the Projection Against Desired Results
a. Rate changes calculated to make the predicted results match the desired

b. Needed rate change = (projected loss ratio / desired loss ratio) - 1

c. Increasing rates impacts assumptions used to derive projection

d. Becomes a recursive process, requiring successive approximation

e. Expenses (page 156 of notes)
- Can lead to either inadequate or excessive revenues to cover those expenses

f. Profit
- Expressed as either a percent of premium or a percentage return on equity, or a return on investment
- ROE, translated into a percentage of premium, so target loss ratio can be calculated

Step 5: Apply Regulatory and Management Adjustments
a. Management reasons include competitiveness, profitability in other lines, relations with public or producer, or public or social policy
- Desire to manage the block from a long-term perspective

b. Regulatory interventions
- Minimum loss ratio standards over the future lifetiem and over the entire lifetime
- Requirement that rates be approved by Insurance Department before being used
- ACA set a minimum loss ratio of 80% for individual major medical (if lower, insurer pays rebates back to policyholder)

Question 8

Turning Claim Costs into Gross Premiums

1. Rating Philosophy determined by type of company
2. Block Rating Approach
3. Asset Share Approach

Answer 8

1. Rating philosphy determined by type of company

a. Blue Cross and HMOs
- Manage business as open blocks (new insured continually added)
- Manage business as a renewal block each year
- Short term profit horizon
- “Block rating” rating approach

b. Di, LTC
- Involve long term projections due to: The future claims are predictable, the claim costs increase over time, premium structure tends to be issue age based
- Asset share model: Long term projection treated as a closed block

c. Commercial medical insurers
- Price using asset shares, but assumptions aren’t realistic over the long term
- Durational Deterioration Limitation Period (DDLP)
(1) Reflects limited durational deterioration recognized in today’s rate practices
(2) DDLP = 5 means insurer recognizes durational effects through year 5, but not beyond

d. ACA Considerations
- ACA-compliant plans must use block rating (exception is grandfathered plans)
- Must use single risk pool - Uniform Rate Review Template (URRT) - mechanism to enforce the single risk pool

2. Block Rating (Short Term Horizon) Approach
a. Annual claim costs are calculated

b. Gross premiums calculated by adding expenses and profit to the claim costs

c. If claim cost based on average demographic profile, adjust for any changes when calculating rates

d. Helpful to translate claim costs in to age/gender neutral basis
- Put figures into understandable context
- Helpful for maintaining an understandable manual rate book
- This process is called “normalization”

e. Once average claim cost is demographically neutral, final claim costs calculated by applying demographic rate relativities

f. Age factors for underwritten individual insurance, flatter by age than those for group insurance
- Because individual underwriting has bigger impact at higher age
- Curve changes with duration, since underwriting wears off as duration increases

g. Net premium (claim cost) is N, expesnes that are a percentage of E(n), fixed expenses E(f). Profit and remaining expenses expressed as percentages of gross premium E(G), gross premium G expressed as
G = [N * (1+E(n)) + E (f)] / (1-E(G))

3. Asset Share Approach
a. Calculation done for representative rating cells
- DI might have one cell for each quinquennial age, for each of 4 elimination periods, for 4 benefit periods, for occupation classes

• Separate asset share calculations for riders
• LTC calculations for representative ages, each elimination period, each benefit period, each benefit level, and each inflation protection option

b. Policy year basis or calendar year
- Advantage of policy year basis simplicity - no partial year calculations are necessary

• Downside is to translate into calendar year financial forecasts, partial year calculations must be made in aggregate
• Calendar year approach has advantage of greater rigor regarding premium modes, frequency of policy issue

c. Asset share’s elements (columns)
a. 1. Exposure Values
- Number of policies sold or in force, number of claims, number of premium collections, and number of units sold or in-force
- Complexity when differentiate between options of policy years (annual premium paid July 1) in order to model calendar years
- Complexity because of non-symmetric policy issuance
- Incurred claims have steep durational slope within year

b. 2. Revenue Values
- Includes premium, investment income
- Received basis, written and renewed basis, or earned basis
- Earned premium = cash received + (increase in premium due & unpaid) - (increase in unearned premium) - (increased in premiums paid in advance)
- Important considerations are other possible uses of asset share model other than initial pricign

c. 3. Claim Values
- Shown both on “paid” and “incurred” basis

• Two definitions (financial, runout). For longer term coverages an interest adjustment needed to reconcile these two
• For asset share no need to distinguish between reserves and liabilities. Value might be tabular or from a triangulation / development method
• Claim Adjustment Expense (CAE) - (aka Loss Adjustment Expense (LAE)) - money needed to cover cost administering the claims. This is a reserve item
• Policy reserves also called contract reserves, additional reserves or active life reserves - set aside early premium to pay for part of later claims

d. 4. Capital Values
- Model cost of capital relative to total return
- Level of capital is set in response to regulation (RBC), rating agencies, or management’s perception of risk
- Capital isn’t available to be used for other purposes, resulting in an opportunity cost
i. Opportunity cost is called cost of capital in asset share model
ii. Accumulation of capital itself is not charged against profits in the model - only the cost of capital
- If investment income is accounted for separately, the sum of present values of changes in capital, can also be considered the opportunity cost of capital

e. 5. Expenses and Profit Targets
- The first method is to calculate present value of future profits, and compare to PV of future premium
- Target such as PV of profit is 7-9% of PV of premium
- Second method is return on investment (ROI). At some interest rate, PV of future profits exactly equal initial investment
- ROE. If initial investment in the ROI calculation increased by the capital set aside to cover that business