Premium Deficiency Reserves

Question 1

Introduction

Answer 1

1. The testing for the need for PDR’s
2. The manner in which a PDR, if needed, might be determined
3. Some details around the financial reporting of PDR’s

Question 2

PDR Background

Answer 2

1. Required for GAAP and Regulatory Accounting (STAT)
a. STAT, the focus is on the solvency of the legal entity
i. More conservative than GAAP
ii. More rigidly defined

b. GAAP accounting, focus is the reporting of income properly allocated to the reporting period, assuming the organization is capable of continuing in business

2. Statutory Financial Reporting
a. An emphasis on solvency for the protection of policyholders

b. Reserve reduces entity’s statutory capital and surplus, by an amount equal to the excess of future benefits and expenses over future revenues and current contract reserves

c. Identify situations where the reduction in statutory surplus could result in impairment regarding the entity’s ability to meet its obligations

3. GAAP Financial Reporting
a. Concerned with an entity’s value to its owners, and with providing financial information about the entity’s ongoing operations

b. GAAP balance sheet is intended to reflect the economic value of the entity’s financial resources and obligatons

c. GAAP places much more importance on a reporting entity’s income statement, from a going-concern perspective

4. The purpose of a PDR is to ascertain whether the entity has an unfunded obligation, and to represent the effect on the entity’s financial condition
a. GAAP is concerned with the expected results of future operations
i. Although recognizing the PDR in the current period reduces current profitability, it results in improved representation of future earnings

b. The recognition in the current GAAP balance sheet, could have negative impact on commitments the reporting entity has entered into, and fail to meet shareholder expectations related to current period earnings

c. GAAP purpose for PDRS is the recognition and disclosure of an obligation that may affect an interested person’s judgment of the financial value of a business

5. General Principles Underlying the Calculation of PDRs
a. Uncertainty of Insurance
i A company that makes products or provides services often has a high degree of knowledge about the company’s costs of the product sold
ii. The company’s own costs are known at the time of sale
iii. Contracts between a company and customers will be priced to produce a profit and the profitability will be realized with relatively little error
iv. Insurers take on financial responsibility for uncertain situations, and attempt to mitigate risk by various techniques
v. Blocks will often experience a period of unprofitability, which may be ended by price adjustments or simply by the end of a random period of adverse experience.
vi. Distinguish between situations that do require further scrutiny, and those that are part of the normal course of business

b. Statutory Financing Reporting
i. Principle 1:
1. losses over the near time, either b/c of premium inadequacy of b/c the losses on a particular subset will exceed profits on other subsets
2. A block of business will be profitable in the near term, but long-term guarantees will cause it to be unprofitable over the proejction period

ii. Principle 2: The PDR should be determined to minimize “false positive”
1. No PDR should be required unless there is a meaningful potential for loss

iii. Principle 3: The PDR also should be determined to minimize “false negative”
1. That is, a PDR should be required whenever there is an expectation for loss

6. Considerations regarding the first principle
a. “a block of business” doesn’t specify whether a “block” is the entity’s accident and health business in the aggregate, or a narrowly defined grouping of contracts
i. Insolvency is a condition of the reporting entity as a whole; subordinate grouping cannot itself be insolvent

b. Second, projection period for the business.
i. based on such factors as the guarantees made in the contracts and the number of contracts that constitute the block

7. Considerations regarding the second principle:
a. Even profitable entities may have blocks of business that are temporarily unprofitable
i. a PDR will increase the entities’ capital requirements, even though they are at negligible risk of having their capital reduced by entity-wide loses

b. entities that could be pushed into a loss situation by midly adverse experience, may not have to set up PDRs at all

c. Any “false positives” will divert regulatory attention from at-risk entities to the financially strong entities

8. Considerations for third principle
a. not only over the full, projected lifetime of a block, but also over shorter intervals, to ensure that impairment in the intermediate term is not overlooked

9. Degree of conflict between the second and third principles
   a. Approaches to eliminate false positives are likely to increase the false negatives, and vice versa
10. In determining whether a PDR is needed, the annual release of a policy reserve should be viewed as a source of revenue

11. How the 3 principles apply to GAAP PDR
a. would not require a PDR where existing policy reserves, combined with premiums, are expected to adequately fund the future benefits and expenses

b. “false positive” - whether reporting a deficiency would give a misleading picture of how the entity’s future results might differ from historical results

c. A “false negative” - failure to establish a PDR would prevent a user of the financial statements from recognizing a decrease in the entity’s financial strength

Question 3

Financial Reporting Impacts

Answer 3

1. The PDR affects not only the balance sheet, but also the income statement
2. The establishment of a PDR will affect reported net income by moving losses to an earlier period
   a. In the year the PDR is established, the income (underwriting gain) is reduced by the amount of the PDR
   b. In the following years, the PDR will be reduced and this reduction will offset the loss it was established to cover
   c. If the estimated loss does not match the actual loss an additional loss or gain will result
   d. The income-statement effect may have significance in terms of dividend restrictions, identification of financial trends, financial ratio analysis, etc
3. Two entities that would have the same income stream if PDRs were determined on aggregate basis, could have very different reported income streams reflecting block-by-block PDRs because of the incidence of profits and losses among blocks of business

Question 4

Specific Issues Regarding Assumptions and Calculations

Answer 4

1. Interaction with other reserves
a. There is an interaction among PDRs, contract reserves, and any additional actuarial reserves
i. For a group health contract with no contract reseres, a PDR reflects the expectation that premiums for the next contract year will not cover the benfits and expense

ii. When a company stops writing a line of business and runs off its remaining claims, consider whether cash flow requirements would involve selling allocated assets
1. If the market value of these assets is less than the book value, the actuary may set up additional reserve to reflect this difference

iii. When developing experience of long-term contracts is adverse, the actuary may revise the assumptions used in contract reserves

b. No single preferred approach. Consistency in financial reporting will influence the use of one or more of these options

2. Business to be included
a. ASO contracts are excluded, however, when the fees are not sufficient to cover expenses for the remainder of the contract period, a liability should be established

b. It is appropriate to include new business in the projection if the new business is guaranteed-issued and will be written at a loss

c. Consider premium-deficient contracts with effective dates after the valuation date, but with rates known as of the valuation date

3. Contract grouping
a. For purpose of determining if a prem deficiency exists, contracts grouped consistent with how policies are marketed, servied, and measured. A liability for each grouping where a prem deficiency is indicated. Deficiencies shall not be offset by other policy groupings.

b. 2 levels of grouping process
i. Testing - the minimum level at which financial projections are performed; and
ii. Reporting - management’s combination of the testing level result for reporting in the various external statements

c. Testing Level - factors that may affect grouping
i. Materiality of a group relative to size of the whole reporting entity
ii. Similarity of product types
iii. Differences in marketing methods
iv. Potential rate restrictions
v. Geographical rating areas
vi. Length of rate guarantee periods
vii. Regulatory requirements
viii. Line of business (individual vs. group)
ix. Case size within group business
x. Expected future growth or decline of a possible grouping

d. Testing Groups
i. Comprehensive medical
ii. Medicare supplement (including Medicare Select)
iii. Medicare risk
iv. Medicaid
v. Dental
vi. High-deductible medical reinsurance premiums

e. Size categories
i. Small-group
ii. Large-group
iii. Mega-group
iv. Any large group comprising 10 percent or more of the carrier’s total enrollement

f. Factors affecting groupings
i. State regulations governing group insurance rating
ii. The level at which a company considers a group fully credible
iii. Whether a single policy that has both life and health benefits can offset a deficiency in the health with surplus from the life portion

g. Marketing
i. One group (comprehensive medical, dental, etc.) is marketed as a means to treat adverse health conditions
ii. Other products (disability income) are marketed as a means to replace income lost
iii. Other products (LTC) are marketed to provide custodial services necessitated by some medical condition
iv. miscellaneous products marketed to address narrowly defined health-related needs

h. Servicing
i. How proof of loss is submitted
ii. How eligibility for benefits is determined and confirmed
iii. And to whom payment is made

i. Measurement
i. All health business must fit into 1 of these 4
1. Comprehensive major medical (includes Medicare supplement and any coverage where benefits subject to inflation - e.g. DT and vision)
2. Long-term care insurance
3. Income protection (disability income) insurance
4. Limited benefit plans (e.g. hospital indemnity, critical illness, and other coverage where the benefits not subject to inflation)
ii. How the results from testing will be illustrated in the appropriate statutory financial format

j. Valuation actuary’s decision
i. At what level should groupings be tested
ii. What groups with a sufficiency should be allowed to offset other groups with a deficiency?
iii. How should a reporting entity report the results

4. Projection Period
a. Should be based on “the remainder of a contract period”. Consider
i. Terminations
ii. Rate increases
iii. Claims trend
iv. Regulatory restrictions
v. Renewability provisions
vi. Prior company practices regarding cancellations and exiting lines of business

b. Deficiency period = period for any block where the reserve value for testing premium deficiency is positive

c. PDR = PV(paid claims through the end of the deficiency period) + PV(expense) + ending reserves - beginning reserves - PV(prem)
i. “paid claims” is all claims paid in the future, not just claims that are incurred in the future
ii. “reserves” in the formula include IBNR, tabular claim reserves, and contract reserves

d. What should be done if a guaranteed-renewable block of business will be in a deficient financial position forever?
i. Project the deficiency as a perpetuity, and discount it at an appropriate rate of interest

5. Premium rate changes
a. future premium rate changes should be incorporated into the PDR calculations
b. Age-related rate changes for attained-age rated contracts should also be included
c. Retrospective premium changes should also be included

6. Claims Projections
a. Current trends in medical cost and utilization
b. Provider risk-sharing
c. Changes in provider contracts
d. Environmental and demographic impacts on morbidity
e. Potential improvements in technology resulting in new services being offered
f. Positive morbidity impact of growth in underwritten coverage
g. Durational wear-off
h. The impact of benefit changes
i. The leveraging impact of static co-pays and deductibles
j. The anti-selective impact of premium rate increases

7. Expenses
a. Include fixed and variable, direct and allocable indirect costs

b. The expenses that are attributable to the business being modeled must be reflected in the PDR calculation for that business

c. Some expenses may not be relevant at all to the business being modeled

d. All other expenses must be supported by some business
i. Acceptable to allocate some expenses to lines of business outside the health PDR calculations, as long as those lines can support those expenses

e. **Problem Situation 1: **A start-up situation, where the reporting entity has just begun to write business
i. a PDR calculation becomes necessary and full expenses of the entity must be incorporated into the calculation

ii. May result in expense burden being supported by a very small number of contracts

iii. Expenses could reflect the expense level that is expected to apply when the business is mature

iv. The expenses could be based on a more near-term projected volume

v. The expenses could be graded down during the projection period, based on the volume expected to be added during that period

vi. To simply incorporate the full expense level in the projections for the existing contracts

vii. The selection of an approach requires careful consideration of the assumptions as well as discussions with the relevant authorities

f. Problem situation 2: Wind-down situation
i. Whether the entity has enough capital to absorb the losses likely to occur

ii. Suppose the PDR leaves a positive statutory surplus below the mandatory control level for RBC purposes
1. Might require the regulators to take control even though its affaris are being wound up

iii. A single line of business is being exited. The fixed expenses associated with keeping that system in operation might result in a PDR and a false positive for regulators (if other lines of business could absorb the expenses)

8. Interest Rate
a. The chosen assumption will be influenced by the time period of the projected deficiency

b. The extent the existing investments will turn over, and how market interest rates are likely to change

c. Anticipated reinvestment rates, and whether investment expenses will be recognized explicitly or implicitly

d. 4 Interest rates
i. Average earnings on portfolio
ii. Current new money rates
iii. Rate assumed in pricing
iv. Rate prescribed by standard valuation law

9. Taxes
a. should be calculated without recognizing impact of income taxes

10. Reinsurance
a. amount of reinsurance premiums and recoveries usually considered in the PDR estimate
b. Actuaries usually calculate aPDR both gross and net of reinsurance

11. Conservatism
a. assumptions should not be conservative for GAAP, since if actual loss is less than the PDR, the result will be a future recognition of income
b. Statutory guidance is not explicit concerning the use of conservatism in establishing a PDR

12. Documentation
a. Regardless of the need for a premium deficiency, include:
i. Description of the groupings, along with
1. The rationale for the groupings (such as “marketed”, “serviced”, and “measured”)
2. An indication of which lines of business were combined due to immaterality
3. The basis for changes from prior years
ii. All assumptions used in the projections
iii. Discussion of the time periods chosen for the projections