Sec M Grp LTD/LTC

Question 1

Uses of credibility for group long-term disability (LTD) insurance

Answer 1

1. Valuation of claims
   a) The 2012 Group LTD valuation standard requires insurers to use credibility to reflect company-specific claim termination experience in their valuation assumptions
   b) The formula for determining the full credibility standard (f) is:
   i) 0.05 = 1.44 * (selected variance factor / f) ^ 0.5
   ii) f = # of claim terminations required for full credibility
   iii) The selected variance factor varies by claim duration: 4.0 for 2-24 months, 3.0 for 25-60 months, 2.5 for 61-120 months, and 2.0 for > 120 months. This factor ensures that fewer terminations are required to be considered fully credible in later claim durations, since terminations in later durations are less volatile
   c) For insurers with fewer terminations than f, the credibility factor (C) = (# of expected terminations / f) ^ 0.5
2. Experience rating - the most common formula is: Premium rate = C * experience rate + (1 - C) * manual rate
3. Manual ratemaking - for estimating credibility factors for manual rate development, approaches include:
   a) Subjective educated judgments, such as deeming experience to be credible if results are stable across multiple time periods
   i) Advantage: simplicity and flexibility
   ii) Disadvantage: it may be difficult to justify subjective decisions on credibility
   b) Formal procedures, such as limited fluctuation credibility concepts
   i) The minimum # of claims required for full credibility = lambda = (1.96² / 0.05²) * (1 + (σ/µ)², where µ and σ are the mean and standard deviation of the claim amounts.
   ii) For insurers with fewer claims than lambda, C = (# of expected claims / lambda)^ 0.5
   iii) Advantage: objective and theoretically justifiable
   iv) Disadvantages: may be difficult to implement and may not be applicable depending on the experience and the underlying credibility model

Question 2

Challenges in applying credibility for LTD insurance

Answer 2

1. Non-independence of claims
   a) Claim incidence is not independent due to external factors (such as economic recessions) and group-specific dynamics (such as work conditions and the physical demands of some jobs)
   b) Claim terminations are not independent due to external factors such as changes in claims management practices or changes in the economy
2. Heterogeneous claims - claim experience does not always emerge similarly to how it did in the past due to:
   a) Changes in the demographic mix of employees
   b) External factors like economic recessions
   c) Changes in underwriting or claim management practices
   d) Changes in plan design
3. Competitive pricing pressures - due to a competitive market environment, there is pressure to give past experience more credibility than it theoretically should be given
4. Claim duration - claim experience tends to be more volatile in the early claim durations
5. Benefits from other sources - the approval of Social Security benefits or the loss of workers’ compensation benefits can significantly impact net benefit amounts
6. Outlier claims - when credibility is based on claim amounts, large outlier claims could artificially increase the credibility of the past experience
7. Regulatory requirements - some states have adopted credibility requirements, such as requiring credible data to support changes to existing pricing factors
8. Estimating parameters of a credibility model is often based on a combination of subjective opinion and empirical testing

Question 3

Reasons LTD claim experience tends to be more volatile in early claim durations

Answer 3

1. Terminations in early durations are dominated by recoveries (as opposed to deaths), and there is a strong correlation between recoveries and cause of disability
2. Benefits from other sources are typically awarded within the first few years of claim, creating irregular payment streams
3. The change in definition of disability from “own occupation” to “any gainful occupation” usually occurs within the first few years of claim, resulting in a spike in recoveries at that time
4. The maximum benefit period for mental and nervous claims is usually limited to 24 months

Question 4

Implications for an employer to consider before deciding to self fund long-term disability (LTD) coverage

Answer 4

1. Loss of third-party guarantee for employees - an employer who self funds is responsible for the entire LTD liability, so there is no third-party insurer to guarantee benefit payments
2. Volatility in claims - an employer who self funds will not benefit from insurance risk pooling, so it is not protected against fluctuation in claim incidence and severity. The employer is also at risk for claims liabilities that are larger than expected
3. Economic cycles - LTD claim costs are often tied to economic conditions. Claim costs often increase at the same time the company’s profits are suffering
4. Employee relations - any legal suit regarding a claim will be brought against the employer
5. Accounting regulations - financial accounting standards require that employers recognize a liability for self-funded LTD benefits
6. Tax risks - if a trust is used for maintaining reserves, contributions are limited to paid claims plus a reasonable claim reserve. There are substantial penalties for making excess contributions

Question 5

Types of long-term claims and reserve methods

Answer 5

1. Open claims - claims currently being paid (uses tabular reserves)
   a) Reserve = V_n = Σ_{t=n to BP}Benefit_t * Continuance_t * InterestDiscount_t
   i) Benefit = monthly benefit (may vary over time due to product provisions)
   ii) Continuance = probability of a claim continuing to receive payments in the future
   iii) Interest discount = factor to reflect time value of money
   iv) Summation runs from current time period (n) to end of benefit period (BP)
2. Pending claims - claims that have been reported but payments have not yet begun
   a) Reserve for claims that are still in the elimination period = pending factor * tabular reserve
   b) Reserve for claims that have completed the elimination period = pending factor * (tabular reserve + accumulated value of past payments not yet made)
3. IBNR claims - claims that have been incurred but have not been reported to the company

Question 6

Methods for calculating IBNR reserves for long-term claims

Answer 6

1. Percentage of premium method (a special case of the factor method)
   a) For a historical year in which all claims have been reported, list all claims incurred prior to yearend that were reported after yearend. These are the IBNR claims
   b) Calculate a tabular reserve for each of these claims as of yearend of the historical year
   c) Sum these tabular reserves to get the IBNR reserve for the historical year
   d) Divide this reserve by earned premium for the historical year to get an IBNR reserve factor
   e) Multiply the IBNR reserve factor by earned premium from the current year to produce the IBNR reserve for the current year
2. Lag method - a simple case of the development method
3. Loss ratio method
4. Combination methods - e.g., use the lag method for earlier incurral months and the loss ratio method for recent incurral months where the completion factors are low

Question 7

Features (or aspects) of LTD and LTC contracts to consider when setting reserves

Answer 7

1. Periodic benefits - benefits typically equal some specified monthly or daily amount
2. Long-term benefit periods - these plans have maximum benefit periods that are much longer than benefit periods for other health benefits
3. Elimination periods - LTD and LTC plans have a variety of elimination periods (often 90 days or more)
4. Optional benefits - these may affect the timing or amount of monthly payments (e.g., partial disability benefits and cost of living adjustments)
5. Integration of benefits - these plans often coordinate benefits with Social Security and Medicare
6. Limitations and exclusions - some claims are excluded (such as intentionally self-inflicted injuries) or subject to limited periods (such as mental and nervous claims)

Question 8

Common types of reinsurance for group life and health business

Answer 8

1. Coinsurance - the insurer cedes a portion of the business to one or more reinsurers. Each reinsurer holds the policy liabilities on its portion of the business
2. Modified coinsurance - the insurer cedes a portion of the liabilities to other insurers, but retains the assets backing the policy liabilities (as an amoutn owing to reinsurers)
3. Excess of risk reinsurance - the coverge of amoutns above the insurer’s retention limit is ceded to a reinsurer who holds the policy liabilities related to the coverage

Question 9

Challenges in valuations for group life and health business

Answer 9

1. Group insurance encompasses different lines of business with different features
2. There is a wide variety of benefits and financial arrangements
3. For groups beyond a certain size, contracts are usually customized and contain side agreements
4. Record keeping and administration practices for third party administrators do not always meet the actuary’s needs
5. Statutory experience refund reserves may not equal the group’s surplus due to a difference in valuation bases
6. There is a wide variety of benefit types, contract provisions, and rating practices
7. Group contracts are traditionally short term, but some liabilities may be long term
8. There are often data issues