Summary of

Individual Health
Insurance
Summarised by: Putu Laseria 10/1/18 PAI Exam F34
Contents
Contents............................................................................................................................................................................. 1
Disclaimer........................................................................................................................................................................... 2
II. The Products .................................................................................................................................................................. 3
2.1 Major medical coverage..................................................................................................................................... 3
2.2 Limited benefit medical coverages ................................................................................................................... 5
2.3 Group conversion coverage ............................................................................................................................... 5
2.4 Medicare supplement coverage ....................................................................................................................... 5
2.5 Medicare advantage plan ................................................................................................................................. 5
2.6 Disability income coverage................................................................................................................................. 6
2.7 Business protection coverage ............................................................................................................................. 7
2.8 Long term care coverage ................................................................................................................................... 8
2.9 Dental coverage ........................................................................................................................................ 10
IV. Managing Antiselection........................................................................................................................................... 11
4.1 The three faces of antiselection ....................................................................................................................... 11
4.2 Underwriting the individual risk (external antiselection) ................................................................................ 11
4.3 Changes in plan (internal antiselection) ......................................................................................................... 12
4.4 Antiselection upon lapse (cast/durational antiselection) ............................................................................ 13
4.5 Modelling anti-selection ..................................................................................................................................... 13
V. Setting premium rates ............................................................................................................................................... 14
5.1 Rate setting process............................................................................................................................................ 14
5.2 Rate structure used today ................................................................................................................................. 15
5.3 Fundamental pricing .......................................................................................................................................... 16
5.4 Rerating................................................................................................................................................................. 19
5.5 Turning claim cost into gross premium .................................................................................................... 22
VI Reserve and Liability .................................................................................................................................................. 24
6.1 Type of and use of reserve and liabilities ........................................................................................................ 24
6.2 Premium reserves................................................................................................................................................. 24
6.3 Policy reserve ....................................................................................................................................................... 25
6.4 Claim reserves ...................................................................................................................................................... 28
6.5 deficiency and other reserve ............................................................................................................................ 30
VII. Financial Reporting and Solvency......................................................................................................................... 32
7.1 Financial Reporting ............................................................................................................................................. 32
7.2 Solvency testing................................................................................................................................................... 35
7.3 result of the calculation...................................................................................................................................... 37
VIII. Forecasting and Modelling .................................................................................................................................... 38
8.I Purpose and uses of the models ........................................................................................................................ 38
8.2 Characteristic of a good model ....................................................................................................................... 38
8.3 Building a good model ....................................................................................................................................... 38
8.4 Choice of assumptions ....................................................................................................................................... 41
8.5 Auto-correlative models .................................................................................................................................... 43

Summary of Individual Health Insurance 1|Page

Disclaimer

 This summary made with adding some personal understandings of summary

creator, hence summary creator will not responsible for any misunderstanding
arise caused by reading this summary
 This summary was not made for sale
 It is forbidden to copy this summary without acknowledgment of summary
creator

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 II. The Products

2.1 Major medical coverage

Definition: certain minimum combination of covered services.

Allocating some portion of the coverage expense (cost sharing) to the insured is often
deemed to be a good design.

Type of cost Definition

sharing
1 Deductible Amount that insured responsible (specified in policy, for
which the insured is responsible before any benefit are
payable.
2 Coinsurance Once deductible are satisfied, benefit above that amount
are payable at percentage of covered expense (most
common is 80%)

Wording deductible often used inconsistently, somehow it

called 20% coinsurance.
3 Out of pocket The out-of-pocket limit is the maximum amount a health
limits insurance policyholder will pay for covered healthcare over
the course of a policy year.

4 Maximum limits Overall maximum benefit payable on behalf an individual,

can be limit per year, or over life of individual, expressed as
amount.
5 Internal limits Apply only to specific subsets of benefits. For example, an
outpatient mental nervous benefit might be limited to $40
per visit, and @20 visit in a year.
6 Copays Cost sharing that occurs each time a service is provided.

Example

OOP max 6000

deductible 4500
coinsurance 40% paid by insured
claim 10000

paid by:
insurer insured
after deductible 4500
without OOP after deductible and coins 3300 2200
with OOP after deductible and coins 4000 1500

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Per cause vs calendar year benefits

Today most contract are calendar year contract

Per cause: when covered expenses occurred from a new cause, it would generate a
benefit period, which would end at some point in the future, such as 3-4 years later.
All expenses from that cause would be considered part of single claim, even those
occurring 3-4 years later.

Claim payment are the allocated to those incurral dates, leads to unusually long
claim run out period and substantially higher claim reserve. Than occur under
calendar year policies.

Variation on a theme-related products

1. Comprehensive major medical coverage (CMM)

 Is intended to cover more of smaller expense – small deductible
 Some carriers allow for customisable major medical plans – more anti-
selection as insured will tend to choose the benefit they are most likely
to use.
2. Catastrophic medical
 Intended to protect from risk that opposite addressed by CMM
coverage
 This is actually the true intention of the insurance
3. Short term medical
 Usually has feature of single limited term (3,6,9,12 months)
 Underwriting is quite limited (yes/no questions), but somewhat
complicate the claim administration process, since most claim must be
investigated for the potential that they are due to a pre-existing
condition.
4. High risk pool plans
 With choice of deductible and a relatively modest maximum ($350k-2
Mio). Such plan include an intentional level of subsidy of around half of
operating costs.
5. Consumer directed plans
 Typically offered in a group context, some are individuals as well.
 High deductible major medical plan, combined with an underlying
personal spending account owned by insured.

Networks

 Most individual major medical insurer develop one or more provider networks.
 A provider network consist of: doctors, hospitals, and other providers, who
have agreed to provide certain services for insured of insurer
 Usually benefit provided by network is better compare to outside of network

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2.2 Limited benefit medical coverages
Definition: medical coverage that do not meet the comprehensive definition of major
medical

Feature Underwriting
1. Hospital  Intended to supplement MMC coverage not to replace Usually no
indemnity it
plan  Intended not to cover the cost of care, but provide
relatively small amount the income to help offset
unspecified cost associated with hospitalisation.
 Typically pays a flat amount per day of inpatient
hospitalisation, start after a period of few days (called
elimination period) and often limited numbers of days,
such as 365
 Have additional benefit riders attached, foremost ICU
benefit
2. Other Constructed of one or more indemnity type benefits,
scheduled each of which provided limited benefits amount.
benefits

3. Dread The coverage only for a specified list of medical

disease condition, to product lower premium compare to MMC
and critical Major category:
illness  Cancer policies
Pay flat amount (or charge up to that amount) for
hospital inpatient days, ambulance to or from hospital,
ICU confinement, surgery, loss of time (disability
income), therapies (radio and chemo), death benefit.
 Critical illness coverage
Lump sum benefit in the case of heart attack, stroke,
heart surgery, cancer (except skin) or diagnosis
specified conditions.

2.3 Group conversion coverage

Group conversion contract: Group medical policies contain provision which

guarantee that when someone leaves the group and its coverage, they will be
offered the opportunity to purchase an individual health insurance contract from the
same insurer.

2.4 Medicare supplement coverage

2.5 Medicare advantage plan

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2.6 Disability income coverage
Definition: individual income health insurance that is intended to cover lost income
due to an illness or injury

Renewability
There are 3 categories:
 Non-cancelable
Guaranteed renewable for a guaranteed premium level
 Guaranteed renewable
Guaranteed to renew upon payment of the applicable premium, but
premium level could be changed over time
 Conditionally renewable
Insurer could refuse to renew the policy

Business purpose of the insurance

There are other purpose than replace lost personal income due to disability, will
explained in later section

Lost income vs indemnity

Elimination period
Disability occurs when policyholder meets the condition specified in the policy,
and the policy start paying.

Elimination period: period of disablement that must occur before disability

payment start. This help reduce claim cost and expenses, because eliminate
small claims that would occur of the payment began on day one.

Benefit period
Is the maximum length of time for which benefits are payable, once all
conditions are met.

Total vs partial vs residual

 Partial disability is to recognise that sometimes disability and loss of income
are not black or white, 0%-100%, insured may be able to perform only some
of the material duties of their job.
 Residual benefit developed as a modification to total disability benefit
where, after a person had been totally disabled for some qualification
period, such 7 days, they could then be eligible for a partial benefit for
some period of time

Recurring disability
A disability is considered a separate disability if full, partial, or residual benefit
were payable for an earlier disability, no longer payable, and either:

 The cause of later disability is not medically related to the cause of the
earlier one
 The cause of later disability is related to the cause of earlier one and the
later disability start at least 12 months after any full, partial, or residual
benefit under this policy cease being payable for the earlier one.

Cost of living adjustment (adjust for inflation)

Provision added to contract that adjust the inflation in 3 different ways

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 1. Adjusting inflation is automatically offer increased coverage to active
insureds, which they must either accept or reject. The offer is made at
specified intervals.
When the offer made, some portion of the policyholder population will
have become less insurable (a higher risk, and those are more likely to
accept the increase coverage, resulting in antiselective and higher claim
cost. Tis coverage logically added cost.
2. Adjusting inflation is to have a benefit which automatically adjust insured
amount over time, without action by insured.
3. Adjusting for inflation applies to the benefit payment of claimants

Social insurance supplements

Cause: potential over-insured, yaitu insured having comparable or greater
income while disabled than did while active) because of social security.

Basic policy is typically issued at face amounts that assume the insured will
receive payment under social security.

Group wrap around policies

Intended to supplement group disability policies, by providing additional
benefits to individuals in the group.

Waiver of premium provision

Provision for the policy to remain inforce without premium payment, when
policyholder become disabled (contained in individual life and group life
policy). This benefit usually as a rider.

2.7 Business protection coverage

Disability coverage can also be used to meet specific business needs, serving
financial purpose by protecting a business against the impact of having an individual
employee become disable.

1. Key person coverage

Background: individual who dispensable (usually founder, partner) become
disable, business might have difficult time finding replacement.
Purpose: to protect the business against risk of disable key person
Feature: short term benefit, usually up until the replacement is found and
company become financially productive
2. Disability buy out coverage
Background: when there are multiple partners or owners in the business, they
may want the ability to buy out one of their partner’s ownership interest, when
the partner become disabled.
3. Business overhead expense
Purpose: to enable small business to continue cover their business overhead
expense in the event of disability of the owner.
Feature: usually short-term coverage

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2.8 Long term care coverage
Long term care (LTC) insurance offer financial pre-funding for expenses associated
with care and services, skilled, custodial or personal in nature, that an individual may
need in order to perform basic activities of daily living (ADL).

Benefit triggers
To become eligible to receive benefits under LTC plan, the insured individual
must satisfy the plan’s benefit trigger: inability to perform ADLs or the presence
of a significant cognitive impairment.

Activity of daily living

Typical ADL are: bathing, continence (ability to perform personal hygiene,
dressing, eating, toileting, transferring.

Cognitive impairment
Example of behaviour: wandering and getting lost, combativeness, inability to
dress appropriately for the weather, poor judgment in emergency situation.

Elimination/waiting period
LTC plans have an elimination period or waiting period, during which the
insured needs to remain disabled and benefit eligible, before benefits are paid.

Type of LTC plan

There are 3 types distinguished by the manner in which plan benefit are paid to
insurer
1. Service reimbursement model
 Most popular model
 Insurer reimburses the insured for the cost of LTC services, subject to
fixed limits that are specified in the contract.
2. Service indemnity model
A fixed benefit payment is made for any day or week that formal LTC
services are received, regardless of the actual charges incurred for those
services.
3. Disability model (cash model plan)
A predetermined benefit is paid for each day an insured is eligible for
benefits, whether or not the insured is actually utilising formal LTC service.

Covered services
Type of service generally covered:

 Nursing home care

 Assisted living facility care
 Home and community-based care
 Hospice care
 Respite care
 Home modification and equipment
 Care management

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 Alternative plan of care (APC)
This allows insurer to pay benefits for services that might not be explicitly defined
or covered by the insured’s contract.

Benefit limit
Almost all plans have daily limits for institutional care

Inflation protection
1. Automatic inflation protection.
All benefit limits increase automatically each year by a pre-set
percentage.
2. Periodic increase offers.
The insured is periodically given opportunity to purchase additional amount
of coverage on a guaranteed issue basis.

Non-forfeiture benefits
A non-forfeiture benefit is generally offered with individual LTC as an option, for
an additional premium. It allows an insured who voluntarily terminates or lapses
coverage to receive a reduced, paid-up benefit without having to continue to
pay premiums.

Ancillary plan feature

Other plan features which may included as a base benefit or as option include:

Bed reservation benefit, caregiver training, death benefit, spousal riders and
discount.

Rate increase
The rate increase is regulated (by NAIC), by limiting the ability of insurer to
correct for rate inadequacy, by requiring a high loss ratio to be applied to the
portion of premiums due to rate increases after issue.

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2.9 Dental coverage
Dental benefits can be defined as either a scheduled amount per service (according
to a specific schedule) or as a percentage of allowed charges.

Potential service categorised into 4 types:

Type I: diagnostic and preventative

Type II: basic services (including extraction, restoration, endodontics, periodontics,

and anything not included in the other description)

Type III: prosthetic coverage (including inlays and crowns)

Type IV: orthodontia

Multiple treatment options

Accumulated untreated conditions
External anti-selection

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 IV. Managing Antiselection

4.1 The three faces of antiselection

Antiselection as happening at once of three times in the course of a policy’s life

 As the person is first becoming insured (external antiselection_

 While they are insured (internal antiselection)
 They make decision about whether to end the contract
(durational/cumulative antiselection)

4.2 Underwriting the individual risk (external antiselection)

Potential insureds who know they are likely to have a claim are more likely to seek
coverage tha potential insured who are don’t they will have a claim.

This external antiselection is controlled by insurer through a variety of mechanism:

 Individual (medical) underwriting before issue

 Policy provisions that exclude or limit coverage due to pre-existing condition
 Requiring an enrollment mechanism that doesn’t permit anti selection (such
as minimum participation percentages for associations)

Underwriting tools

 The individual application

 Attending physician statement (APS). This is the common way to get
additional information, if the insurer’s response depend on details of the
condition or procedure which aren’t included in application.
 Commercial database
 Internal data
 Telephone interview. Now days become major tool used in underwriting, often
replacing APS
 Inspection reports
 Lab testing
 Medical exams
 Tax return. Financial information provided through the application can be
difficult to evaluate, particularly in small business where financial flows can
vary dramatically at the choice of owners.
 Pre-existing condition provisions.
Pre-existing condition provision, a provision of the policy itself, is the tool. This
provision typically says that any condition for which there was treatment or
symptoms for up to 6-12 months prior to the application, will not be covered
for 12-24 months after issue.

Analysis of the information

 Debit manuals
 Genetic testing
 Predictive models

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Underwriting action

 Offered full coverage with no restriction

 Decline coverage completely
 Offer coverage at a higher premium rate. The higher premium could be
temporary or permanent
 Offer a standard policy, but excluding coverage that specific condition or
affected body system.
This is accomplished by use of a “waiver”, “impairment”, or “exclusion” rider.
This solution viewed negatively by some regulators, because it excludes
coverage for condition for which the insured has greatest needs.

 Offer a different policy or plan than the one applied for.

 Offer a different plan of benefits than the one applied for.

Pre-ex investigation, material misinterpretation, and rescission

Xxxxx

4.3 Changes in plan (internal antiselection)

Premium leakage: is the different in expected claim and expected premium when
there is a change in plan.

Formula:

Expected claim after plan changes – average new premium

Change in plan, change in deductible, change in premium, usually followed by

change in composition of insured (some might decide to change the plan) cause
change in the expected claim (so the expected claim not same with the expected
premium as in the initial product design) and premium leakage.

Buy down effect: difference in expected claim before plan changes and average
new premium.

Formula: expected claim before plan changes – average premium after plan
changes

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4.4 Antiselection upon lapse (cast/durational antiselection)
High risk individuals are:

 Less likely to be able to find coverage elsewhere

 Less likely to be willing to become uninsured
 Emotionally less willing to change their current insurance situation

As lapses continue year after year, the proportion of persisting policyholders in the
group who are higher risk will grow.

Lapse rate of high risk individuals is generally assumed to be less than that of low risk
individuals.

4.5 Modelling anti-selection

1. The partition model

 Drawing the line in a CAST model

 Drawing the line in a MNAM model
 Drawing the line in internal antiselection
 Markov processes

2. Projecting the model

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 V. Setting premium rates

5.1 Rate setting process

Approaches:

1. Based on direct, existing experience (such as the experience of an existing

block policies), sometimes called rerating
2. Based on fundamental pricing – rating from other data source (used as
benchmark), which adjusted to apply to the current situation

Fundamental nature of pricing (regardless whatever the approaches)

1. Measuring the past

2. Evaluating and adapting it to the future
3. Using it to project the future in order to determine needed rate levels

Consideration in rates setting:

1. The market, is a major factor, like how the product is priced by competitor to
meet market expectation, and thereby limit the insurers pricing option.
2. Existing products,
3. Distribution system
4. Regulatory situation
5. Strategic plan and profit goals of the company, the ability to price
competitively yet profitable is always the challenge.

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5.2 Rate structure used today
Theoretically: premium rate should be set to vary by ANY variable discovered to have
a material correlation to claim cost

Practically: rating variable limited to those that have both a rational causal and such
a correlation.

Major rate structure elements:

 Age, such as: attain age at renewal, entry age.

 Duration, or the age of policy in force
 Gender, parental, marital status
 Geographical area, such as: location of issue and location of residence.
Other coverages affected by area include LTC (where one state’s much
higher availability of nursing homes might cause utilisation to be higher), and
DI (where varying legal environments by state can cause larger differene in
claim cost). Typically, granularity of geographic rating areas for medical
coverages tends to be much finer than other coverages, often to level where
rates might vary by country.
 Occupational. Disability income insurance is the one area of IH that relies
heavily on occupation, both underwriting and rate setting.
 Other factors, such as: health status (substandard rate for higher risk), past
claim history (sometimes renewal rates can be based on claim experience),
smoking status, weight, etc.

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5.3 Fundamental pricing
Involves using tables or claim cost developed through other sources as the basis for
pricing, this particularly useful when pricing for new benefit. Company’s own
experience is preferable compare to using other source since it was generated by a
group of policies that are underwritten in the same way.

There are 3 basics method in fundamental rate development

A. Tabular method
 In this method, an existing table, or modification of it, is used as the morbidity
(claim cost) basis for pricing
 Typically used for long term, non-inflation sensitive products like DI
 Modelling technique usually deterministic
 Formula:
𝑓𝑖𝑛𝑎𝑙 𝑦𝑟

𝑁𝑃 = ∑ 𝑃𝑟{𝐶𝑙𝑚𝑧 } × 𝐴𝐶𝑧 × 𝑣 𝑡 × 𝑙𝑧
𝑧=𝑖𝑠𝑠𝑢𝑒 𝑦𝑒𝑎𝑟

Where:
𝐴𝐶𝑧 : average claim (assuming a claim occur) is year z
𝑙𝑧 : proportion of originally issued lived still in force in year z, typically calculated by
applying decrements for lapsation and death to the starting model population.
𝑓𝑛𝑙 𝑐𝑙𝑚 𝑝𝑦𝑚𝑛𝑡

𝐴𝐶𝑧 = ∑ {𝐶𝑙𝑚$} × Pr{1 − 𝑇𝑛𝑠 } × 𝑣 𝑠

𝑠=1

Where:
S: claim duration
𝐶𝑙𝑚$: the claim dollar payable at claim duration s
Pr{1 − 𝑇𝑛𝑠 }: probability of a claimant at claim duration 0 remaining disabled at
duration s
Fnlclmpymt: the claim duration of final possible claim payment

There are additional complexity in the calculation caused by the following

factor:
 Modal premium
 Modal lapse rate
 Exposure calculation
 Additional benefit
 Interest
 Multiple decrement

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 B. Build-up and density function
For inflation-sensitive product

Build up

 The benefit provided are considered the sum of a number of composing

pieces, there could be very detail categories of claim.

build up method
(c) (e)
(a)
(b) gross (d) net
annual
service category average claim cost claim
utilisation
charge cost sharing cost
per 1000
PMPM PMPM
Hospital inpatient
medical 130.1 3277 35.53 35.53
surgical 84.2 5369 37.67 37.67
psychiatric 25.7 1209 2.59 2.59
Substance abuse 15.4 803 1.03 20 1.00
hospital outpatient
emergency room 207 663 11.44 5 11.35
surgery 122 3528 35.87 35.87
radiology 190 728 11.53 10 11.37
laboratory 225 226 4.24 4.24
Physician 160 219 2.92 2.92

(c ) = (a) x (b) / (12 months x 1000 lives)

(e)= (c ) – [(a)x(d)/(12 months x 1000 lives)]

Density function

 this is very useful when calculating the impact of deductibles, out of

pocket limit, and other benefit characteristics which do not depend on
the particular services provided.
 Density function become difficult to deal with when trying to evaluate the
impact of changes in portion of the benefits, such as copays

Combining build up and density function in PPOs

 In-network benefit often have copays associated with them. Out-of-

network benefit typically have significant deductible and coinsurance
instead
 Average charge level are likely to differ significantly between in-network
and out-of-network claims
 when calculating claim cost for such PPO programs, the typical approach
is to separately calculate:
o in-network claim cost (using the build-up approach)
o out-of-network claim cost (using density approach)
o then combine these 2 claim cost as a weighted average, where
the weight are relative claim dollar expected to occur in and out
of network.

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 C. Simulation
 Based on Monte Carlo simulation
 Such a simulation for an individual’s claims can be constructed in various
ways. A good method is
o to first develop an “expected” value based on the whole block
experience
o expected value is modified for past experience, claim history, other
medical information about individual
o it is modified to simulate random statistical fluctuation from this
adjusted expected value
 the advantage of this stochastic method is that it allows us to examine the
projection over the whole distribution of the future claim result, over the
whole portfolio.
 This method allows us to develop extensive and complicated function
relationship between model values. For example, lapse rate might
depend on the rate increase percentage presented, prior rate increase,
absolute rate level relative to the market place, characteristics of
policyholder, policyholder’s own claim experience and other factor.
Many of these relationships are not linear, so it maybe misleading to
assume average values each of them and calculate average lapse rate.

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5.4 Rerating
Step 1 Gather experience
 Experience here means historical premium and claim figure
 There are several guidelines which should be used in gathering experience
o Preferable deal with Incurred claim and earned premium rather than
paid claim and premium received
o Run out basis claim experience rather than financial basis
Financial basis
Incurred claim=paid claim + ending claim reserve – beginning claim reserve
Ending claim reserve – beginning claim reserve = change in reserve
Change in reserve = reserve estimate for the most recent period + correction to prior
reserve based on recent knowledge
Run-out basis
Allocate the correction to prior reserve estimate back to those periods
(rather than to the time they are recognised)

Step 2 Restate experience

 In doing rerate analysis, if we use the experience from step 1 “as is”, we would
typically be working with premium that was earned under multiple rate
schedules. Judgment we made about the appropriate level of those rates
would be with respect to the average rate level in effect during the
experience period.
 To address this, we can either:
o Do the analysis with respect to the average level, and then adjust for
the relationship between average rates in the experience period and
the current rate level
o Adjust past experience to be on a current rate level, and do the
analysis with respect to the current rates

Policy reserve consideration

 It is important to consider policy reserve when do rerating, especially for

product with significant policy reserve such as LTC and DI
 Typically, experience analysis is conceptually an A/E comparison, where
actual loss ratio compared with expected loss ratio. It would be inappropriate
to compare actual loss ratio (without policy reserve) against an expected
lifetime loss ratio, which would implicitly be on ”with policy reserve” basis.
 Joe Pharr – it is necessary to make an interest adjustment in the loss ratio when
actual experience meet expected. And also include the policy reserve in
order to achieve an actual loss ratio “with policy reserve”

𝑝𝑜𝑙𝑖𝑐𝑦 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 + 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 𝑐𝑙𝑎𝑖𝑚 𝑖

𝑃𝑥 = + (𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 − 50% 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 𝑐𝑙𝑎𝑖𝑚)
1+𝑖 1+𝑖

 Thus in doing A/E analysis, one can do it with or without policy reserves. If
done with them, it is important that the loss ratio be interest-adjusted.

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Step 3 Project past result to the future
This step use the result of step 2, together with set of adjustment for “what do we think
will happen if we don’t change the rate?”

The following factor could be material to identify cause of future changes:

 Changes in covered population
 Changes in duration
 Changes in benefit
 Changes in claim cost
 Leveraging
The impact of fixed benefit characteristics such as deductibles, copays, OOP
limit, cause leveraging effect which generally result in claim cost increasing at
higher rate than underlying cost.
The source of leveraging: from arithmetical mechanics and the fact that there
are expenses in year X that do not hit the deductible but with inflation, they
do hit in year X+1.
 Other changes
 Whether the company’s renewal business might have been
“cannibalised” by re-underwriting existing policyholder into new policies
(this is a concentrated form of cumulative antiselection)
 Changes in underwriting
 Sudden increase in lapse rates, possibly indicating higher-than-market
rates on healthy lives
 Changes in policy provision
 Changes in Business operation
 Changes in Premium and benefit, etc

Typical projection of claim for major medical policy might include:

S: experience period
t: projection period

𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝑐𝑙𝑎𝑖𝑚𝑠𝑡 =
𝑐𝑙𝑎𝑖𝑚 𝑐𝑜𝑠𝑡 𝑃𝑀𝑃𝑀𝑠 × 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑚𝑒𝑚𝑏𝑒𝑟𝑠𝑡 ×
{(1 + 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝑐𝑙𝑎𝑖𝑚 𝑐𝑜𝑠𝑡 𝑡𝑟𝑒𝑛𝑑𝑠)𝑡−𝑠 − 1} ×
𝐴𝑣𝑔 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑓𝑎𝑐𝑡𝑜𝑟𝑡
{ } × {(1 + 𝑎𝑛𝑡𝑖𝑠𝑒𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑢𝑒 𝑡𝑜 𝑙𝑎𝑝𝑠𝑒)𝑡−𝑠 } ×
𝐴𝑣𝑔 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑓𝑎𝑐𝑡𝑜𝑟𝑠
{(1 + 𝑎𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑓𝑜𝑟 𝑜𝑡ℎ𝑒𝑟 𝑐ℎ𝑎𝑛𝑔𝑒𝑠)𝑡−𝑠 }

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Step 4 Compare the projection against desired result
 In this step, actuary will compare the projected loss ratio (from step 3 result) and
desired loss ratio.
 Factor influenced desired loss ratio: company expenses and profit
Expenses
 The expenses reflected in the target loss ratio are those that the company
attributes to that linen of business
 Such expenses are typically expressed as a formula, involving one or more
of the following element:
𝑥1 × ($ 𝑜𝑓 𝑝𝑟𝑒𝑚𝑖𝑢𝑚) +
𝑥2 × (𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑜𝑙𝑖𝑐𝑖𝑒𝑠, 𝑏𝑦 𝑑𝑒𝑓𝑖𝑛𝑖𝑡𝑖𝑜𝑛 = 1) +
𝑥3 × ($𝑜𝑓 𝑐𝑙𝑎𝑖𝑚) +
𝑥4 × (1 𝑖𝑓 𝑓𝑖𝑟𝑠𝑡 𝑁 𝑦𝑒𝑟𝑎𝑠 𝑜𝑓 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛, 0 𝑜𝑡ℎ𝑒𝑟𝑤𝑖𝑠𝑒) +
𝑥5 × (𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟) +
{ 𝑥6 × (𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑚𝑒𝑚𝑏𝑒𝑟𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡)

Profit
 The other name usually used to express profit: contribution to free
reserve, contribution to free surplus
 Profit typically is expressed as:
o % of premium (most common with CMM coverages)
o % of return on equity (most common in LTC and DI)
o % of return on investment

Step 5 Apply regulatory and management adjustment

 This is the last step after needed premium level are calculated
 Management reasons typically might include competitiveness of the premium on
new business, company profitability in other lines, relations with public or the
producer force, or public or social policy.
 Regulatory interventions typically happen when regulators try to hold down the
rising cost of health insurance for public. This motivation is expressed at least 2
different ways:
o Application of minimum loss ratio standards
o Requirement in many states that rates be approved by the insurance
department before being used

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5.5 Turning claim cost into gross premium
 Method used to turn claim cost into gross premium depend on the time horizon
being implicitly used in company’s rating philosophy (determined by type of
company, mostly).
 DI, LTC, and other non-inflationary benefit typically involve long term projections,
because:
 The future claims are predictable, relative to medical coverage
 Claim cost increase over time
 Premium structure tends to be issue age based

When pricing these benefits, insurer typically use asset-sharing model.

Block rating (short time horizon) approach

 Gross premium (actual premium charged to policyholder) = claim cost + expenses
+ desired profit
 Claim cost translated into age/gender neutral basis. This helps to:
o put the figures into understandable context, particularly for anyone
not personally familiar with what the unadjusted figures mean
o maintaining an understandable manual rate book
 Profit targets expressed as % of premium in the projection period.
 Gross premium can be expressed as:
𝑁 × (1 + 𝐸 𝑁 ) + 𝐸 𝐹
𝐺=
1 − 𝐸𝐺
G: gross premium
𝐸 𝑁 : expense as % of net premium
𝐸 𝐺 : expense as % of gross premium
𝐸 𝐹 : fixed expense

Asset share approach

 This calculation is generally done for each of variety of representative rating cells.
For example, for a major medical plan it might be for quinquennial (every 5
years) ages, each gender, each of 5 plans.
 LTC policies will most often have asset share calculation done for
A. representative ages
B. Each elimination period
C. Each benefit period
D. Each home care benefit level
E. Each inflation protection option
 Asset share calculation can be done either on a policy year basis (more simple)
or calendar year basis.
 Typical asset share elements:
A. Exposure value
B. Revenue value
Revenue elements are the premium, investment income, and any other
revenue related items such as explicit subsidies.
Could be expressed as:
 Received basis
(as simple as cash received)
 Written and renewed basis

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 (cash received + increase in premium paid in advance – increase in
premium due and unpaid)
 Earned basis
(written and renewed – increase in unearned premium)
C. Claim values
D. Capital values
 It is important to understand the need for capital created by the line of
business, and to model the cost of capital relative to total return.
 Whatever the rationale – when a policy is sold by the company, it
explicitly create a need for additional capital by the company beyond
what would otherwise needed. This may go beyond the marginal extra
capital, since if every policy just had marginal capital allocated to it, the
total allocation would not equal the total capital.
E. Expense and profit targets
Profit calculated in 3 ways:
 PV profit
Using a specified interest rate, compare that to the PV future premium
 ROI
There is a presumed investment by the company to issue the policy.
This is a negative profit at time of issue. Positive future profit are
presumably great enough to offset initial profit plus additional return on
that investment.
 ROE
If cost of capital has not been included in the asset share as an
expense, it can be included in the profit measurement.
If the initial investment in the ROI calculation is supplemented by the
capital that is set aside to cover business, then greater profits needed
to cover that expenses. Note that, at an interest rate of zero, the PV of
capital set aside at issue is zero, since it is all ultimately released. At
non-zero interest rates, future payments must be larger to offset the
initial required capital. This calculation is called ROE.

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 VI Reserve and Liability

6.1 Type of and use of reserve and liabilities

At any given point of time, there are number of situations in a typical insurance block
where:

 Cash flow has occurred but the event to which it applies has not, or
 Vice versa

Reserve and liabilities are used to adjust for these timing differences, so that financial
reports can accurately measure various aspects of that operation. Without this
adjustment, financial report are on a cash basis. With them, they are on an accrued,
earned, or incurred basis.

A major reason for reserve: the matching revenue to cost over time.

Reserve vs liability
 Term liability refer to all financial obligations of a company that appear on its
balance sheet
 According to NAIC, liabilities refer to obligation that are already incurred
and accrued. Reserve refers to obligation which have not been incurred or
are not yet accrued.

Type of reserve
 Based on Functions
Premium reserve, claim reserve, policy reserve, gross premium reserve
 Context for reserves
This refers to which accounting bases, for example statutory statement (SAP),
GAAP statement, tax statement embedded value based statement.

6.2 Premium reserves

Unearned premium
In most cases, the calculation is pro-rata portion of the actual gross premium
received. Sometime approximated by taking 0.5 of all modal premium in force in
valuation date.

Premium paid in advance

Sometimes a policyholder will pay more premium than is strictly required to pay
for current renewal period on the valuation date, such as having paid two
monthly premium on 15 December for a monthly renewal. When this occur
insurer must set up reserve for such premium until the period occur for which they
are apply.

Premium due and unpaid

Sometimes premium payment are made late. When that occur, some or all of
that premium is expected to be received, and some credit is taken on the
statement (as an asset) for such premium due and unpaid (D&U).

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6.3 Policy reserve
Policy reserve are amount of money set aside to account for current funding of cost
over the future lifetime of policies. Also called as: contract reserve, additional reserve.

Theory
Net premium in this context are those which are sufficient to exactly cover the
cost of the claims, with no allowance for expenses and profit.

Basic formula, policy reserve at time t, for a policy issued age x

𝑡𝑉𝑥 = 𝑃𝑉{𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑙𝑎𝑖𝑚} − 𝑃𝑉{𝑓𝑢𝑡𝑢𝑟𝑒 𝑛𝑒𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚}

𝜔 𝜔
𝑧
= ∑{𝑖𝑝𝑥 × 𝑣 𝑖−𝑡
× 𝑖𝐶𝑥 } − ∑{𝑖𝑝𝑥 × 𝑣 𝑖−𝑡 × 𝑧𝑖𝑃𝑥 }
𝑖=𝑡 𝑖=𝑡

Where:

𝑖𝑝𝑥 : probability of survival to i of policy issued at age x

𝑣 𝑡 : present value factor, (1+ annual interest rate)-t
𝑖 𝐶𝑥 : claim cost for someone age x duration i, issued in year z,
𝑧

𝑖 𝑃𝑥 : net premium for someone age x at duration I, issued in year z

𝑧

When t=0, PV future claim – PV future net premium, 𝑡𝑉𝑥 = 0

Complication and variation to the reserve formula

 The major complication is came from expenses calculation. Since early
expenses (mostly at issue) are typically higher than later expenses, the
double whammy of having to pay those expenses plus start holding policy
reserve can put a large strain

In statutory accounting

 to tackle expenses, statutory accounting allow modified reserve method

 for other than LTC: 2YFPT reserve (two year full preliminary term)
this can be thought of as allowing the insurer, as they start holding reserves,
to treat the policy as if it was actually issued two years later than it was,
with policyholder actually 2 years older.
𝜔 𝜔
𝑧
𝑧 2𝑃𝑇
𝑡 𝑉𝑥 = ∑ {𝑖𝑝𝑥−2 × 𝑣 𝑖−𝑡+2
× 𝑖𝐶 𝑥+2 } − ∑ {𝑖𝑝𝑥+2 × 𝑣 𝑖−𝑡+2 × 𝑧𝑖𝑃 𝑥+2 }
𝑖=𝑡−2 𝑖=𝑡−2

For 𝑡 ≥ 3, 𝑎𝑛𝑑 = 0 𝑓𝑜𝑟 𝑡 = 1,2

For LTC: 1YFPT, has similar conceptual basis.

GAAP accounting

 Expenses are explicitly reflected.

 The policy reserve (benefit reserve)calculated using net premium (for
claim only, exclude expenses)
 DAC and expense reserve
o to recognise expenses, a parallel calculation is done using
expenses rather than benefit.

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 o This expense reserve is actually asset, but conceptually
equivalent to negative reserve, perform opposite to benefit
reserve.
o Expense reserve allow a company to postpone recognition of
certain expenses, and thus allow funds to flow through to profits
earlier than they would. This is opposite with benefit reserve, it
cause a company to set aside fund which would otherwise
become profit.
o The equivalent of the reserve in expense terms is called the DAC
asset.
o The DAC is composed of deferrable expenses, which those
incurred to acquire the business.
DAC formula:
𝑧
𝑡 𝐷𝐴𝐶𝑥 = 𝐴𝑉{𝑑𝑒𝑓𝑒𝑟𝑟𝑎𝑏𝑙𝑒 𝑒𝑥𝑝𝑒𝑛𝑠𝑒} − 𝐴𝑉{𝑛𝑒𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑟𝑒𝑚𝑖𝑢𝑚}
𝑡−1 𝑡−1
𝑧
= ∑{𝑖𝑝𝑥 × 𝑣 𝑖−𝑡
× 𝑖𝐸 𝑥 } − ∑{𝑖𝑝𝑥 × 𝑣 𝑖−𝑡 × 𝑧𝑖𝑃 𝐸𝑥+𝑖 }
𝑖=0 𝑖=0

𝑖𝐸 𝑥 :
deferrable expense at time t, from a policy year z, to a policyholder
𝑧

aged x

Purchase GAAP
 When a company is acquired, the DAC asset is released, since when a
business is sold, future profit is capitalised into the sales price, so DAC as well
 In its place, the acquiring company creates a VOBA (value of new business
acquired), calculated as PV of cash profits over the future life time of the
business assumed, discounted at a risk rate of return, this include in appraisal
work done to determine purchase price for the business.

Pre-funding trends
 Pre-funding is another term of policy reserve) means today’s environment,
with multiple trends (durational, aging, and secular).
 Another complication to the basic policy reserve is caused by the various
sources of increasing claim cost.
 There are 3 sources of increasing claim over time
A. Inflationary
B. Aging insured
C. Durational trends
 It is not feasible to completely pre-fund 3 sources of claim cost increase.
Most typically insurer only pre-fund aging of the insured and few years of
durational deterioration, but no claim trend.
 Most of major medical premium do not pre-funds trends, but instead use
premiums calculated to exactly match that year’s claims. Most DI and LTC
products are priced on a level premium basis, recognising aging and
durational effects.

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 Hold or not to hold (the policy reserve)
 Regulator does not prescribe the policy reserve hold for all product, for
example, LTC and DI is required, but inflation sensitive product is not (may be
it is because it is difficult to adjust such experience to make meaningful A/E
comparison) impacting claim cost.
 Further, any prefunding at all will increase the initial rates, which will hurt
competitiveness in this heavily premium driven market place. So,unless pre-
funding is mandated, it is unlikely to occur to any great degree, unless
particular carrier has their competitive advantage to sacrifice in order to
prefund.

Rate increases
Method to calculate change in policy reserve (by E. Paul Barnhart):
 Leave the existing stream reserve factors alone
 The rate increase could be considered to be a recognition of increment to
that stream.

Reserve bases
(This is not applicable, discuss about NAIC regulation)

Policy reserve and experience monitoring

If actual experience unfolded to exactly match pricing assumptions, we would
expect to see actual reported loss ratio equal the lifetime anticipated loss ratio.
It turns out that, algebraically, this will not happen if we do 2 things which are
not otherwise intuitively obvious:
1) Increase/decrease in policy reserve each year must be added to or
subtracted from the incurred claims that year
2) An interest adjustment must be made to claims, to account for that year’s
interest earnings on reserves assumed in the reserving processes.

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6.4 Claim reserves
Claim reserve and liabilities are the amount set aside to cover future payments for
claims which have been incurred under the contract, which have not been paid.

There are 7 methods used in calculating claim reserves:

1. Triangular method
 This method uses past claim runout history (how payments occurred over
time for past incurral dates) as a predictor for future run out. Also called
run-out method, or development method.
 Steps to calculate claim reserve using triangle method:
 Paid claim run-out table (claim paid since incurral date)
 Cumulative claim paid table
 Completion ratios table (claim paid at t/claim paid at t-1)
 Completion factors table
𝑝 𝑝
𝐹𝑖 = 𝑅𝑖 , 𝑓𝑜𝑟 𝑝
= 𝜔, 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑙𝑎𝑡𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑚𝑜𝑛𝑡ℎ ,
𝑝−1
= 𝑅𝑖𝜔 × 𝐹𝑖 , 𝑓𝑜𝑟 𝑖 < 𝑝 < 𝜔
𝑝
𝑝
𝐹𝑖 = ∏ 𝑅𝑖𝑡 , 𝑓𝑜𝑟 𝑖 < 𝑝 < 𝜔
𝑡=𝜔
𝑝
𝐹𝑖 : completion factor, incurral month I and payment month p
𝑝
𝑅𝑖 : completion ratio

 Calculate ultimate paid claim

 Adjust the result, compare and weight these alternative result.
Adjustment include:
o Averaging the completion ratios attributable to a given
month of pay out
o Averaging the completion factors used to calculate
ultimate claims
o Developing and using “seasonality” factors, which
month (or season) based on completion factor
o Taking rolling sums of multiple month incurrals, to
smooth the result.
 One major assumption in this whole development is that: past claim run
out pattern is representative of the future one,
If there is any reason to believe otherwise, this analysis must be modified
to address that issue, example of such reason:
 Company mechanism changed to or from electronic submission
of claim
 A change in administration IT systems with concomitant change in
work flow
 Slow down or speed up the claim administration department –
including unusual holidays and vacation
 Change in benefit
 Change in level claim backlog during historical period
 Unexplained fluctuation in the claim payout.

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 2. Claim cost / Loss Ratio method
 The methods involves developing an estimate of claim cost (incurred
claim in a month divided by the exposure, such number of members) for
older month, and using it to estimate the claim cost for the recent month.
 Combining loss ratio and triangle:
o For recent month: using loss ratio method
o For older month: using triangulation method
 The more sophisticated method combining LR and triangle: Bornheutter -
Ferguson

3. Tabular method
 There are some coverages that have low number high claims, or may also
have claim payout that extend over a long period of time.
 Notable coverage with this claim characteristic typically: disability
income and long term care
 This tabular method produce separate claim reserve figure for each claim
which exist on the valuation date. The company total reserve are the sum
of these separate reserves.

4. Regression method
5. Average claim size method
 This is a simple method of applying an average expected claim size
against the count of known claims.
 The method is not useable for unreported claim
 The method is most useful for estimating the value of reported but
unprocessed claim (backlog claims), where there is a count of claims but
no other information.

6. Formula method
 This refer to methodology where past relationships of reserve to other
statistics is calculated, and is applied to those statistics on the valuation
date.
 The statistics such as: number of policies, premium in force, paid or
incurred claim count, number of pending claim, etc

7. Seriatim case reserve

 “case” reserve are reserves set based on judgment applied to each
individual claim (case)
 This method is appropriate when:
o For claims that being contested in judicial proceedings might be
held based on the company’s attorney’s opinions
o Where there are catastrophic medical claim, and knowledge of
the details of the claim examiners can yield much more accurate
predictions of ongoing claim payments than the application of
other mechanical method

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6.5 deficiency and other reserve
Deficiency reserve
 Sometimes insurer required to hold “deficiency reserve” by regulator
 Deficiency reserves are slightly specialised form of gross premium reserve. This
specialisation occurs because the reserves are developed specifically for the
statutory blank, and therefore they are boundaries set by regulators, on how
reserve be calculated.
 Deficiency reserves are commonly intended to be only for:
1) A specific block of policies (rather than insurer’s entire, as might used
for gross premium reserve)
2) The limited period of time for which current rates are expected to be
valid.

Other reserve
 For insurer subject to Standard Valuation Law
 The appointed actuary must annually file an opinion which include an asset
annually analysis, which determine the likelihood that current asset plus future
revenue will be able to cover future liabilities. This include cash flow testing.

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Formula from Rate Making and Reserving

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 VII. Financial Reporting and Solvency

7.1 Financial Reporting

Business periodically report to regulators and owners, they prepare it using a set of
accounting principles

Those principles are:

Statutory reporting GAAP

(generally accepted accounting
principles) reporting

Is a set of accounting principles and In the US is based on a different set of

practices prescribed by the regulators
who supervises insurers.
Tend to focus most heavily on solvency
protection for the public, and is therefore
relatively conservative
Tend to provide both asset and liability
values on a basis which would
demonstrate solvency if the insurer
closed its doors on the date on
valuation.
accounting principles and practices
determined by FASB (financial
accounting standard board)
focus more on accurate reporting of
revenue and earnings, and has only
limited and explicit conservatism
Is on a going concern basis, meaning
that value in the statement assume that
the enterprise will continue into the future

3rd basis is Tax basis

The purpose of tax basis “is to limit the amount of tax deductible life insurance
reserve to the minimum level under prevailing valuation standard of the States”

Moving from statutory to GAAP, the major aspect of such modifications are:
 Capitalisation of DAC.
DAC allocates the higher initial expenses of acquiring business, which would
otherwise be charged at the time it is incurred, proportionately to the future
earnings attributable to that business, with a modest amount of conservatism
 Replacement of statutory conservatism in policy reserve with the PfAD, a less
conservative basis.
 Some differences in recognition of deferred taxes, all receivables and
allowances
 Reporting of reserves is net-of-reinsurance in statutory reporting

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Gain and loss

Gain =
total revenue – total underwriting deduction

Total revenue=
net premium income
+ change in UPR and reserve for rate credit
+ fee for service (net of medical expense)
+ risk revenue
+ aggregate write-ins for other health care related revenue
+ aggregate write-ins for non-health care related revenues

Total underwriting deductions=

total hospital and medical
+ non-health claims (net)
+ claims adjustment expense including cost containment expenses
+ general administrative expenses
+ increase in reserves for accident and health contracts
+ increase in reserve for life contracts

Analysis of claim unpaid – prior year net of reinsurance

Claim incurred in prior years = claim paid in this year on prior incurrals + the portion of
this year’s ending reserve applicable to prior year’s incurral

Aggregate reserve for accident and health contract

Health policy reserve=

UPR
+ additional policy reserve
+ reserve for future contingent benefit
+ reserve for rate credits or experience rating refunds for investment income
+ aggregate write-ins for other policy reserves
– reinsurance ceded

Health claim reserves =

PV of amount not yet due on claims
+ reserve for future contingent benefit
+ aggregate write-ins for other claim reserves
– reinsurance ceded

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Accident and health contracts

Total active life reserve (gross)=

UPR
+ additional contract reserves
+ additional actuarial reserves
– asset / liability analysis
+ reserve for future contingent benefits
+ reserve for rate credits
+ aggregate write-ins for reserve

Total claim reserve (gross)=

PV of amount not yet due on claims
+ additional actuarial reserves
– asset/liability analysis
+ reserve for future contingent benefits
+ aggregate write-ins for reserve

Claims for life and accident and health contract

For categories of liability:

 Due and unpaid
 In course of settlement (resisted)
 In course of settlement (other)
 Incurred but not reported

Gain from underwriting before dividends or refunds=

Premium earned
+incurred claims
-cost containment expenses
-increases in contract reserves
-total other expenses incurred
-aggregate write-ins for deductions

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7.2 Solvency testing
For statutory financial reporting

The major tool currently used by regulators in monitoring and evaluating capital
adequacy is the risk-based capital (RBC) formula. There are separate formulas for life,
health, and P&C company.

RBC monitoring is conceptually quite simple:

 Company data is put into the RBC formula to calculate the benchmark
authorised control level (ACL) RBC value
 Company’s capital and surplus is taken, with some adjustment specifically for
this purpose, to find adjusted capital
 The ratio of adjusted capital to the ACL level is calculated. If the value of that
ratio falls under 200%, corrective action is specified by the RBC law. The
severity of that action depend on how far under 200% trigger it falls.

Theory

RBC formulae, in particular HORBC (RBC for health organisation) are designed to be a
set of relativities that reflect the widely varying risk profiles that different kinds of
coverage and insurance experience.

The HORBC formula was developed based on presumption that risks is embodied as
unexpected negative fluctuation in financial result. This fluctuation could be seen
from historical result.

Fluctuation were assumed to be composed of 2 elements:

1. Statistical fluctuations.
Which were purely random fluctuation based on probability distributions of
individuals in the group and the size of portfolio.
2. Historical (or residual) fluctuation
Which were remaining fluctuation, assumed to be based on everything else,
but which did not vary by size of the portfolio

The theoretical formula was developed by Monte Carlo simulator that was
specifically designed for that purpose, combined with ruin model that simulated on
going capital level of a block of business. The result of theoretical formula was
modified for simplicity and accessability.

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Using the formula

HORBC formula is:

𝐴𝐶𝐿 = 0.5 × (𝐻𝑜 + √𝐻12 + 𝐻22 + 𝐻32 + 𝐻42

This is assume H factor is independent each other

H1: risk of invested asset loosing value

H2: underwriting risk
H4: Business risk

The most important item in this list for most health insurer is H2, the underwriting risk. This
is the risk due to the possibility that the business will incur underwriting losses – that the
claim and expenses will exceeded the revenue and put the company’s capital at
risk.

The H2 value is calculated separately for medical and other coverage, DI, LTC, and
certain limited benefit plan.

1. H2 for medical coverage

The main RBC value is calculated using following nested logic:

RBC after managed care discount=

Base underwriting risk RBC
x managed care discount rate

Base underwriting risk RBC=

Underwriting risk revenue
x underwriting risk claim ratio
x underwriting risk factor

𝑢𝑛𝑑𝑒𝑟𝑤𝑟𝑖𝑡𝑖𝑛𝑔 𝑟𝑖𝑠𝑘 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 𝑐𝑙𝑎𝑖𝑚𝑠

Underwriting risk claim ratio=
𝑢𝑛𝑑𝑒𝑟𝑤𝑟𝑖𝑡𝑖𝑛𝑔 𝑟𝑖𝑠𝑘 𝑟𝑒𝑣𝑒𝑛𝑢𝑒

Managed discount factor

Managed care provider payment occur in a variety of ways, with a wide
range of impacts on underwriting risk. For each of these, the paid claim in
each category is weighted by a corresponding discount factor, and
merged into a single factor
 Category 0: arrangement not included in other categories
 Category 1: payment made according to a contractual
arrangements
 Category 2: is for payments subject to withhold or bonus
arrangement, etc
𝑤𝑖𝑡ℎ𝑜𝑙𝑑 𝑎𝑛𝑑 𝑏𝑜𝑛𝑢𝑠𝑒𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒
Average withhold rate=
𝑐𝑙𝑎𝑖𝑚𝑠 𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝑡ℎ𝑒𝑚

𝑤𝑖𝑡ℎ𝑜𝑙𝑑 𝑎𝑛𝑑 𝑏𝑜𝑛𝑢𝑠 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠

MCC multiplier=
𝑤𝑖𝑡ℎ𝑜𝑙𝑑 𝑎𝑛𝑑 𝑏𝑜𝑛𝑢𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒

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 2. H2 for DI
There are 2 categories in tis coverage: noncancelable and other
3. H2 for LTC
There are factors that apply to earned premium, incurred claim, and claim
reserves. Furthermore, there are different factors depending on whether
the coverage is non-can.
4. H2 for limited benefit plan
There are 3 categories of such plans included in HORBC calculation
 Hospital indemnity and/or specified disease plans.
The factor is 0.35 x premium + $50,000
 Accidental and dismemberment
 Other accident, flat factor 0.05 applied to premium

Excessive growth

This element suggested due to a belief by some practitioners that only highly
correlated predictor of significant losses with a short period of time is rapid growth in
the size of block of business.

Formula:

Excessive growth risk=0.5 x excess of H2 RBC growth above safe harbour

Where:

Safe harbour=last year’s H2 RBC x growth in H2 revenue figure this/last year +10%

7.3 result of the calculation

Once the values of H0 to H4 are calculated, the RBC benchmarks can be calculated.

The ACL value is the level where, if TAC falls below this number, regulators are
authorised to take control of the company. There are actually four such levels, each
representing successfully more dire situation with successively more severe action:

 Company action level, 200% of ACL. If adjusted capital falls below this level,
the company required to submit a plan of action to the regulators, to address
shortfalls
 Regulatory action level, 150% of ACL. If adjusted capital falls below this level,
regulators can specify the corrective action to be taken by the company
 ACL described above
 Mandatory level, 70% of ACL. If adjusted capital falls below this level,
regulators are required to take over management of the company.

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 VIII. Forecasting and Modelling

8.I Purpose and uses of the models

The purpose of the model includes:

1. Pricing. Financial and sales models are typically used to determine the
premium rates necessary to achieve goals.
2. Reserve calculation and reserve basis evaluation. This is result of a forecasting
model
3. Monitoring result. This can be done to test the validity of assumptions, to warn
deviation from expected values, for resource planning, or for other reason
4. Solvency testing. Gross premium reserve are ultimate test of the need of
5. Financial forecasting
6. Appraisal. Typically used when transferring ownership of the block.

Deterministic vs stochastic

 Deterministic model show the interrelation of variables, but each piece of

output is a single value. Deterministic model can still be helpful. When we
want to test the impact of specific alternative situations (scenario testing) they
can quite useful.
 Stochastic model treat one or more variable stochastically, meaning that,
rather than representing the variable’s value at a point in time by a single
point of estimate, the variable’s whole distribution of possible result is used.
Sometimes this representation is parametric, meaning that the distribution is
assumed to match particular known distribution (with parameter suitably
chosen), such as an F-distribution or a Normal distribution.

8.2 Characteristic of a good model

 Reliable accuracy. Of course model is not worth much if it does not do a
good job of predicting the future.
 Suitability for use. The model should produce the result it is designed for,
including all appropriate aspects of design and detail, without adding
unnecessary complication.
 Appropriate precision, for example on how many decimal should be kept,
used, and displayed
 Sensibility. Model should reflect a logical theoretical construction on what is
being modelled.
 Effectively communicated.

8.3 Building a good model

Step 1. Choosing the basic structure of the model
Modelling tools.

 Spreadsheet, for managing and building the model, very straioght forward
and easily modified
 Database model, when large amount of data must be manipulated,
 Sequential program, when user friendly interface is important, written in
computer language, equivalent to macro in spreadsheet

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 Asset share type model

 This is the most common model type.

 When used for pricing, asset share model are typically done on a per
policy or per unit coverage basis. Asset share can also be used in
projecting future earning for appraisal work

Reserve development model

These model come in a number of flavours; claim lag (development) models,

tabular reserve models, and active life reserve models.

Deterministic vs stochastic

Stochastic models are reserved for situation that require their unique output, and
deterministic ones are used otherwise.

Step 2. Choosing the information to be carried

Depend on the purpose of the model

1. Pricing model
 Is typically project model offices, spreadsheet representations of an
expected mix of policies
 A detailed asset share model might carry a number of exposure
values, such as the number of policies in force at the end of the
year, and average inforce for the year
 Claim values that might carried include paid claims, incurred claims
(financial basis), and incurred claim (runoff basis)
 Reserve values carried might include premium reserve (unearned
premium, paid in advance, premium due and unpaid), policy
reserves, claim reserves, and gross premium reserves.
 Expense values carried will vary widely, depending on the
company’s particular circumstances.
 Profit is calculated on either statutory or GAAP basis, a dependent
variable
 For many purposes, it is important to know how much capital is
required to support the block of business over time, given
company’s chosen capital and surplus target
2. Reserve model
 Reserve models for developing short term claim reserves (claim
triangles) are usually based on paid claim exposure
 Reserves for tabular claims are usually either taken directly from
table or based on promulgated factors
 Policy reserves involve exposures and claim and may involve
premium
3. Recoverability test
 Recoverability test for GAAP purpose are similar to gross premium
reserve calculation. They test whether, under updated assumptions,
current premium levels are sufficient to cover benefit, DAC, and
maintenance cost
4. Monitoring
 Monitoring of financial (or other) results generally is a comparison of
recent actual result against expected result.
5. Solvency test and risk analysis

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  Risk analysis, in insurance company context, generally modelled as
financial risk. This is an analysis of the likelihood of various negative
financial results.
6. Financial forecasting
 The most common approach is an asset share calculation, used for
short term budgeting for the corporation
 Corporate models typically include projection of needed capital,
including risk based capital requirements
7. Appraisal
 This is a long term financial projection, used to set a value on a
block of business

Step 3. Choosing assumptions and building prototype projection

1. Asset share model
 Asset share projection is typically created as a 2-dimensional matrix
(column: data or information element, row: time period)
 Some of the informational data elements of an asset share model.
Example: exposure value for the number of policies (or coverage units)
starting at tome t=0. The number of policies at time t>0 is usually
successively calculated from time t=0 value. For example: if l0=10,000
and the lapse rate is p0lapse=0.25, then l1=10,000 x (1-p0lapse)=7,500
 For NB asset share calculations, the year t=0 values are theoretical,
and represent initial assumed or derived value.
 For either NB or inforce projections, once the values for year t=0 are
input, year t=1 is built for the first, prototype cell. These calculation are
usually based on a combination of year t=0 values and other basic
assumptions.
 One characteristic that is an important choice of assumption is the
number of projection to be made.
 The real challenge in using such long term assumptions lies adequately
communicating the level of uncertainty that goes with it, as that
uncertainty increases over time.
2. Development reserve model
The most significant assumption or choice needing to be made include:
 Number of months experience to use, and method of averaging
 Whether to account for seasonality
 The method to use for recent, less than fully credible, months of
experience
 The denominator to use for trending purposes (claim per policy, per
member, pre dollar premium, etc)
 The trend rate to use to determine the recent period
3. Other model
Including experience monitoring and risk analysis models, tend to be
specialised, designed and built in a way that is dependent on the
coverages being modelled.

Step 4. Extending the prototype

 The proto-cell has been chosen to represent a given subset of the
business being modelled.
 The proto-cell will be composed of policies that, for purposes of this
modelling, are identical to it. In reality, the cell is one that is chosen to
represent all the policies which will be mapped to it. In doing so there
are 2 things that might happen in that cell

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 o Use average value for the cell, for example average policy
reserve value
o Give the cell value for a specific, representative policy
 The choice of whether to use average or specific representative value
depend on the coverage being modelled
o Non inflation sensitive coverages (DI and LTC) tend to use
representative cell
o Inflation sensitive coverage (like medical) tend to use averages

Step 5. Validating the model

This step is basically to know how well the model represent the business
There are four general ways in which the model are validated
1. The value of the model in the starting year are compared directly to the
actual values for that year
2. The year changes produced in the model are compared to actual past
history result. This is an important test for long term asset shares, particularly
when it is important to make sure the year to year operators are working
in a way that reproduces reality.
3. Reasonableness check by people familiar with the business
4. Stress testing or sensitivity test

The second step is to check robustness or the ability of the model to stand up to
the varying condition.

Step 6. Documenting the model

Model has to be documented for various of reason:

 Professional reason. Without documentation, the work is not presented

in a way that can be evaluated by other professionals.
 Business reason.
o The employer or the client may want to duplicate the
underlying work, modify it, discuss it, or otherwise refer to it. This
can be done if the work is adequately described
o Even the best memory could not remember the details of the
model over time. The model should be evolved and modified.
Documentation enable this process done with minimum error
and efficiently.

Step 7. Designing output and communicating result

The output should be design in a way that it puts the context of the questions
being asked.

Effective report should:

 Write by the people who qualified to do so

 Intent is state clearly (issues, approach, limits, and caveats)
 Compare to some standards (original and current pricing targets,
corporate performance, management basis target)
 Answer the readers expectation

8.4 Choice of assumptions

Standard assumptions: lapse, mortality, claim cost, expense, profit, and model office.
Other assumptions are coverage-specific

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Lapse
 Lapse rate vary widely by product, by duration, and by company. Therefore
there is no inter-company studies (except for LTC)
 Generally lapse are high in year one, and decrease thereafter.
 In cumulative antiselection models, where healthy and unhealthy lives are
being modelled separately, health lives are assumed to have higher lapse
rate than unhealthy lives, since:
o Unhealthy are less insurable
o Tend to hang on their coverage more than healthy lives, regardless
rate increases

Mortality
 Usually age-based and there are tabular published table
 Termination rate is mortality and lapse combined together, sometimes only
refer to lapse rate since:
o Lapse rate is significantly higher
o There is typically nothing in the policy provision that depends on the
manner of termination
o It is very difficult to determine the cause of termination – only the
company knows is that premium stopped being paid.

Claim cost
 Claim cost gets more attention since this is about what actually cost the
company and usually a lot bigger than other cost.

Expense
 Cost of capital as become more important overtime
 Cost of capital is the expense of holding the capital, typically assumed to be
difference in earning rate between what the capital actually earned (as the
company’s invested asset) relative to what it could have earned if invested
somewhere else (desired rate of return of the investor, this is also the discount
rate used in PV profit in appraisal)
 There are 2 profit model:
o Profit released model project future profit according to the model’s
assumption and those profit no longer impact value within the
projection because they are assumed to be paid to the company’s
owner
o Profit retained model assume the profit accumulate over time and
generate additional investment income on it

Profit
Profit could be measured or targeted using a number of methods

 Percentage of annual premium (this is most common and simplest)

 PV profit as percentage of PV premium, this is useful when profit may vary
from year to year
 ROI. Interest rate is determined such as PV Stream of profit equal to zero
 ROE. Calculation is similar with ROI except additional component added:
investment of capital.

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8.5 Auto-correlative models
In predicting future using historical data of individual claims, actuary usually utilised
credibility. Credibility theory, as it has been classically, was mostly based on models
presumed independence of individual claims between the experience and
projection period. More recently, model have been used that recognise the
dependence (or autocorrelative) nature of these claims

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