Canadian Institute of Actuaries PD-2 L’Institut canadien des actuaires TR-2

Sources of Earnings - Group October 2007 - committee formed to develop Group-specific Sources of Earnings (SOE) guidance. Chair is Tom Strickland Committee representation : 9 Group insurance 1 Group reinsurance 1 Group consulting Working on final draft for exposure later this year Today’s session will discuss the concepts developed so far and ask for feedback

Why is Group SOE Different? For individual and annuity lines of business, reserves based on full future cash flows are projected as soon as a premium is received CALM projection of cash flows can be done for Group - then SOE is very similar to individual CALM allows an approximation that does not generate full cash flows if no material interest rate risk, pricing is adequate Most companies apply the approximation for Group business, with the possible exception of Long Term Disability (LTD)

Implications of Group Valuation for SOE CALM valuation - earnings after first premium based on variances from valuation assumptions CALM approximation - most earnings based on variances from pricing assumptions at quote and renewal Draft shows what to do when the approximation is used Draft is fairly detailed – expect some companies will need to simplify External reporting less detailed (need for consistency with other lines)

Characteristics of Group Business Short Term vs Long Term For many companies, most premiums come from high credibility, short term benefits: Health, Dental, Short Term Disability (STD) Life claims are mostly short term, but about 10% lead to long term reserves (waiver of premium on disability, paid up life) Change in PfADs on reserves plays a minor role in earnings, except for LTD – could be ignored for other lines

Characteristics of Group Business Underwriting/Pricing Initial (quote) underwriting and renewal underwriting are separate processes, usually done in separate departments Group underwriters / sales have substantial leeway to give marketing discounts or load rates at quote and renewal Competition and lack of data at quote lead to generally lower earnings in first policy period Renewal underwriting should gradually improve earnings each policy period after the first to achieve overall target profit levels Overall underwriting process as critical as (maybe more critical than) tabular rates in maintaining profitability

Definition of New Business For Group, the impact of the initial pricing really extends to the end of the first policy period, when the pricing can first be revised The first policy period is typically 15 months, but could be longer (especially for Life and LTD) Committee strongly recommends analyzing first policy period results vs renewal period results separately Where to classify first policy period results in SOE?

Definition of New Business Option 1: expected earnings (until the first repricing opportunity) in first policy period classified as New Business Gain Advantage: Aligns well with the way the business is underwritten and managed (separate initial and renewal underwriting processes) Disadvantage: Inconsistent with definition of NBG used in life and wealth businesses Option 2: Group New Business gain is impact at time zero only For most group benefits, no initial reserve is established hence NBG will be $0 If option 2 adopted Committee recommends that expected earnings and experience gains be split into first policy period and renewal year components Feedback would be appreciated!

Types of Group Business The main portion of the draft deals with fully insured (pooled) and ASO (fee for service) business There are also brief sections covering other types of business: Refund accounting: Profit margin from retention accounting Limited risk if in surplus or covered by hold harmless agreement - but could still have risk elements: Pooled elements (e.g. high amount Health) Policy reserves different from valuation reserves Expense charges in the retention accounting vs actual Interest credits on policy reserves/deposits vs actual Reinsurance ceded - recommend gross SOE with fairly simple reinsurance adjustments Reinsurance assumed - depends on data available

Preliminary Information Needed Expected pricing margins as % premium - commissions, premium taxes, expenses, standard risk and profit margins Must also understand the pricing and underwriting philosophy (real profit margins by policy period) Profit margins - both explicit and implicit (claims trend?) Expected and actual marketing discounts by policy period Likely larger discounts in first period than in later periods Differentiate between risk adjustment and marketing discount Risk adjustment Real risk factor - not in base pricing module Profit neutral (price could go up or down) Marketing discount – only down For many companies, expected profits as % premium would not be level by policy period

Treatment of PfADs For most Group lines, PfAD buildup/release has a very small impact on overall earnings The exception is LTD: Increase in reserves typically 70-100% of first year claims Total initial PfADs could be 20-25% of reserves Should model the buildup and runoff of PfADs by policy period as additional expected profit elements

% Premium Earnings by Policy Year 1 2 3 4 5 -22.6% 13.5% 6.0% 4.2% 1.7% Total -9.1% -3.1% 1.1% 2.8%

Typical Group SOE Report + Expected profit on inforce operations + new business gain (loss) + Experience gains + Changes in assumptions and other changes = Earnings on operations Option 2, NBG measured at t=0, assumed

Expected Profit on Inforce Operations Profit margin on first policy period business premiums (including expected release of PfAD) + Profit margin on renewal business premiums (including expected release of PfAD) + Expected gain on interest + Expected gain on commission, expenses, and premium taxes + Expected gain on fee income

Develop Margin Gains (Beginning of Year) Identify expected % gain for various sources of earnings: Potential source for assumptions below: prior pricing, Business Plan, last year’s SOE Net risk and profit as % premium Explicit margin + implicit margins - marketing discounts + gain/loss from PfADs (LTD) Should be analyzed by policy period (at least period 1 vs renewal) Expected % gain on interest Expected % return on assets backing liabilities - % required interest on liabilities Expected % gain on fee income (fee income - expenses allocated to fee income groups) / fee income Expected % gain on commissions and premium taxes Usually explicitly priced for - most companies would assume zero expected gains Expected % gain on expenses (expense loads - actual expenses - change in expense reserves) / expense loads Excludes fee income groups

Calculate Expected Profits (Quarterly Reporting) From net risk and profit margin = actual premium received * (net risk and profit as % premium) Split between first policy period business and inforce (renewal) Could split renewal into multiple years From interest = actual mean liabilities * expected % gain on interest From fee income = actual fee income * expected % gain on fee income From expenses = actual premium * expense margin * expected % gain on expense margin From commissions, premium tax – same as expenses (but usually zero) First policy period expected profits are just net risk and profit margin – remainder are inforce (renewal) items for simplicity Seasonality in claims experience could be reflected in expected earnings

Comparison to Plan SOE expected profits based on actual premiums received If mix of premium is much different from Business Plan (e.g. big new business), this may create a variance from Plan You may wish to do an analysis of expected profits from Plan premiums vs actual premiums to better understand this variance – would be outside the core SOE process

Experience Gains & Losses + Claims experience gain: renewal business + Claims experience gain: first policy period + Investment income experience gain + Expense experience gain + Commissions experience gain + Premium taxes experience gain + Fee income experience gain

Experience Gains and Losses Claim Experience Gain Usually the biggest source of experience gain Split between first policy period and renewal business “Actual” claims vs “Expected” claims “Expected” claims = premiums + required investment income – expense loads – commission loads - premium tax loads – net profit loads “Actual” claims = claims paid + actual change in claim reserves

Experience Gains and Losses Claim Experience Gain Refinements for longer term lines of business Long Term Disability Incidence gain + Termination gain DLR portion + IBNR portion + Paid Claim portion Settlement Gain Offset Gain Actual vs expected incidence & termination rates Life Mortality Gain + Morbidity Gain Actual vs expected mortality rate

Experience Gains and Losses Investment Income Experience Gain “Actual” vs “Expected” investment income “Actual” = income statement investment income “Expected” = actual required interest + expected profit from interest Impact of fair value accounting Fair value of assets (CICA 3855) vs Fair value of liabilities (through CALM) Net market gain (loss) Mismatch (C3) PfAD

Experience Gains and Losses Expense Experience Gain “Actual” vs “Expected” expenses “Expected” = expense loads (non-fee income) + required investment income on expense reserves - expected expense gain “Actual” = income statement expenses (non-fee income) + change in expense reserves

Experience Gains and Losses Other Expenses Experience Gain Commissions experience gain Premium taxes experience gain Fee income experience gain Calculated using same principles as expense gain, except no reserves

Other items Other SOE items can generally be treated same way as for regular life SOE Of particular interest are: Changes in assumptions Other changes and management actions

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