Group LTD Pricing Issues SOA Spring Meeting, Dallas, Texas May 30, 2001 Session 48 Rick Leavitt - Smith Group Delaine Hare - Fortis Benefits Dave Fitzpatrick - The Standard

The economy, circa 1998-2000 Decline in unemployment Interest rates started to rise Rising Index of Leading Economic Indicators

LTD industry, circa 1998-2000 Improving LTD profits Positive results, but is ROE strong enough? But it beats the early 90’s Deteriorating STD profits Suddenly losses!

Where’s the cheese? Who got the cost savings resulting from managed and integrated disability? The carrier???? The employer????

The economy, circa 2001 Stock market has stumbled Unemployment starting to rise Interest rates falling Index of Leading Economic Indicators is on the rise Consumer Confidence falling

Agenda Manual rating pitfalls Competitive pricing pitfalls Measurement & accountability

Manual rating pitfalls Rick Leavitt Smith Group

How Useful Are Your Manual Rates? 1. Do they accurately predict claim costs? 2. Are they adjusted for current risk dynamics…Unemployment? Discount Rate? 3. Do your underwriters use them? 4. Do you track sold to manual rates?

Common Pitfalls: Inforce vs. New Sales For Example: Current Rate Block Change Segment A: 33% -10% Segment B: 33% 0.0% Segment C: 33% 10% Estimated Rate Impact: 0% In Reality: New Rate Sales Change Segment A: 60% -10% Segment B: 30% 0.0% Segment C: 10% 10% Actual Rate Impact: -5%

Common Pitfalls: Rate Variables are Dependent Consider an example Current Factor Actual Cost Own Occupation: 24 Month 1.00 1.00 Unlimited 1.10 1.10 Industry: Doctors 1.50 2.00 Lawyers 1.20 1.10 All Other 1.00 1.00 24 Mo Unlimited Variables are Doctors 30% 70% Dependent Lawyers 50% 50% All Other 80% 20%

Common Pitfalls: Rate Variables are Dependent Hypothetical Example: Results of Own Occupation Study Pricing Factor Observation Unlimited 1.10 1.26 24 Month Own Occ 1.00 1.02 Do you need to adjust the Own Occ factor?

Common Pitfalls: Changing Dynamics Over Time ? Three Year Study shows rate is right on… What is appropriate for 2001?

Smith Group Comparison of Filed Manual Rates 12 Top Companies Sample Calculations on over 1000 Representative Cases Manual Rates Calculated as Publicly Filed

Smith Group Comparison of Filed Manual Rates:

Smith Group Comparison of Filed Manual Rates: Variation of Individual Companies

Smith Group Comparison of Filed Manual Rates: Variation of Individual Companies

Smith Group Comparison of Filed Manual Rates: Industry Factors

Smith Group Comparison of Filed Manual Rates: Area Factors

Delaine Hare Fortis Benefits Pricing pitfalls Delaine Hare Fortis Benefits

Recipe for top line growth Discount 10% for “value” contract Discount 10% for early intervention Discount 10% on “good cases” Discount 5% for packaged LTD/STD Guarantee the rates for 3 years Value contract - improvements by the product development shop Early intervention - improvement by the claims shop Good cases - improvement by the underwriting shop Package sales - improved efficiencies Where in all of this did the distribution system improve?

…and the bottom line Have you been too aggressive? If so, can you recover? Renewal is a double-edged sword One big increase - can you afford the poor persistency? Layered increases - can you afford the good persistency? Do you try to recoup past losses? (“You can’t make up your losses if the policy leaves.”) Do you just try to get back to square one? You’ll never be satisfied with your overall returns if you keep making mistakes on new business. Traditional actuarial pricing models target the desired return over the life of the policy. It may not be reasonable to try to recoup losses on your mistakes after the fact. But if your business model has embedded mistakes, you’ll have trouble hitting your return objectives.

Watch your tail Better claim management improves claim closures at early durations What happens to closures at later durations? Is your reserve tail as strong as it used to be? It’s like a balloon - you push down on the front end of the reserve, and the tail pops up on you.

Simple reserve illustration For relative comparison only Not an opinion on what is an appropriate pricing discount Sensitive to termination rate assumptions Valuation table, age, sex, etc.

Manage the early claims... 45 year old 20% better term rate for 24 mo. Same term rate after 24 mo. 19% cost savings Base Example Improved

…without managing the old 45 year old 20% better term rate for 24 mo. 20% worse term rate after 24 mo. 9% cost savings Base Example Improved

Watch your assumptions Improved claim management & stronger contract Did they add to your margins? Did you give it all away? Was it as big as you thought? Some cases may not benefit at all Could have been making hay while the sun was shining. Perhaps our customers took the hay we made (and then some?) Perhaps some of the hay was actually weeds.

Table 95a / Basic 2000 Table Concerns expressed over appropriateness of this table Termination rates in later durations appear to be overstated Reserves may be deficient

Value of early intervention...

…is relative

Claim Manager of the Year The award goes to… Nobody!!! Starvation effect Elimination period is akin to a deductible Nothing controls incidence like loss of income When you add STD coverage, what are you replacing? Have we enabled more LTD claims by emphasizing a need for STD? Which provides more incentive to RTW during the STD period: 60% to $500/week 60% to $1,385/week Line between STD & LTD is arbitrary. We may expect claims to close at the STD/LTD transition - does the claimant share that expectation?

What is a “good case”? Manual rates already reflect the “good” plan design & “good” industry Is “good” experience really credible? Have we enabled more LTD claims by emphasizing a need for STD? Which provides more incentive to RTW during the STD period: 60% to $500/week 60% to $1,385/week Line between STD & LTD is arbitrary. We may expect claims to close at the STD/LTD transition - does the claimant share that expectation?

Persistency & profitability Blue line is target rate - the long-term run rate - this rate may not be known to you when the case is sold - or maybe your underwriter rolled the dice on their risk selection Red line is actual charged rate pattern over the policy lifetime - losses emerge early, and you react to them with a series of increases First 4 years, the area between blue and red represents your losses. After 4th year, area between red & blue represents your gains Can you keep the group long enough to make your return over the life of the policy? Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

…during a recession Drop in interest rate raises the bar Higher unemployment may raise the bar Have we enabled more LTD claims by emphasizing a need for STD? Which provides more incentive to RTW during the STD period: 60% to $500/week 60% to $1,385/week Line between STD & LTD is arbitrary. We may expect claims to close at the STD/LTD transition - does the claimant share that expectation?

Measurement & accountability Dave Fitzpatrick The Standard

Calculated (Manual) Rates Group Aging and impact on rates? (recession and baby boomers) Aging census one year can increase claim costs 5-10% Multiple year rate guarantees?

“You can’t manage what you can’t measure.” “What gets measured gets done.” Bill Hewitt, 1991

Successful Measures of Sold-to-Calculated Rates Actual-to-Expected Analysis Can easily be aggregated at underwriter/rep /plan level Can help in pricing vs. loss ratio analysis only Provides a measurable target that is easily understood

Reasons Why Rates May Vary Underwriting Considerations Mistakes Experience Rating Credibility Underwriters may discount loads Change in census from proposal to effective date

Return on Equity (ROE) Formula for Underwriters to ensure attainment of ROE targets ROE = Net Income/(Average Equity) Equity = Required surplus + (STAT reserves - GAAP reserves)

Return on Equity (ROE) An elegant formula: Equity = where C0 = Asset Risk - Affiliated Amounts C1 = Asset Risk - All other C2 = Insurance Risk C3a = Interest Rate Risk C3b = Health Credit Risk C4a = Business Risk C4b = Health Adm Exp - Business Risk

Return on Equity (ROE) Pros and Cons of an elegant formula: Impressive to look at and discuss Difficult to challenge Hard to explain Not understood by underwriters and many normal actuaries

Return on Equity (ROE) An example of a much simpler formula: Equity = 30% of annualized premiums + 30% of case reserves Possible to approximate to fit individual company’s equity requirements!

Return on Equity (ROE) Pros and Cons of a simple formula: Easy to understand and explain More likely to be used by underwriters Convenient to periodically review Approximates equity to the satisfaction of most normal actuaries Percentages may vary by company Can be further refined as % of premium

Industry/Occupation Variations One role of the underwriter is to assign the “best” occupation class Individual DI has some lattitude in assigning which might result in 5-20% difference Group occ factors are combination of industry/occupation assignment

STD - What’s Up! JHA Profitability Survey reports STD profits are negative Lack of concrete evidence that managing STD reduces LTD claim costs Brings into question the assumed savings of integrating disability Probably caused by aggressive acquisition pricing or assumed expense saving

Group Insurance Handbook Maximize participation - preclude individual selection Voluntary/contributory LTD violates these two principles Most selection can be priced and/or controlled 100% participation on a rich plan design may not be a good thing (gross-ups).

High Maximum Benefits Less pressure in recent years Impact of bonus and incentive compensation Selection may be controlled through EOI Evidence is your friend Doesn’t need to be an inconvenience Free cholesterol check

“If you aren’t getting the results you want, ask the magic question, ‘What is being rewarded’.” Getting Results, Michael LeBoeuf

Manual Rating - Quality Assurance Field Office Managers/Reps Accountability Combination of office loss ratio and sold rates in relation to manual Actual loss ratio tied to predetermined target Positive or Negative!

Bottom-line Accountability Sales reps/Office Managers tied to target loss ratios and sold-to-calc ratios In year 2000, positive and negative compensation impacts were offsetting, but significant at the individual level. Percentage of reps received higher compensation due to favorable sold-to-calc ratios was somewhere near moiety

Pricing - Reserve Analysis Measuring results requires appropriate reserve analysis Incurred But Not Reported Reserves Reported Reserves Actual-to-expected Termination Rate Study - theoretical elegant Actual reserve runouts better

Reserve Analysis “The whistles and bells don’t cost much during good economic times.” Rick Leavitt, Las Vegas - 2000 “Reserve runouts on IBNR and reported reserves are better during good economic times.” Dave Fitzpatrick, Dallas - 2001

Reserve Analysis IBNR reserves and reported reserve runouts fluctuate over time for many reasons (incidence rates, claim management, RTW offsets, SS awards/denials, re-opens, economy, replacement ratios, mortality) IBNR range 1993-1998 without adjusting - 40% of reserve Reported range 1993-2000 without adjusting - 12% of reserve

Rate Filings Required in several states prior to use (FL, WA, CO, ND, NY) Inability to gain timely approvals may impede progress in improving profitability