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

2. Sources of Earnings - Group
October 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

3. 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)

4. 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)

5. 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

6. 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

7. 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?

8. 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!

9. 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

10. 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

11. 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 % 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

13. % Premium Earnings by Policy Year1 2 3 4 5
-22.6%
13.5%
6.0%
4.2%
1.7%
Total
-9.1%
-3.1%
1.1%
2.8%

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. Feedback
Questions or comments?