1. Inside the Black Box Aspects of Actuarial Pricing AcademyHealth June 8, 2004 John C. Lloyd FSA, MAAA Reden & Anders, Ltd.

2. © 2003 Reden & Anders, Ltd. Overview of the Black Box  Underlying Concepts - Commercial Insurers  End Game  Predictability and Adequacy for Risks Assumed  Generation of Surplus  Elements  Claims Costs: Estimation and Management  Expenses  Profit / Surplus

3. © 2003 Reden & Anders, Ltd. Pricing and Surplus – Linkages Benefits Expenses Taxes Premium Contribution to Surplus External Capital SurplusSolvencyInvestmentViability Investment Income Service Improvement Balance Sheet

4. © 2003 Reden & Anders, Ltd. Conceptual Model – Linkages BenefitsExpensesProfit Premium Benefits 75 - 90% 75 - 90%Expenses 8 - 15% 8 - 15%Profits 2-10% 2-10% Predictability Predictability Frequency Control Frequency Control Network Negotiation Network Negotiation Recovery Recovery Efficiency Efficiency Risk / Reward Risk / Reward Surplus Goals Surplus Goals

5. © 2003 Reden & Anders, Ltd. Reasons for Surplus  Solvency  Minimum amounts of surplus to weather underwriting downturns  Measured by RBC formula based on industry earnings simulations  Investment  Multi-year capital investments in products and systems  Amortize expense over several years  Viability  Lower premiums for competitive positioning  Pure R&D  Mergers, acquisitions, strategic initiatives

6. © 2003 Reden & Anders, Ltd. H2 Product Specific Risk Managed Care Credit Rate Guarantees Solvency Surplus Health RBC H3 Reinsurance Capitation Receivables Credit Risk Operational / Business Risk H4 Admin Risk Rapid Growth ASO Underwriting Risk Market/Asset Liability Management Risk H1 Asset Devaluation Asset Concentration H0 Interest in Affiliates

7. © 2003 Reden & Anders, Ltd. Pricing - Framework  One-Year Horizon  Almost all employer group coverage focuses on a single year  Prices are reset based on actual and anticipated cost  Pooling Concept  Average rate: low-cost individuals cover the catastrophic claim  “ 80 / 20 Rule” bulk of the cost incurred by a few individuals  Turnover  Seldom the same individuals at risk or on claim  Groups lapse, employees change  Claimants recover, new accidents and illnesses are incurred  Underwriting  Used to create and maintain a broad pool of risks  Can be used to position and entire block of business

8. © 2003 Reden & Anders, Ltd. Claims Costs – Pooling Concept

9. © 2003 Reden & Anders, Ltd. Claims Costs – Changes over Time Aging Broader Coverage Trend

10. © 2003 Reden & Anders, Ltd. Underwriting – Maintaining the Pool  Contractual Provisions - Eligibility  Rate for Deviation from Pool – Demographics  Rate for Deviation from Pool – Industry Factors  Historical Claims Analysis – Rx; Large Claims  Employee Medical Underwriting  Predictive Modeling Balance between cost, market acceptance, practicality

11. © 2003 Reden & Anders, Ltd. Pricing Approaches  Experience Rating / Aggregate Claims Basis  Historical Claims on Aggregate Year-of-Experience Basis  Typical of Employer-Based Indemnity Group Insurance  Service Component Basis  Utilization/1000 times Cost/Unit for Types of Service  Typical of MCO  Selection-Based  Anticipated Utilization by Group for Various Options  Often Used in POS or Consumer-Driven Health Plans

12. © 2003 Reden & Anders, Ltd. At Last – Formulas Experience Rating Premium = [(Claims t-1 * Cred) + (Pool Claims * (1-Cred)] * (1 + Trend) (1 - %Expense - % Profit)  Claims: Historical Claims Cost  Employer experience if available  Pool Claims  Manual Rates (drawn from the broad pool of risk)  Aggregate block of business claims, often throw out big claims and replace with pool charge  Credibility Blending  Manual Rates or Prior Year Claims  Credibility based on size of group, may be multiple years  Adjustments to Resulting Claims Cost  Benefit Changes  Demographics

13. © 2003 Reden & Anders, Ltd. Experience Rating Formula [(Claims t-1 * Cred) + (Pool Claims * (1-Cred)] * (1 + Trend) (1 - %Expense - % Profit)  Claims: Historical Claims Cost  Adjustments  Expenses  Recovery of cost of operations  Can be flat or % of premium – often converted to % anyway  Profit / Surplus  Trend Projection  Claims Costs: Estimation and Management  The primary factor in terms of impact and uncertainty

14. © 2003 Reden & Anders, Ltd. Service Component Formula  Utilization of Services times Cost/Service  Net Claims Cost is Trended and Expenses/Surplus Loaded

15. © 2003 Reden & Anders, Ltd. Selection-Based Pricing  POS blends In-Network and Out-of Network Versions  CDHP blends interplay between Priced Options and PCA In-NetworkOut-of-Network Movement Employe r PCA PCA1PCA2PCA3HMOPCAPPO Employee Options