Inside the Black Box Aspects of Actuarial Pricing

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

2. 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. Investment Income External Capital Service Improvement Contribution to Surplus Pricing and Surplus – Linkages Benefits Expenses Taxes Premium Balance Sheet Surplus Solvency Investment Viability

4. Conceptual Model – Linkages Benefits Expenses Profit • Predictability • Frequency Control • Network Negotiation Benefits 75 - 90% Expenses 8 - 15% Profits 2-10% Premium • Recovery • Efficiency • Risk / Reward • Surplus Goals

5. 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. Solvency Surplus Health RBC Market/Asset Liability Management Risk Credit Risk • H3 • Reinsurance • Capitation • Receivables • H1 • Asset Devaluation • Asset Concentration Operational / Business Risk Underwriting Risk • H4 • Admin Risk • Rapid Growth • ASO • H2 • Product Specific Risk • Managed Care Credit • Rate Guarantees • H0 • Interest in Affiliates

7. 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. Claims Costs – Pooling Concept

9. Aging Broader Coverage Trend Claims Costs – Changes over Time

10. 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. 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. At Last – Formulas Experience Rating Premium = [(Claimst-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. Experience Rating Formula [(Claimst-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. Service Component Formula • Utilization of Services times Cost/Service • Net Claims Cost is Trended and Expenses/Surplus Loaded

15. In-Network Out-of-Network Movement Employer Employer Employer PCA PCA1 PCA2 PCA3 PCA HMO PPO Employee Options Employee Options Employee Options Selection-Based Pricing • POS blends In-Network and Out-of Network Versions • CDHP blends interplay between Priced Options and PCA