Taking A Holistic Approach To Disability Income Risk Management
“Risk management” is the big buzzword you hear in the insurance and financial services industries today. The need for risk management occurs in any contractual arrangement by insurers if the revenues received and the obligations incurred are subject to uncertainty.
Of course, insurers are in the business of assuming risks, but to be successful, these risks must be identified, quantified if possible, and managedprecisely the definition of “risk management.” Otherwise, the business of assuming risk resembles a gambling proposition in which the insurer is counting on luck, anecdotal evidence, and the power of prayer to be financially successful.
In general, insurers working with their actuarial staffs do a decent job in risk management for most products and services. But disability income (DI) is a special animal for several reasons:
*DI has an anti-selective aspect to it because the beneficiary is the policyholder.
It is rare for an insured to take his own life so that his beneficiaries and loved ones can be financially secure. However, it is conceivable for someone in a successful work environment to feign a back injury to receive DI benefits as a form of early retirement.
*Closely linked to the first point is the subjective nature of a DI claim.
While a death claim is conclusive and irreversible, the same cannot be said of a DI claim. Claims based on mental and nervous disorders, complications arising from pregnancy, back injuries, etc., can be subjective. Also, claim recovery is possible in DI and may be accelerated through a rehabilitation process. All this adds to the subjectivity and duration of a legitimate DI claim.
*DI is a complicated product.
There are several more factors impacting morbidity (i.e., incidence rates of disability and claim recovery rates) than mortality experience. Studies show that morbidity varies by age and gender of the policyholder, occupational class, waiting period before benefits can be received, incurral age and duration of disability, etc. In addition, there are variations by state; and morbidity experience is also impacted by external factors such as economic swings and medical advancements.
*Accurate, up-to-date data on morbidity experience is unavailable.
This makes it difficult to properly price and manage the business. Also, while your own companys experience is preferable in estimating morbidity rates, the lack of credible data is often the problem.
*DI claims experience is inherently volatile.
While incidence rates of disability are relatively low and exhibit predictive patterns, claim recovery rates are more difficult to estimate. Claim termination rates are high in the early months after claim incurral and then rapidly decrease to virtually zero within a couple of years, with claim termination occurring only because of death. This makes it difficult to determine the magnitude of claim payments that will be made, thus adding to the volatility in DI claims experience.
On the flip side, the DI line of business with an established risk management process poses numerous opportunities for a company.
–DI is a much-needed coverage and, unlike life insurance, the market is far from being saturated.
–Many companies have exited the business because of the losses they have experienced. This has left the market open for existing providers and companies wanting to enter the business.
–Unlike whole life insurance and annuities, there isnt any concern about legislation that may eliminate the favorable tax treatment of the inside build up of cash values. DI coverage does not include cash values and, thus, is not marketed as an investment vehicle with preferred tax status.
A Holistic Approach to DI
What is risk management in DI and why a holistic approach? If there is one thing that can be learned from the DI losses in the past decade, it is that the only way to be successful in DI is to establish a comprehensive or holistic risk management culture at every level in the business. Failure to establish a holistic risk management process makes managing a DI line close to a gambling venture in which you have no control or understanding of how to remain successful.
A working definition of a holistic risk management process in DI is: a process that can identify, quantify if possible, and manage the pricing, financial, and operational risks that a DI line of business is exposed to. These risks can be broken down further into the following:
–Adequacy of premiums being charged.
–Appropriateness of product design.
–Adequacy of active life reserves and claim reserves.
–Asset liability management and tests for solvency.
–Financial underwriting and underwriting for morbidity risk.
–Managing the claims payment process.
Another way to describe a holistic risk management process in DI is to separate the risks into qualitative and quantitative risks. Included in the qualitative risks are the following:
*Evaluation of policy forms language, exclusion provisions, and coverage provisions. An example of a qualitative risk management provision would be setting limits on benefits that will be paid on subjective disability conditions such as mental and nervous disorders, etc.
*Establishment of financial underwriting standards, morbidity risk categories and classification criteria. For example, a good risk management practice could be to require a full-credit risk analysis for large policy issues to uncover any possibility of over-insurance or anti-selection.
*Establishment of claims processing and claims monitoring standards. Because a DI claim is subjective and recovery is possible, it is important that proper procedures are established in processing new claims and monitoring existing claims to ensure their legitimacy.
While the impact of these qualitative risks is difficult to quantify, these risks are real and must be properly managed. Failure to do so could open up a DI business to anti-selection and a breakdown in controls, which could lead to disastrous financial consequences.
It is important to note that good risk management practice is not geared simply toward preventing anti-selection and fraud, but rather to ensure that the operation of the business is efficient and streamlined both in underwriting good risks, and in the processing and payment of legitimate claims.
The area of quantitative risks in DI is what most companies have failed to address and manage. These risks can be broadly classified into the following:
*Evaluation of premium adequacy by pricing class.
While most companies do tests of premium adequacy in aggregate, there is little work done to ensure that each pricing class is self-sufficient. This requires the determination of an explicit charge or risk premium to cover the volatility in claim payments. This risk charge should vary by pricing class and will ensure that no cross-subsidization occurs between pricing classes. Doctoral level research in this area at the Center for Actuarial Studies and Risk Management, University of Connecticut, can be used to calculate the risk charge at a given level of confidence or certainty.
*Asset liability management and solvency testing.
While regulations require that companies perform at least annually prescribed tests of asset liability management, it is important that these tests also cover the degree to which a companys solvency is threatened under adverse morbidity scenarios. Interestingly enough, because DI payments are staggered, companies have more flexibility in adopting a long-duration, high-yielding asset strategy in DI than in other lines of business. In fact, companies that have incurred losses in DI have always had the capability of meeting current claim payments from cash flows. The problem is the inability to meet all future obligations with current reserves and future premiums, i.e., the morbidity risk is what is significant.
*Determination of risk adjusted reserves.
DI companies must hold active life reserves to cover future obligations for all policies in force, and claim reserves to cover future obligations for policies on claim. Similar to the determination of a risk premium to cover future obligations, the reserves held should also include an explicit provision for fluctuation in claims experience. Again, there is established research from the University of Connecticut Center to calculate risk-adjusted reserves so that there is a predetermined level of confidence or certainty to cover all future obligations
Note that these quantitative risk management processes are all connected. For instance, the risk premium charged to capture the volatility in claims experience is precisely what is used to set up the additional or risk reserves to cover the same volatility in future claim payments.
Current Morbidity Experience Tracking
All of the quantitative risk management procedures discussed above require some initial estimate of a companys morbidity experience. Despite the use of a careful, scientific method to determine this estimate, it remains only a best guess. It will indeed be a miracle if actual experience matches this initial estimate.
Most DI companies do some analysis on comparing actual morbidity experience to a benchmark or plan. A common method is to compare the actual loss ratio to an expected loss ratio. An incurred loss ratio of 75% means that for every dollar of premium collected, 75 cents goes toward making claim payments and setting up reserves for future claim obligations. If the benchmark loss ratio is 80%, this is an indication of favorable morbidity experience.
The problem with an aggregate analysis of this nature is that it neither captures the complexity of the line of business nor facilitates in understanding how to better manage the business. Also, because the incidence rates of disability increase by age, a newly issued block of DI policies will have a low loss ratio, while a more mature block will (and is expected to) exhibit higher loss ratios.
Claims Monitoring System
The only way to understand how a DI line of business is performing relative to pricing expectations, is to implement a DI claims monitoring system. This system should be able to capture the following:
–actual versus expected earned premiums;
–actual versus expected change in active and claim reserves;
–actual versus expected terminated claims;
–actual versus expected incurred loss ratio;
–actual versus expected morbidity cost or gain for the period.
This information should be available for every policy in force so that claims monitoring can be provided in aggregate, by age, by agent and agency, by pricing category, or by any desired sub-category of business.
To develop this system, the starting point is the morbidity table used to calculate risk-adjusted premiums and reserves. Once this is established, the expected or priced-for values can be calculated on an individual policy level.
The DI claims monitoring system should be run monthly or as frequently as a company runs its valuation systems. The results should be presented in a form that can be easily analyzed and acted upon. The types of action that this analysis could initiate would include a revision of premium rates, more stringent underwriting, adjustment of the level of dividends to pay out for a participating block, or the discontinuation of business written by particular agents or agencies.
The risk management ideas and techniques discussed in this article must be utilized holistically. The term “holistic” goes beyond everything described here. It also refers to the relationships between these various procedures, e.g., the claims monitoring system influencing risk practices in underwriting, etc.
A DI line of business with a holistic risk management culture will include a full understanding and control of the risks it has assumed and how to charge for and manage them. Risk management in DI is not a one-time analysis. It is an ongoing, disciplined, and dynamic process and, will ensure sustained financial success for a company if properly executed.
is Deloitte Professor & Director of the Center for Actuarial Studies and Risk Management.
John Bevacqua, Mark Charron and Bill Zeilman, Human Capital Advisory Services, Deloitte & Touche and Charles Vinsonhaler, Chairman of the Math Department at UConn were co-authors.
Reproduced from National Underwriter Life & Health/Financial Services Edition, October 8, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.