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.