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If you sell group long-term disability insurance, you want to work with an insurer that takes a flexible but sensible approach to risk analysis.

One problem is that some of the carriers you work with may be using an outmoded approach to analyzing your requests for increases in maximum disability benefit levels.

You call about Passaconaway Sprockets, a manufacturer that wants to increase its in-force LTD maximum to $15,000, from $10,000, to cover its CEOs recent salary increase.

The underwriter dutifully calls up the groups census, averages the top 3 salaries, checks the benefit percentage and finds the average benefit. If the average benefit of those top 3 is $15,000or close enoughthe underwriter will agree to the request and you will be happy. If it isnt, the underwriter may decline, and you may use forceful, colorful language to explain why the underwriter ought to change the decision, or else.

Some underwriters will give in and grant the request. Others will hold firm. Others will get their supervisors, managers or reinsurers to approve or decline.

The story stays the same from insurer to insurer, from year to year. The other thing that stays the same is the Top 3 test.

So, what is the Top 3 test and why should you be worried about it?

The Top 3 test is supposed to protect insurers from an inadequate spread of risk. In theory, a measure of the top 3 salaries gives the insurer an idea of where the maximum should be placed. Unfortunately, in todays market, the growing difference between what top executives earn and what other employees earn often weakens the reliability of the Top 3 test.

Lets look at one example of a case that exposes the limits of this popular test:

A 200-life group requests a $20,000 maximum. Top salaries are $650,000, $400,000 and $175,000. The average is $408,333. If the monthly benefit is 60%, the average monthly benefit for the top 3 is $20,416. The group “qualifies” for the $20,000.

But, if the third highest salary is $175,000, that individuals monthly benefit would be $8,750.

The additional exposureall $11,250 of itis concentrated on 2 people. Plus, any exposure from new employees or salary increases over $8,250 has been created by just 2 employees. Applying a Top 5 test and assuming 2 more $175,000 salaries reduces the average benefit to $15,750. Still, even at a max of $16,000, the same 2 employees are the only ones over $8,250.

This represents a spread-of-risk issue, of course, but it also represents a lack-of-premium issue. What will a claim from one of those top earners do to the groups experience? Typically a $20,000 claim results in more than $1 million in disability reserve, and the $20,000 monthly payout quickly swallows any potential profits from a small group like this.

Whats the true appropriate maximum for this group? That depends on the occupations, salaries and demographics of the other 197 lives. But an application of the Top 3 test would often preclude this sort of analysis simply because the group “passes” that exam.

The test has not evolved over time. What has evolved over time is executive compensation. In 1982 CEOs made an average of 42x that of the average worker; in 2000 they made 531x, according to Business Week. The numbers for 2003 are trickling in, and executive compensation is on the rise again. The New York Times reports that the first few reporting companies show an 8.3% increase in executive pay. So, how do trends in executive salary and bonus affect the Top 3 test?

The test does not consider such trends, and in its simplicity does not provide for real risk analysis. For the insurer, this presents not only an immediate riskthese executives will “qualify” for very high maximumsbut also a hidden one, in that the inattentive underwriter may not have a thorough understanding of the salary structure of the group being underwritten.

Of course, using an outmoded test also poses a risk for the producer. Underwriting flexibility is great, but the last thing a relationship-oriented producer wants is to do business with an insurer that does a poor job of assessing its claims risk.

So, if the Top 3 test is not enough to judge appropriate maximums, what is? That is certainly open to discussion, but possible solutions might be as simple as an average of the top 10 or 20 salaries, or some new method like a multiple of the groups average salary, or a percentile of salary distribution, say the 75th percentile. Another option is to combine group plans with individual disability income products.

Any discussion of alternatives also could look at the underlying necessity for high maximums. If the market needs higher limits, however, we need better ways to assess risk exposures than simply applying a Top 3 test.

is an underwriting consultant, disability reinsurance, at ING Res Minneapolis-based Group Life, Accident and Health Reinsurance operation. ING Re is a unit of ING Groep N.V., Amsterdam.


Reproduced from National Underwriter Edition, May 7, 2004. Copyright 2004 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.