SMS 3230 Principles of Healthcare and Reserving Lecture Notes

SMS 3230 - Principles of Health-care and Reserving
Contents
1 Income Protection (IP) Insurance 4

1.1 Income Protection (IP) Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.1 The Product Cycle and the Nature of the Product . . . . . . . . . . . . . . . . . . . . 5
1.2 Product features of individual IP business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2.1 General Policy Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
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1.2.2 Benefit definitions (amount) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.3 Benefit Definitions (Timings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.2.4 Claim definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.3 Risk and rating factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
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1.4 Variations of the Product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.5 Accident and sickness insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2 Critical Illiness (CI) Insurance

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2.1 Critical Illiness (CI) Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.1.1 Characteristics of CI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.2 Conditions Covered . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
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2.2.1 Core "Major" Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.2.2 Other conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
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2.2.3 Terminal illness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.2.4 Total and permanent disability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.2.5 Children’s benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.3 Tiered benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
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3 Long-Term Care Insurance (LTCI) 21

3.1 Long-Term Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.1.1 Informal Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.1.2 Formal Care . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
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3.2 Types of long-term care insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

3.3 Pre-funded Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.3.1 Claim definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.3.2 Benefit types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.3.3 Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.4 Immediate needs products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3.5 Variants of long-term care insurance design . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3.5.1 Unit-linked investment products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
4 Private Medical Insurance (PMI)and Related Products 28

4.1 Private Medical Insurance (PMI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
4.1.1 Policy Excess . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.2 Related PMI Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.2.1 Major Medical Expenses (MME)-UK . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.2.2 Waiting list plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.2.3 Health cash plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.2.4 Dental plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
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Lecture Notes, BAS Y2S2 Principles of Health-care and Reserving
4.2.5 Optical plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

4.3 Personal accident . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.3.1 Benefit definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.3.2 Exposure measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.3.3 Claim characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.3.4 Risk factors and rating factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
5 Distribution Channels 36
5.1 Main Distribution Channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.1.1 Insurance intermediaries (brokers) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
5.1.2 Tied agents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.1.3 Own Sales-force . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.1.4 Direct Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
5.2 Worksite Marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
5.3 Different Types of Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
5.3.1 Initial and renewal commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
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5.3.2 Level commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
5.3.3 Alternative commission structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.4 The effect of different channels . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.4.1 Demographic Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
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5.4.2 Contract Design . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.4.3 Contract Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.5 Group Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.5.1 Small Groups . . . . . . . . . . . .
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. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
5.5.2 Large Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Reserves and Embedded Value

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6.1 Purpose of Calculating Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
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6.2 Types of Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

6.2.1 Long-term insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
6.2.2 Short-term insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
6.3 The Role of Statistical and Case Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
6.3.1 Case estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
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6.3.2 Statistical estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

6.3.3 Long-term insurances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
6.3.4 Short-term insurances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
6.4 Embedded Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
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6.4.1 Purpose of Embedded Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

6.4.2 Calculation of Embedded Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
6.5 Appraisal Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
7 Approaches to Setting Reserves and Solvency Capital

Requirements 49
7.1 Solvency Capital Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
7.1.1 Purpose . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
7.1.2 Interplay between reserves and solvency capital requirements . . . . . . . . . . . . . . 49
7.1.3 Value-at-Risk (VaR) approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
7.2 Market-consistent reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
7.2.1 Market-consistent methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
7.2.2 Illiquidity premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
7.2.3 Risk Margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
7.3 Active and Passive Valuation Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
7.3.1 Passive valuation approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
7.3.2 Active valuation approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
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7.3.3 Combinations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
8 Investment 55
8.1 Asset characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
8.1.1 Conventional government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
8.1.2 Index-linked government bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
8.1.3 Corporate bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
8.1.4 Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
8.1.5 Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
8.1.6 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
8.2 The principles of investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
8.3 Asset-liability matching requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
8.3.1 Nature, term and currency of the liabilities . . . . . . . . . . . . . . . . . . . . . . . . 57
8.3.2 Effects of the nature of liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
8.3.3 Free assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
8.3.4 Regulatory framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
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8.4 Developing an appropriate investment strategy . . . . . . . . . . . . . . . . . . . . . . . . . . 60
8.4.1 Using a model office to determine an investment strategy . . . . . . . . . . . . . . . . 60
8.4.2 Fund manager assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
8.4.3 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
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8.4.4 Effect on product development and pricing . . . . . . . . . . . . . . . . . . . . . . . . 61
8.4.5 Asset valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
8.4.6 Treating customers fairly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
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Chapter 1
Income Protection (IP) Insurance
Introduction
Concept of Health and Care
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Health has evolved over time as a concept from an individual concern to a global social goal comprising the
whole quality of life. The changing need and environment has forced people and government to embark of
health insurance to protect themselves or its citizens from adverse health challenges.
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Health and Care Products Al
The main types of health and care product are:
(i) Income protection insurance
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(ii) Critical illness insurance
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(iii) Long-term care insurance

(iv) Health cash plans
(v) Major medical expenses
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(vi) Private medical insurance and

(vii) Group and individual covers
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1.1 Income Protection (IP) Insurance

Individual IP insurance is insurance that provides the insured with regular, short- or long-term
payments during periods of incapacity. Group IP are insurance products, bought by employers wishing
to provide benefits to their employees. Incapacity in this context means being ‘unable to work due to
illness or injury’.
Therefore, IP benefits are in the form of a temporary annuity that continues until the policyholder
recovers, dies or the policy expires, whichever event occurs first. To make premiums more attractive
(lower) and to match the policyholder’s needs more closely, there is usually a deferred period (which could be
up to two years), during which the claimant must be sick (incapacitated), before benefits will be payable. No
benefits are paid during the deferred period. In most cases, either the State or the policyholder’s employer
(or both) pay sickness benefits for short-term sickness.
The aim of an IP insurance product is to replace part of the income that the insured lives would
have earned if they were unable to work due to accident or illness. IP insurance therefore pays a
benefit in the form of a regular income. The insured event that gives rise to this benefit being paid can be
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broadly described as the inability of the insured life to work (referred to as incapacity) through
illness or accident.
However, as with other health and care insurance products, the policy document needs to define care-
fully the situation or circumstances that need to exist in order that the benefit becomes
payable, and under what circumstances it will cease. Not all kinds of illness / physical injury will
be covered, such as attempted suicide. In addition, unemployment, redundancy, early retirement
and reluctance to return to work are a few examples of situations that should not be covered by the
policy. The insurer needs to ensure that the policy is not misused in such circumstances.
Unlike under private medical insurance, premiums do not usually increase with age, although in-
flation linking is common and premiums may be reviewable, i.e the insurer may reserve the right to increase
the premiums should claims experience across the whole portfolio be poor (and may reduce premiums if the
experience is good).
The age of the policyholder at the date of policy issue (and other rating factors) will determine the
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initial premium. That is, the initial premium will increase with the age at entry.
If the policy has guaranteed premiums then the premium cannot be changed. If the policy has re-
viewable premiums, then the premium may be changed on the review date. However, the review is a
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review for the whole portfolio of policies and not for an individual policy. If premiums are changed they will
be changed in the same way for all policies in the portfolio. In this way the concept of insurance as the
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pooling of risk is maintained.
1.1.1 The Product Cycle and the Nature of the Product

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The product cycle refer to the process a product must go through over its lifetime. The following diagram
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shows the main elements of the product cycle:

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Figure 1.1: The Product Cycle
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Product Design
A system must exist to pay claims, and record a lot of information about each claim. For instance,
the system should not only be able to record the date on which a claim starts, but also the reason for
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the claim, the date it ceased, and why.
Pricing
Experience will vary widely by insurer, but it is imperative that the practices employed by each area of the
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product cycle are reflected in the premiums charged (e.g weaker claims management should be reflected in
higher premium rates).
Marketing and Sales

IP insurance may be seen as a genuine need to some customers, e.g the self-employed, and so the product
may be actively bought. For other customers, it will be necessary to spend money on marketing and selling
the product.
Underwriting and Claims Management

Underwriting and claims management are more complex for IP insurance than for most other life assurance
products. Both have fundamental implications for the resulting claims experience. For instance:
For term insurances, the probability of dying is relatively simple to assess as it is mainly affected by
age and gender. For IP insurance, the probability of being unable to follow your normal occupation
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(say) as a result of illness/accident is affected by many more factors, e.g occupation.
For term insurances, the sum insured is usually fixed and known. For IP insurance, while the
annual benefit amount is typically known, the length of a period of sickness is not known in advance
and is influenced by lots of health factors, e.g type of illness.
Experience Monitoring and Valuation

There are actuarial difficulties with the methodology used to measure morbidity risk. Another difficulty is
that it is generally unwise, if not dangerous, to use standard published tables of morbidity without
adjustment, as the experience of different insurers will vary and the standard tables are generally out of
date. There is certainly the potential to lose a lot of money on an IP insurance portfolio, and how the
business is managed will undoubtedly affect its profitability. The nature of the product means that the true
experience will not be known for a long time.
The ‘potential to lose a lot of money on an IP insurance portfolio’ arises primarily from poli-
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cyholders who claim early in the policy term – before the premiums paid have accumulated sufficiently to
cover the benefit payments, expenses and commission. This risk can be reduced by selling a large number
of policies, or by using reinsurance.
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The ‘true experience will not be known for a long time’ as the insurer will use current morbidity
rates (with suitable adjustments) to calculate the premium. For a very long-term policy, these rates are likely
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to change significantly over the term of the policy, so the true experience will not be known until nearer the
end of the policy term.
1.2 Product features of individual IP business

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A rating factor is a characteristic of the features of the policy or the policyholder that directly affects the
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premium charged. Features of the policy may relate to the amount of the benefit or the conditions that
must be satisfied before the benefit is payable. So, for example, for IP insurance, the benefit amount and
the deferred period are rating factors, as are policyholder characteristics, such as age, gender (if permitted
by legislation) and occupation.
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1.2.1 General Policy Conditions

IP insurance is often seen as a complex product. The most complex part is the policy conditions, which must
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cover the procedure to be followed under various scenarios (lapse, claim, recovery, partial recovery,
retirement, death). Robust policy design, through the structure of the product and the wording of the
policy conditions, is one way of managing some of the less measurable IP insurance risks. Here we are look-
ing at risk from the point of view of the insurance company. Careful policy wording is essential to
ensure that the insurer can make reliable estimates of its expected cost of claims for any block of business.
General policy conditions need to be clear. Unclear policy conditions run the risk of being interpreted
by the courts or regulatory supervisor in favor of the claimant, if disagreement over entitlement to claim
leads to a dispute. Policy conditions should aim to:
• reflect the true intentions of the insurer - The policy conditions should specify clearly, in words
that the policyholder understands, what the insured events are and which events are not insured by
the policy.
• give some cushion against adverse events over which the insurer has no control - The
insurer must know all the contingencies that it faces and be able to assess the risk(expected costs of
claims) relating to each one. So if, for example, the insurer feels unable to assess the extra cost of
claims that would result if war was declared, it should use the policy conditions to exclude these claims
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• be, as far as possible, simple and unambiguous, to assist the sales, underwriting and
claims processes - At the sales stage, prospective policyholders should be able to decide immediately
if the risks that are important to them are actually transferred to the insurance company.
Straightforward conditions will mean that it is clear what information the policyholder needs to sup-
ply at the proposal stage, and are more likely to ensure that the policyholder provides the correct
information. From the company’s point of view this will mean accurate underwriting (the pre-
mium quoted reflects the risk), and from the policyholder’s point of view it will mean a rapid
underwriting decision.
At the claim stage the company wants to avoid a large proportion of claims that are denied because
they do not satisfy the policy conditions. These would increase the company’s claims expenses
and harm its reputation, which may in turn affect its future sales. Clear policy conditions will also
act to reduce the number of declined claims.
1.2.2 Benefit definitions (amount)
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There are several conditions relating to the benefit that must be defined for an IP contract, which include;
• replacement ratios
• over-insurance
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• escalating benefits (and premiums)
• proportionate or rehabilitation benefits
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• waiver of premium benefit, etc.
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Replacement Ratios
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The replacement ratio is usually defined as the ratio of post-claim income to pre-claim income, in
both cases net of income taxes. The ratio used should reflect the reduction in disposable income after
incapacity, and should be easy to calculate from the available data.
The level of the replacement ratio is usually seen as a critical indicator of likely claim experience; the
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higher the replacement ratio, the lower the incentive to return to work and the worse the mor-
bidity experience is likely to be. Some sources have suggested that, over some ranges, a 1% increase in
the replacement ratio might mean a 1% increase in the expected cost of claims.
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A linked-claims period in the policy conditions, or a condition that allows a return to part-time
work with reduced policy benefits are features that are often included in the policy. These conditions
encourage rehabilitation back into the workforce, with a consequent reduction in the cost of claims.
Over-insurance
Over-insurance refers to a higher than appropriate replacement ratio. There are several ways in which
over-insurance can arise:
• over-insurance from outset
• subsequent over-insurance, through salary inflation not keeping up with benefit increases,
or through a reduction in salary (e.g when changing jobs)
This might happen if a policy had benefits that increased automatically on each policy anniversary or
if salary reduced (e.g through part-time working), or a combination of these two
• a reduction in the tax levied on IP insurance claims, applying to existing policyholders,
increasing net benefits received relative to net salary
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• multiple policies or receipt of other non-disclosed sources of income

Robust product design should attempt to avoid these, as far as possible. Ways of addressing the issue
positively or pro-actively include:
• an appropriate maximum benefit formula at point of sale such as a maximum replacement
ratio, e.g 75% of pre-incapacity earnings,an overall maximum benefit limit etc.
• quality training of those conducting the sale, reducing the incentive to over-insure
• regular reviews to ensure that the level of benefit remains appropriate (although this may
not be practicable)
• clear policy conditions highlighting the likely action at the claims stage in the event of
over-insurance
If the above methods fail to prevent over-insurance, many policies will address the issue at claim stage,
with claim benefits being cut back where benefits exceed the maximum benefit formula. If there is no
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corresponding refund of premiums, this can result in policyholders having paid for cover to which they are
not entitled. Failure to manage the expectations of policyholders can lead to conflict between insurers and
those responsible for representing the interest of consumers, so that a robust initial design is better than
relying on cutting back benefits at claim stage. The process of checking the proposer’s income and other
ex
circumstances to prevent over-insurance is known as financial underwriting.
Escalating Benefits and Premiums

Al
IP insurance policies can be completely level, whereby the benefit to be paid on sickness remains at the same
level as that specified at the outset of the policy and does not increase in or out of claim. It is not prudent
ti
to have escalation rates that exceed expected rates of earnings escalation, as these increase the
replacement ratio. High escalation rates may also result in difficulty for the insurer in matching assets
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and liabilities. For this reason, insurers restrict the level of fixed rate escalation that they will offer on new
business.
Examples are:
.O
• Benefits escalate at the same rate in and out of claim: relatively straightforward, and the
most common design
• Some benefit escalation out of claim but none in claim: an unusual design motivated
Mr
perhaps by a desire to encourage a return to work

For example, benefits and premiums might increase each year by the rate of inflation subject to a
maximum of 5% pa, but once a claim commences, the claim payment remains constant
Proportionate or Rehabilitation Benefits

These offer a reduced benefit to claimants who return to work in a different occupation, or in a
reduced capacity. The reduction will relate to the ratio that the gross earnings from the new job bear to
those from the occupation against which disability was being claimed.
Waiver of Premium Benefit

Most IP policies will include the condition that premiums are waived (i.e credited without the policyholder
making payments) during periods when benefits are payable. This will usually be charged for by a small
percentage addition to the premium rate.
9
1.2.3 Benefit Definitions (Timings)

Refers to when benefits are payable. There are three relevant ‘periods’ to consider,i.e.,
• waiting period
• deferred period
• linked-claims period
As well as the expiry age or term of the policy.
Waiting period
The aim of a waiting period is to control selection against the insurer, i.e the risk that those who think
they have an increased chance of falling sick in the near future will choose to buy an IP policy. This is
necessary as the proposal form may not pick up that there is an increased risk of sickness, perhaps because
N.
the current symptoms have not resulted in the proposer seeking medical advice yet. A period at the start of
the policy (e.g six months) during which premiums are paid but there is no entitlement to benefits
may dissuade prospective policyholders from seeking insurance if they expect to make a claim soon. If they
do buy insurance, it removes the liability to pay benefits as a result of early claims.
ex
However, the idea of paying premiums with no entitlement to benefit will not appeal to many prospective
policyholders and so initial underwriting is generally now used to reduce the risk of anti-selection
instead. Al
Deferred period
An insurer will not usually pay benefits during the first few weeks of sickness. This is known as the deferred
ti
period. The main reasons for most contracts having a non-zero deferred period are to:
nso
• integrate with employer-supplied benefits

• reduce the cost of claims to the insurer (and therefore the price (premium))
• reduce the insurer’s administration costs (and therefore the price (premium))
.O
• meet true customer needs (e.g most policyholders would not want to submit a claim for a couple of
days off with ‘flu).
In the UK, for example, the most common deferred periods in the market are 4, 13, 26 and 52 weeks.
Mr
Other less common deferred periods are 0, 1, 8 and 104 weeks. 28 weeks is often found as a deferred period
under group arrangements.
Another possibility is a ‘split deferred’ policy. An example of this is a policy that pays out a benefit of
£250 per week after 13 weeks’ sickness, increasing to £500 per week after 26 weeks’ sickness.
Recently it has become common to insert a policy condition that requires the policyholder to notify the
insurer when they have been sick for a given period (e.g one month), even though the deferred period is
much longer than this.
What is the insurer hoping to achieve by the use of this early notification condition?
This allows the insurer to offer help and advice through their rehabilitation services at an early stage.
This early intervention may help to reduce or even eliminate a claim at the end of the deferred period.
The policyholder gets a ‘free’ benefit in the form of an advice service, but the insurer is hoping that the cost
of providing the service will be more than paid for by the claims costs that are saved. This is seen as part
of the claims management process.
Early notification also means that near the end of the deferred period, the insurer can conduct a
thorough claims assessment and so be ready to pay a valid claim immediately when the deferred
period ends. This will remove the pressure to assess a claim quickly at the end of the deferred period, thus
reducing the likelihood of a disputed claim.
10
Linked-claims period
One way in which many insurers seek to encourage a return to work when claiming is to waive the deferred
period if sickness recurs within say 26 or 52 weeks. This is sometimes known as a ‘linked-claims’ condition.
How does a linked-claims period encourage claimants to return to work?

If you return to work and relapse into sickness within a short period you would have to
serve another deferred period before policy benefits resume. As a result you might tend to
delay returning to work until you are certain of not falling sick again within a short period of
time. With a linked-claims period you can try returning to work, without the fear of having
to complete another deferred period if you fall sick shortly after returning to work.
Expiry age or term

The expiry age is the age at which benefits cease and is often the same as the expected retirement age.
N.
Typical expiry ages in the market are 50, 55, 60 and 65. Other expiry ages are sometimes offered (either
intermediate or lower for those with lower normal retirement ages, e.g professional sportspeople).
Also, some policies that are written to an expiry age have premiums that are payable for an exact number
of years. It is not normal to charge premiums at the very end of the policy (the duration being governed by
ex
the deferred period), when any new sickness could not result in a claim.
1.2.4 Claim definitions

Al
Focuses on what conditions result in a valid claim, i.e the definition of incapacity.
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Occupational definitions
The insured’s occupation affects IP insurance product design in two ways:
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(i) the price charged

(ii) claim payment
.O
(a)The effect of occupation on the price charged
IP insurance rates are usually dependent on the policyholder’s occupation. Most occupations are divided
into different classes (eg between three and six). The cheapest rates are then applied to the least risky class,
with other classes usually being set as some flat multiple of these. The multiples can be quite high, eg:
Mr
• Class 1= 100%
• Class 2= 175%
• Class 3= 300%
• Class 4= 400%
The categorization of occupations is related to the claims experience. Claims experience is reflected
in the number of sickness inceptions and also the length of the periods of sickness. Some
occupations have an obvious physical danger. Some others might be thought of as being ‘healthy’ but in
reality experience high levels of absence e.g due to mental illness. Claims experience can also be worse when
the demands of the occupation require complete recovery before the policyholder can resume working.
The increase in claims is most likely to be a result of the increased pressures of the job. This has
resulted in an increase in stress-related illnesses, such as psychiatric illnesses and heart attacks. The
class into which an occupation falls may vary by insurer. Sometimes some occupations (such as doctors or
dentists) might have entirely separate rates.
11
(b) The effect of occupation on the claim payment
There are many possible definitions of claim. The main distinction is between those that relate to
being able to carry out an occupation, and those that do not. The former may be unsuitable for those
not in paid employment (e.g housepersons and the unemployed).
Most definitions are occupational – examples are as follows:

• inability to perform own occupation
• inability to perform own occupation and any other suited occupation by education, status or training
• inability to perform own occupation for an initial period (e.g the first two years) of claim followed by
inability to perform any occupation thereafter
• inability to perform any occupation
N.
Alternative incapacity criteria
The alternative to an occupational definition will need to define the claim event in terms of an inability to
perform various tests, regardless of occupation. Examples of possible types of test are:
ex
• functional assessment tests (FATs)
• activities of daily living (ADLs)
Al
• activities of daily working (ADWs)
• personal capability assessment (PCA)
ti
nso
1.3 Risk and rating factors

Focuses on some other rating factors that may be used for IP products – namely occupation and residence
/ location.
.O
State four other rating factors that may be used for an IP product
(i) age
(ii) deferred period
Mr
(iii) gender
(iv) smoker status
Occupational changes
Some policies require that the insurer is told if the insured changes occupation, with the intention of
modifying the premium if necessary. A claim is usually then assessed against the ability to perform the
original occupation (or maybe all occupations carried out in the last twelve months). This can, arguably,
be rather subjective and allows the possibility of a dispute if the insured is unable to carry out the
current occupation, but according to the insurer would be able to carry out the former occupation.
12
Residence and location

While there is undoubtedly evidence to indicate that risk varies with residence or location, the insurer
will look at the balance of risk within its book when determining premium levels, without explicitly subdi-
viding its tariff or charging loadings. Where its distribution methods or brand appeal lead to a concentration
of policyholders with particular claim characteristics, the insurer will reflect this in its pricing structure.
For example, if distribution channel is a rating factor and it is known that different channels attract
different proportions of policyholders by place of residence, the insurer will:
• determine expected claim costs by place of residence

• weight these costs, using the proportions by place of residence, to determine the expected claims costs
for each distribution channel
An insurer will require the policyholder to notify it of a change in residence, as any change in the area of
permanent residence represents a significant change in the risk factors. The insurer will be concerned
about whether or not the risk of sickness and accident is different in the new location from that originally
N.
assessed. This will be influenced by the extent to which the incidence of infectious and other diseases is
mitigated by the provision of good quality healthcare. The risk of accidental injury may be different as well.
If the change in the risk is judged important then the insurer might ask for an additional premium or
place a restriction or exclusion on the benefits that would be paid.
ex
Residence affects risk in three ways from an insurer’s perspective:
Al
• where the policyholder lives when underwritten (the initial assessment)
• where the policyholder lives when disability is incurred
• where the policyholder lives when benefit is payable

ti
nso
1.4 Variations of the Product

Focuses on different variants of an IP product that might exist, i.e,
• with-profits and unit-linked designs
.O
• guaranteed and reviewable premium rates

• guaranteed insurability options (GIOs) and other options
Mr
• no claims discounts
With-profits and unit-linked designs

With-profits policies do exist, however, with a bonus being declared each year that builds up to give a
benefit on death or at expiry (with IP insurance claims normally unaffected by the bonus). Receipt
of the bonus is not normally dependent on a good claims record. Premiums for with-profits policies will
be greater than those for without-profits policies, because of the savings element in with-profits policies.
Unit-linked IP insurance is also found in some markets, with morbidity charge deductions being made
from the unit fund. This is a form of policy where the investment risk is borne by the policyholder. Any
unit fund remaining at the end of the policy term is paid as a maturity benefit.
13
Guaranteed and Reviewable rates

Two extremes of product design regarding guarantees, namely a full guarantee of future premiums or no
guarantee whatsoever. In the first case the premium amount will be guaranteed for the full term of the
policy. The premium may be level, increasing at a fixed rate (eg 5% pa) or increasing according to a specified
index. In the second case, the premium amount may be changed at each policy anniversary.
A common middle ground is for the premium to be guaranteed for the first five years of a contract, for
example, with the insurer having complete freedom to review the premium thereafter.
There are several characteristics of the long-term IP term risk that make it difficult for the insurer to
assess the risk at the outset, and so be in a position to offer a competitive premium that is guaranteed for
the full term. For example;
• some diseases that were a major cause of sickness in the past (e.g polio) are now no longer a cause of
long-term sickness, whereas other diseases that in the past went unrecognised have become important
causes of long-term sickness
N.
• some ailments that previously resulted in death are now treatable, but result in a restricted lifestyle
(e.g heart attacks)
• changes in employers’ expectations could also have an effect, e.g they may now have greater expectations
ex
of employees to retrain for a different job after a prolonged period of sickness
• changes in the workplace might also affect claims, such as more shift working and more automation in
Al
the workplace
Reviews of premiums can result in ‘selective lapsing’ or ‘selection against the insurer’. This is where
the healthy lives lapse their policy (or accept reduced benefits instead of paying the increase in premium)
ti
whilst those either claiming or in poor health agree to the premium increase. For this reason, some insurers
have restricted increases on review, possibly to a maximum percentage each year. Where experience is better
nso
than expected, some insurers will reduce the premiums on their reviewable products.
Guaranteed insurability options (GIOs) and other options

Many insurance policies include guaranteed insurability options (GIOs). This may mean for instance that
.O
the policyholder is able to increase the sum insured at the insurer’s standard rates for the then current
age when a particular life-event occurs, without supplying further medical evidence. For example, it is pos-
sible to offer an option that allows the policyholder to increase the benefit on marriage or buying a new house.
Mr
What are the characteristics of a satisfactory life-event to associate with a GIO?

Satisfactory life-events must act like a limited form of underwriting. There must be some empirical
evidence that the morbidity risk of those qualifying is much less than the morbidity risk of the
population at large. For example, individuals who have bought a new house are likely to be doing reasonably
well in life (both financially and health-wise).
Additionally, the life-event must be one that is both fairly common and increases the need for
cover, so that the take-up of the option is high. This should ensure that a mixture of low-and high-risk
individuals take up the option, which should reduce anti-selection. Marriage and moving house are typically
both common events that increase the need for cover (and increase awareness of that need). Furthermore, if
the event increases the need for cover, there will be less incentive to over-insure at the outset. In part, this
can be addressed by checking income replacement ratios or by underwriting at the claims stage.
No claims discounts
Contracts have also appeared that feature a discounted premium if no IP insurance claim has been made.
14
1.5 Accident and sickness insurance

Accident and sickness insurance is a short-term product with similarities to income protection. Typically,
it will provide an income for a specified period (often one year) following a deferred period, payable
for as long as the claimant remains disabled (usually defined as inability to perform any occupation).
Additionally, a fixed lump sum may be paid if the policyholder loses a limb through accident.
Short-term accident and sickness insurance is also often provided (in conjunction with life and unem-
ployment benefits) to protect loan repayments. It can also be called ‘creditor insurance’ or ‘payment
protection insurance’, and can include cover under critical illness or total and permanent disability defi-
nitions.
Accident, sickness and unemployment insurance contracts are often known simply as ‘ASU insurance’.
Accident and sickness contracts will be renewed each year, and so the insurer has the opportunity to review
both the premium and the terms and conditions of the policy, such as the benefits offered, at each renewal.
Short-term accident and sickness policies may even be sold along with IP, because they typically have
shorter deferred periods (if any). For example, in cases where IP insurance is only available with long de-
ferred periods (say 52 weeks), an accident and sickness policy could provide short-term cover for this period.
N.
The contract typically has a relatively low premium.
Practice Questions
ex
1. Published morbidity tables are based on the combined experience of all the IP insurers contributing to
the study. Al
(i) Outline the factors that are likely to give rise to the large differences in the rates observed for
different insurers
(ii) Describe the factors that are likely to cause the published tables to become out of date so quickly
ti
2. A health and care insurance company sells individual long-term income protection (IP) policies, mainly
nso
to self-employed individuals
(i) Describe over-insurance with regard to IP policies, and give examples of how it can arise.
(ii) Explain how over-insurance can cause problems for the insurer
.O
(iii) Describe ways in which these problems might be mitigated

3. A health and care insurer is considering the design of an income protection product for people who
keep house and do not receive a salary of any kind.
Suggest a possible design for this product, focusing on:
Mr
(a) the restrictions on the monthly sickness payments that could be imposed
(b) the criteria for the payment of benefits
4. A health and care insurer is proposing to introduce a new income protection insurance policy that
incorporates ‘objective cover’.
The insurer’s current income protection policies pay claims when the policyholder is unable to perform
the material and substantial duties required in their current occupation. Under the new policy the
claims entitlement will be based on objective tests. In order for the benefit payments to be made, the
policyholder’s illness or injury must be identifiable by objective medical testing, such as blood tests,
X-rays or MRI scans.
(i) Discuss the advantages and disadvantages of this new definition of claims management for the
insurer
(ii) Discuss the advantages and disadvantages of this new definition for the marketing of income
protection policies by the insurer
15
Chapter 2
Critical Illiness (CI) Insurance
2.1 Critical Illiness (CI) Insurance

The benefit under a critical illness policy is typically a lump sum that is payable if the policyholder
N.
suffers one of the defined conditions.
The product may offer the opportunity for the lump sum to be paid in installments, with any outstanding
amount payable on death (if applicable). This can help the claimant to manage their finances better, and
ex
can reduce the potential for fraudulent claims.
Alternatively, the lump sum benefit can be used to buy an impaired life annuity that provides a regular
income from the date of a valid claim until death.
Al
A critical illness product may be a hybrid with the benefit payable in any of the following ways:
ti
• upon the happening of an event, independent of its extent, e.g having a heart attack or a
stroke, where specific medical evidence would be required to check that the events had actually occurred
nso
• on reaching a defined degree of impairment, e.g losing the ability to walk unaided or losing the
ability to speak
• on undergoing a surgical procedure, e.g having a major organ transplant or having a heart bypass
.O
operation
The product is not designed to indemnify the policyholder. Therefore, the sum insured is not designed
to return the policyholder to their position (in financial or other terms) before the insured event occurred,
Mr
but is chosen independently by the policyholder.
In this way, critical illness cover is unlike income protection or private medical insurance where the
products are specifically designed to meet either a defined loss in income or direct medical costs incurred as
the result of the insured event occurring.
CI insurance can be provided as an additional feature on a term insurance policy. Such policies
are called accelerated critical illness term insurances and the sum insured is paid on the diagnosis of
an insured critical illness or death, whichever event occurs first. Alternatively, CI insurance can be provided
as a stand-alone product. In this case, the sum insured is only paid on the diagnosis of an insured condition
and no payment is made on death.
A CI policy is a pure protection product as it is not certain that the sum insured will be paid. It
is possible that the policyholder survives to the end of the policy term without any of the insured events
occurring. So, just as in the case of term insurance, the policy will not acquire a surrender value at any
time. There will be no maturity benefit.
16
2.1.1 Characteristics of CI
• it is a condition perceived by the public to be serious and to occur frequently
• each condition covered can be clearly defined so that there is no ambiguity at the time of claim
• sufficient data are available to price the benefit
Perceived to be serious and to occur frequently

In many cases, it is the first characteristic that is the overwhelming consideration, although ‘perception’ is a
contentious issue. Market research has shown that some diseases are feared by the public out of proportion
to their actual incidence. This may reflect active awareness campaigns or high profile in the press.
To be included, an illness, if not life threatening, should at least be lifestyle threatening. Ideally
illnesses should not be so rare that there is a negligible risk of occurrence.
N.
Clearly defined conditions
Avoiding ambiguity in the definitions of critical illness conditions is not easy. This is a particular problem
where the nature of the benefit structure inevitably leads to the use of complex medical terminology.
ex
For example:
Al
• cancers are usually restricted to those where malignant tumors have invaded adjacent tissue
• heart attacks require evidence that the heart muscle has been damaged as evidenced by enzyme changes
in the blood
ti
The aim is for the policy to cover more serious CIs, and not lead to windfall payments for less serious
conditions where the policyholder’s lifestyle is changed very little in the longer term.
nso
Sufficient data
In practice, the last characteristic (sufficient data) has been difficult to achieve. Any critical illness condition
.O
that is available as a benefit must be capable of being priced both now and in the future as accurately as
possible, bearing in mind the impact of the condition within the overall rate. The requirement to predict
future trends is particularly onerous.
Mr
The ability to avoid anti-selection is sometimes added to the list of desirable features of a critical illness
condition. Examination of early claims could lead to the suspicion of a certain degree of anti-selection,
particularly in relation to benefits paid under the cancer definition.
Anti-selection arises from an asymmetry of information or its interpretation between the insurer
and the policyholder. For example, the policyholder may know that their occupation exposes them to a
higher risk of some cancers, but the insurer’s underwriting procedures may not pick this up. The policy-
holder knows more than the insurer, and so there is asymmetry of information between them.
If it is suspected that underwriting procedures are not sufficient to counter this, then the use of a waiting
period (e.g claims for cancer-related events are not allowed during the first six months of the contract), can
be effective in eliminating or reducing anti-selection.
17
2.2 Conditions Covered
2.2.1 Core "Major" Conditions

Given below is a sample list of ‘major’ conditions, i.e the conditions that, together, account for the majority
of critical illness claims. They will normally be included in virtually all policies within a given market at
any one time, and will account for maybe 90% of all claims.
• cancer
• multiple sclerosis
• coronary artery by-pass surgery
• kidney failure
• heart attack
N.
• major organ transplant
• stroke
ex
2.2.2 Other conditions
Given below is a list of those non-major conditions that will perhaps be included:
Al
• AIDS / HIV contracted by blood transfusion
• AIDS / HIV contracted during occupation

ti
• blindness
nso
• coma
• deafness
• loss of limbs
.O
• loss of speech
• paralysis / paraplegia
• Parkinson’s disease
Mr
There are a number of other conditions that, with the growing popularity of the contract and the increasing
competitiveness of markets, are being included in critical illness cover policies in many territories, e.g,
diabetes. Competition can be on price (premium levels) or quality (the extent of the cover provided).
Around 90% of all claims arise from the major illnesses, and the availability of a cheaper product with less
depth of coverage may increase the sales penetration across the public in general.
2.2.3 Terminal illness

Terminal illness is often added to complete the overall cover. It does not pay out on diagnosis of a spec-
ified disease but instead the claim definition involves the severity of a condition and its effect on life
expectancy (e.g any condition that is expected to result in the person’s death within a 12 month period).
Terminal illness cover ensures that all conditions that significantly reduce life expectancy are covered,
albeit at a late stage.
18
2.2.4 Total and permanent disability

Total and permanent disability (TPD) is often included within a critical illness product. The permanency
of the disability is an important criterion that distinguishes it from income protection cover. Income
protection insurance pays out on temporary total disability as well as on permanent disability.
Often it is initially difficult to determine if a disability is permanent. In these circumstances it is advisable

to use a waiting period before the claim is accepted as valid.
The word ‘permanent’ is often difficult to define in this context and the insurer’s interpretation does
not always match the policyholder’s understanding and expectation. One definition proposed is ‘beyond
the hope of recovery in your lifetime’. This means that even if the disability is severe in the short term,
if it is expected that recovery will eventually occur, the benefit will not be paid.
The word ‘total’ in the definition is usually taken to mean ‘major and substantial’. Even severe
disability will usually still leave the individual able to do something that could be argued to be part of the
N.
job or function. If the elements failed do not compromise a major or substantial part of the role then failure
is not considered total.
Definitions of disability
ex
There are three main types of definition:
Al
• occupation-based - established by the inability to carry out an occupation, e.g, inability of the life
insured to perform their own occupation, all occupations to which suited by education, training or
experience, etc.
• related to activities of daily living (ADLs) - inability to perform a number of normal everyday
ti
tasks, e.g, washing, feeding, dressing, etc. Applicable to housewives, househusbands, those not in
nso
employment or those past retirement age.
• definitions using working activities or functional abilities - based on activities of daily work
(ADWs), personal capability assessments (PCAs) and functional assessment tests (FATs), e.g, skills
like communication
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2.2.5 Children’s benefit

Cover can be provided for each child of the policyholder, usually until they reach the age of 18. An interesting
Mr
feature of this benefit is that claims will not terminate the policy. The policy may pay out for each child
covered as well as for the policyholder. Within the term, cover will only cease on the policyholder’s claim.
Early product design would typically have excluded disabilities that could potentially be caused inten-
tionally, such as third degree burns and paralysis, due to worries about moral hazard. The moral hazard
here arises because of the suspicion that some parents or guardians with this cover might take less care
of their children than those without cover, resulting in a higher incidence of claims relating to childhood
accidents.
2.3 Tiered benefits

This is a variant to the standard CI insurance policy in which, for one or more of the illnesses covered, the
payment of the sum insured is linked to the severity of the disease. Thus, a proportion of the full benefit
is paid out, a proportion that depends on the progress or extent of the illness at the time that the claim is
made.
for example, a malignant tumor that has invaded adjacent tissue might pay 100% of the sum insured,
while angioplasty (the surgical repair or unblocking of a blood vessel, especially a coronary artery) might
19
pay 25% of the sum insured. Further claims may be lodged if the disease advances, and further payments
made from the balance of the sum insured to reflect the increasing impairment.
Reasons for offering tiered benefits

• The CI insurance product becomes more comprehensive; a benefit is offered at levels of disease pro-
gression that would not have triggered payment under a more standard CI insurance contract
• The payments, part or whole, more closely match financial need, reducing the incentive for anti-selection
and for ‘exaggeration’ of symptoms at the claims stage
• Multiple claims are possible, which enhances policyholder satisfaction and retention
• As a variant on the standard product, it also permits the insurer to differentiate itself from its com-
petitors
• It makes comparisons more difficult (and the insurer’s product potentially more profitable)
N.
Practice Questions
1. (i) Compare and contrast the cover provided by critical illness (CI) and income protection (IP)
insurance policies
ex
(ii) Describe the types of individual for which each of CI and IP insurance policies might be suitable
Al
2. Your company’s CI policies currently provide cover for children up to age 18. A claim as a result of a
child’s illness does not terminate the policy.
The marketing manager has suggested that this benefit costs very little and has a high perceived value
among policyholders. She suggests that current and future policies should be revised so that the child’s
ti
benefit is available until the age of 18 or the end of full-time education if this is later, but that premiums
should remain unchanged.
nso
Comment on this suggestion.

.O
Mr
20
Chapter 3
Long-Term Care Insurance (LTCI)
3.1 Long-Term Care

Defn.: Long-term care might be defined as all forms of continuing personal or nursing care and
N.
associated domestic services for people who are unable to look after themselves without some degree of
support, whether provided in their own homes, at a day center, or in a State-sponsored or care home setting.
Long-term care is essentially for people who are not going to get better and is distinct from acute
ex
medical care, as it is not principally concerned with curing or alleviating medical conditions.
While the underlying cause of the changes in a person’s circumstances may be medical (e.g arthritis, a
Al
minor stroke), the care provided is designed to treat the results of the condition rather than the
condition itself. The results of the condition are usually a reduced ability to deal with many aspects of
day-to-day living, such as getting up and going to bed, washing and personal care, cooking meals
and going shopping. Long-term care is designed to help with these tasks. The care is long-term because
ti
the expectation is that ability levels will deteriorate, or at least not improve, in the future.
nso
Long-term care covers a wide spectrum of needs. Some people only require a small amount of assistance to
be fully independent, whilst others could not function without high levels of care. An optimal long-term
care programme would be designed to help people regain as much independence as possible,
slow down the rate of deterioration and provide the necessary care support and environment
.O
to maintain well-being.
The costs of care can be divided between living costs, housing costs and personal care. These might be
defined as:
Mr
• living costs – food, clothing, heating and amenities etc

• housing costs – rent, mortgage payments and State tax etc
• personal care – the additional costs of being looked after, arising from frailty or disability.
Everybody will have living costs, but for those needing care these costs may be greater, e.g the need for a
warmer home and/or special foods.
Everybody will incur housing costs, but in the case of those needing care these costs may be greater than
normal because they need a particular type of accommodation or particular adaptations of their accommo-
dation. The housing costs are often referred to as the ‘hotel’ or accommodation element of the total costs.
For living and housing costs, it is the extra costs rather than the total costs that should form part of
the provision for long-term care.
Personal care includes all forms of care directly involving touching a person’s body, incorporating
issues of intimacy, personal dignity and confidentiality. This itself should be separated into nursing
21
care and other forms of personal care. From an insurer’s point of view the key issue is that nursing
care will be more expensive than other forms of personal care.
A further concept called intermediate care is also sometimes found. This focuses on recuperative
services following an acute event (eg a heart attack, a stroke or an accident requiring a period in hospital)
in order to reduce avoidable hospital admission and minimize dependence on ongoing long-term
care. These services should incorporate intensive therapy and support. The care is ‘intermediate’ between
hospital care and care provided in the home.
3.1.1 Informal Care

Care may be provided formally or informally (normally by the spouse or children). Whilst much of the
informal care is limited to no more than four hours per week, a smaller group provides substantial levels of
personal care and practical help. It should be noted that many of those providing substantial levels of care
are themselves over age 60.
N.
Why Informal Care?
Individuals needing care may be in their 80s and 90s. Most of the informal care is likely to be provided by:
• individuals in the same generation, eg a (more able) partner, sibling / cousin
ex
• a son / daughter (who may be over 60).
Al
Furthermore, those who are over 60 are generally retired and so are more likely to have the time available to
offer substantial informal care. In contrast, younger relatives may be working or have other family respon-
sibilities, and so only be willing to offer a few hours of care each week.
ti
Whilst formal care has a direct cost, informal care has an indirect cost in terms of either the lost economic
activity, or the price of replacing the care support should it no longer be provided.
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3.1.2 Formal Care

Formal care can be delivered in many different settings. The majority of care is provided in the older person’s
own home. This is partly because most people want to stay in their own homes for as long as possible and
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may also be encouraged through government policies.
Care in the community is not synonymous with care in your own home. Some care will be provided in
the homes of near relatives, but the majority of care outside of a person’s home is provided by privately
Mr
owned and managed residential homes
3.2 Types of long-term care insurance

Long-term care insurance would ideally indemnify the policyholder for the additional costs of day-to-day
living when they are in need of long-term care. However, this may be prohibitively expensive, so in order
to control claims costs, these payments may subject to overriding maxima. Alternatively, products might
provide cash benefits rather than covering the direct costs of care, in which case these are not indemnity
products.
There are two generic types of long-term care insurance cover

• pre-funded plans - purchased by relatively healthy people to protect them against the risk of future
disability. Secured by a single premium paid at the outset or by level annual premiums paid throughout
life or until a specified age, eg normal retirement age, with a premium waiver when a claim is being
paid.
22
• immediate needs plans - purchased by long-term care claimants to protect them against the un-
certain survival duration. Secured by a single premium paid at the start of the contract when the
policyholder needs care as a result of failing health.
3.3 Pre-funded Products
3.3.1 Claim definition

The benefit payment is dependent upon the claim definition, which may be triggered by a single event or by
a multiple set of events. The single event may itself depend on a level of disability and its continuation
for a specified period.
Many of today’s pre-funded long-term care insurance products use activities of daily living (ADLs)
and cognitive impairment as the claims trigger to measure dependency. The number of ADLs failed
denotes the level of dependency. The ideas described there for CI insurance apply equally to long-term care
insurance.
N.
One such benchmark list of ADLs was given in Chapter 2:
• washing – the ability to maintain an adequate level of cleanliness and personal hygiene
ex
• dressing – the ability to put on and take off all necessary garments, artificial limbs or other surgical
appliances that are medically necessary
Al
• feeding – the ability to transfer food from a plate or bowl to the mouth once food has been prepared
and made available
• toileting – the ability to manage bowel and bladder function, maintaining an adequate and socially
acceptable level of hygiene
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• mobility – the ability to move indoors from room to room on level surfaces at the normal place of
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residence
• transferring – the ability to move from a lying position in a bed to a sitting position in an upright
chair or wheel chair and vice versa
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In addition, there may be a mental impairment trigger.
The claims trigger requires the policyholder to be incapable of performing a number of these activities
alone and without endangering the health or wellbeing of the policyholder or others.
Mr
Different benefits may also be payable dependent on the level of disability. For example, it is common for
50% of the benefit to be paid on the failure of two out of six ADLs and 100% to be payable on the failure
of three or more out of six ADLs or because of mental impairment. More recent plans have separated
the ADL triggers so that the benefit for each level of disability can be individually selected.
Long-term care benefits can be provided as an optional addition to another policy. The long-term care
benefits are integrated into the main policy benefits as a rider, or addition, to the main policy. In particular:
• IP insurance – this extends the cover so that it continues beyond normal retirement age. At the end
of the IP term, the definition of disability would normally switch from being occupation related to one
that is activity related (eg failure of ADLs).
• CI insurance – this is normally structured so that the definition of total and permanent disability
changes from occupation-related (or activities of daily work) to the loss of independent existence (ie
failure of ADLs) at age 60. However, it should be noted that many common causes of long-term care
(eg stroke, Parkinson’s disease, rheumatoid arthritis, and blindness) are already covered by the main
CI policy.
23
• PMI – the PMI policy pays for the treatment of acute conditions and the LTC rider pays for the care
needed as a result of disabling chronic conditions. The LTC benefit is likely to be restricted compared
to the usual benefits offered, and only provides a pre-specified number of hours of home nursing,
dependent on the level of disability. This is a ‘natural’ rider as some consumers already believe that a
PMI policy should provide such care.
• Whole of life assurance – this pays the sum assured on death, or accelerates a fixed percentage of the
benefit (eg 2% of the sum assured per month) when the long-term care criteria are satisfied. The policy
needs a very large sum assured on death in order to provide a large enough LTC benefit, and so can
be very expensive for older lives compared to other LTCI products.
3.3.2 Benefit types

Level and form of the benefit
The type of benefit could be selected from a range of alternatives, including a single lump sum payment,
N.
an annuity certain, a lifetime benefit subject to ongoing disability, or a restricted benefit (eg
payable for a maximum period, or to a maximum total amount) subject to ongoing disability.
Benefits can be defined in money terms (cash), or paid on an indemnity basis.
ex
If an indemnity basis applies, the policy will provide benefits that are sufficient to cover the
losses the policyholder incurs as a result of the insured event happening. For example, policies
Al
might offer nursing care that the policyholders were assessed as needing, when they were unable to carry out
three out of six ADLs. The insurer would pay for whatever care was necessary, subject only to the policy
conditions (eg a deferred period and restrictions on where the care would be provided).
ti
Indemnity-based policies often have a cash limit on benefits (eg nursing care as required, subject to
maximum payment of £15,000 in any policy year).
nso
The maximum initial benefit is often limited. This is so that the insurance benefit is linked to the addi-
tional long-term care costs incurred. However, more recent plans have removed the upper limit, subject to
satisfactory financial underwriting.
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If the initial benefit level is much higher than the actual costs of care, there will a temptation to make
a claim in order to ‘profit’ from the policy. Financial underwriting may therefore be used to try to detect
over-insurance: in particular, the level of benefits chosen should be no greater than the current costs of care.
Mr
It should be noted that benefits are generally not dependent on the place of residence (ie in the individual’s
own home or a nursing home).
Benefit options
The standard benefit options will include:
• length of deferred period, normally three or twelve months
• the rate of benefit escalation, normally level, a fixed rate or linked to the increase in an inflation index
• length of payment period, normally lifetime, or a fixed period such as three years.
(i) Purpose:
• Length of deferred period – At the beginning of a period of illness that requires care, policyholders
may have sufficient funds to pay for their own care or, for this short period, their family may be
able to provide informal care. This means the policyholder has no need for cover.
24
The period during which they have no need for cover will vary between individuals, and so having
a choice of deferred periods will enable policyholders to select the cover that suits their particular
needs.
The deferred period also provides a period of adjustment so that policyholders can establish a
new pattern of living. This means that at the end of the deferred period they will be in a better
position to choose the care that they want.
• Benefit escalation – Care is largely a people-based function and so care costs are likely to rise
with wage inflation. Furthermore, the older an individual gets, the greater their care needs are
likely to become. Both of these will increase the overall costs of care over time and so increasing
benefit payments are more likely to match the risks faced by policyholders.
• Length of payment period – The State may provide free care to individuals (possibly on the
condition that the individual funds the first few years of care). So a policy with a limited care
period could provide a complement to State provision and thus appeal to prospective policyholders.
(ii) Effect on premium levels
N.
• Length of deferred period – The longer is the deferred period, the lower the premium
• Benefit escalation – The higher is the rate of escalation of benefits, the higher the premium
• Length of payment period – A limited benefit payment period will reduce the premium
ex
3.3.3 Premiums Al
Methods of funding
There are various methods of funding the insurance premiums, including:
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• single payments
• regular payments
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• restricted regular payments that either stop:
– certain age (eg normal retirement age)

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– during a defined level of disability (ie with a waiver of premium)

• retrospective payment, from the equity released after the sale of the home
Regular premiums will generally escalate in line with the chosen benefit escalation rate and will include a
Mr
waiver of premiums on triggering the disability benefit, or possibly a less severe level of disability.
Guaranteed terms
Long-term care insurers may provide both guaranteed and reviewable product variants. Guaranteed prod-
ucts might be introduced to recognize the fact that policyholders who purchase long-term care insurance may
do so to indemnify themselves against all future costs. They may be older with fixed pension incomes,
and cannot afford to take the risk that an additional premium may be required or the benefit may be reduced.
The guarantee may be age dependent and may take effect on reaching age 70 or 75. After this age the
insurer will not be able to seek any further premiums or reduce the benefits. Insurers recognize that for
this type of product, and at this advanced age, the effectiveness of the review is limited and therefore the
guarantee has less significance.
25
3.4 Immediate needs products

They protect individuals needing care from their uncertain survival duration, and thereby provide more
certainty of their capital costs. The insurance provides a guaranteed lifetime income on payment of
a single premium. Therefore the immediate needs products are not indemnity products – the benefits
promised are cash amounts.
The premium is individually calculated based on the health status of the applicant. Immediate needs
plans have often been considered equivalent to impaired annuities. However, the product structure may be
very different; for example, the range of structures has included pure endowments, purchased life annuities
and disability covers. In constructing the plan, consideration should be given to the policyholders’ and
insurer’s tax positions, regulatory capital and benefits flexibility.
3.5 Variants of long-term care insurance design
N.
3.5.1 Unit-linked investment products
Aim
Single premium unit-linked long-term care insurance products are a further alternative. These were devel-
ex
oped to recognize that whilst people would purchase a savings plan, they would rather avoid considering the
subject of long-term care. It was also recognized that a product with no surrender or death benefits was
generally unattractive. Al
The unit-linked solution aimed to be primarily a flexible investment contract and secondly a
long-term care insurance vehicle. Often the product was sold as an inheritance plan, which placed the
investments in trust but entitled the policyholder to the long-term care insurance protection.
ti
nso
Operation
The cashflows under a unit-linked contract are as follows:
1. The policyholder pays a premium (while a regular premium could be paid – either for a specified period
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or for the term of the policy – a single premium is more common for this type of policy).
2. Most of the premium will be used to buy units (in the unit fund), however some of it will go straight
into the insurer’s non-unit fund. This represents the allocation rate and any bid-offer spread.
Mr
3. Regular charges are made from the unit fund (to the non-unit fund), either by cancelling units or by
reducing the unit price. These may be:
• risk charges – these are used to cover any protection offered by the contract
• fund management charges
• policy admin charges
4. Expenses that the insurer incurs will be paid out of the non-unit fund.
5. The benefit paid on death or surrender benefits will typically be the bid value of the units, and so
these will be paid out of the unit fund (unless, for example, there is a guaranteed death benefit that is
in excess of the unit fund, in which case the excess would be paid out of the non-unit fund).
6. Long-term care benefits will be paid primarily out of the non-unit fund – these payments represent the
protection aspect of the contract
26
The benefits that are in the unit fund at the time that the policyholder makes a claim may also be used
to pay the long-term care benefits. Alternatively, some (or all) of them may be returned to the policyholder.
This represents the savings aspect of the contract. In the latter case, the fund is ‘protected’.
Practice Questions
1. Alice is aged 78 and she has recently had a stroke. This has resulted in her needing to move into a
nursing home.
She has £7,000 of net income a year from her State pension and a small occupational pension. The
nursing home chosen by Alice charges fees of £25,000 per year. Alice therefore needs an extra £18,000
pa net income.
She has £75,000 from her savings and from the sale of her property.
N.
You can assume that:
• a stroke increases the initial (q-type) mortality rate by + 0.35 in the year following the stroke,
and by + 0.10 in all other subsequent years
ex
• normal mortality follows ELT15
• the appropriate interest rate to use is 5% pa effective
Al
(i) Describe and quantify the risk faced by Alice.
(ii) Using the information given, suggest an immediate needs solution to the risk faced by Alice.
Justify your suggestion.
ti
nso
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Mr
27
Chapter 4
Private Medical Insurance (PMI)and Related Products
Definition of Key Terms:

• Moratorium - Certain PMI products (and possibly also group CI insurance), in place of formal
N.
medical underwriting at inception, do not cover medical conditions that existed during a pre-specified
period, often five years, but will then cover these conditions if no treatment, symptoms or advice takes
place for a period of, typically, two or three consecutive years after first taking out the policy (or after
receiving further treatment). The insurer is however on immediate risk for all other conditions.
ex
• Co-insurance - This is the general term given to a PMI policy condition whereby the policyholder
is required to pay, at least in part, for medical expenses incurred. The policyholder and the insurer
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share the cost of the claim in fixed proportions (e.g the policyholder pays 20% of the claim).
• Age-at-entry pricing - This phrase relates to the practice in some PMI markets of calculating
premiums with allowance for the increasing probability of claim as the age of the policyholder increases
over the prospective period of cover (often to age 65). Therefore such policyholders are not subject to
ti
the age-related increases that affect PMI products with standard pricing.
nso
• Community rating - Community rating most often refers to the practice of charging all policyholders
or a significant subset of policyholders the same premium rate irrespective of rating factors such as age,
gender and medical history. Community rating sometimes refers to the process of applying tabular
rates to applicants irrespective of claims history.
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• Elective surgery - This is surgery that is not deemed necessary or even advisable, but that the
patient chooses to undergo. It is therefore deemed to be ‘elective’ and is seldom covered by standard
PMI plans. For example, the cure of an acute condition is generally covered by PMI plans but cosmetic
surgery is not.
Mr
• Investigative surgery - This is surgery that is undergone in order to advance the diagnosis, to
determine the nature and extent of the complaint. It is generally covered under PMI products (but
may not be so under Major medical expenses (MME) products)
4.1 Private Medical Insurance (PMI)

PMI, whether individual or group, is usually an indemnity-based product that seeks to provide compen-
sation for the cost of private medical treatment. Individual PMI is a short-term insurance contract, usually
renewable annually. At each renewal:
• since premiums are usually calculated to provide cover over the year, these will normally change for
each individual, e.g due to the increasing age of the policyholders
• the insurer can change the terms and conditions of the policy
The premium payable does not usually depend on the claims experience on an individual policy.
However, some insurers operate a no-claims discount scale for their individual policyholders whereby a
28
discount would be applied to policies that have not claimed in recent years (although the discount scales
in operation tend to be smaller than for other types of short-term business, such as private motor insurance).
As these are short-term policies, cover is not guaranteed from one year to the next. However, in
practice, as long as the conditions of the policy are met, e.g the policyholder keeps paying the premiums,
the insurer would not cancel policies on an individual basis. However, it might decide to cease renewal of all
the policies of a product.
Most countries tend to concentrate on acute types of treatments rather than chronic or incurable condi-
tions, with the latter being viewed as the responsibility of the local State healthcare system.
A medical condition is ‘acute’ if it is expected to be cured (e.g as a result of active treatment). However,
if there is no prospect that further treatment will improve a person’s health (although continuing treatment
or medication may make life more comfortable) the condition is said to be chronic.
PMI is often purchased to gain access to appropriate, good quality and speedy diagnosis and (if
N.
necessary) treatment, where the State is unable to provide this. These events relate mainly to the immedi-
ate treatment of acute conditions. Arguably, the longer-term treatment of the residual effects of the accident
or illness will be of secondary concern and may be adequately provided by the State health service. So in
offering cover for acute conditions only, the policy is providing the cover that the policyholder wants / needs
ex
most.
Al
While it would be possible to provide cover for chronic conditions, the cost of claims would be very
high as payments may last for many years. The expenses associated with paying these ongoing
claims may also be significant. In addition, the uncertainty about how much such claims will ultimately
cost will require the insurer to increase the margins in its pricing basis. All these factors will result in pre-
ti
miums that make the policy look poor value, and would be unaffordable by most people. So, PMI usually
excludes cover for chronic conditions.
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The following table lists benefits of a typical comprehensive PMI product available in markets that follow
a UK model. Note the essential features of the coverage but not the detail of amounts and limits.
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Mr
29
N.
ex
Al
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Mr
Figure 4.1: A UK Model
Thus it would cover specialist consultations, out-patient treatment, in-patient treatment(where a stay in
hospital is required) covering both diagnostic tests and operations as well as curative operations.
With in-patient stays, the room costs, drugs, dressings, theatre fees etc would be covered, but additional
personal items such as newspapers, telephone calls or visitors’ meals would not be insured.
What is meant by ‘in-patient’ and ‘out-patient’ treatment? In-patient treatment generally involves the
patient staying in hospital overnight. This is likely to be the case where the patient is undergoing a major
surgical procedure. Out-patient treatment generally involves treatments received during day visits to the
hospital, e.g changing a dressing or having physiotherapy, which do not involve an overnight stay in hospital.
The following is a guide to what a standard policy might, and might not, include within its contract
conditions:
30
Usually included: Cover for treatment of short-term (acute) medical conditions, in-patient tests, surgery,
hospital accommodation and nursing.
Sometimes included: Out-patient tests, out-patient consultations with a specialist, overseas cover, cash
payments for treatment received as an in-patient on a State healthcare funded basis.
Usually not included: Conditions you had before taking out the insurance (commonly known as pre-
existing conditions), GP services (ie visits to your doctor), cover for long-term illnesses that cannot be cured
(usually referred to as chronic conditions), accident and emergency treatment.
General exclusions: Drug abuse, self-inflicted injuries, out-patient drugs and dressings, normal pregnancy,
cosmetic surgery, gender reassignment, preventative treatment, kidney dialysis, mobility aids, experimental
treatment, experimental drugs, organ treatment, war risks, injuries arising from dangerous hobbies (often
called hazardous pursuits).
N.
4.1.1 Policy Excess
An insured person is often happy to meet lesser expenses personally, but is secure in the knowledge that the
insurer will pick up any significant costs. Thus, for a lower premium, the insured is liable for the first
ex
tranche of any claim (a pre-specified monetary amount known as the excess), which will be met from
regular income or savings; the balance is met by the insurer. The premium discount obviously increases
as the level of excess rises.
Al
A further advantage to the insurer is the likelihood that there is an incentive for the patient to seek
treatment in the public system to avoid the payment of the excess, unless the benefits and severity
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of the procedure offset this outlay.
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Companies may market a range of such products allowing applicants to choose the level of excess to suit
their income levels.
4.2 Related PMI Products

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Where State provision of healthcare is an alternative, sale of comprehensive cover insurance products will
not have mass-market appeal. Insurers have therefore been inventive in developing alternatives to increase
sales.
Mr
The standard product as outlined above will have most attraction in the higher socioeconomic groups
and thus cheaper options may be made available to widen distribution. Simple examples of this are prod-
ucts where policy cover is adjusted by restricting the availability of out-patient treatment or by
restricting the range of hospitals in which the policyholder can be admitted (preferred provider
arrangements).
By using ‘preferred providers’, from whom they buy in bulk, insurers can control claim costs.
Some examples of how out-patient cover may be restricted include:

• limits on the monetary level of claims (e.g per year or per claim) or on the number of treatments
covered
• only covering treatment directly related to in-patient treatment, often with a time restriction, eg within
6 months of discharge from hospital
• only providing initial consultations and diagnostics, but no follow-up treatment
These reduced benefit plans are sometimes called ‘budget plans’.
31
4.2.1 Major Medical Expenses (MME)-UK

This product provides a lump sum when the policyholder undergoes surgery. The size of the lump
sum varies with the class or severity of the procedure and is estimated to be sufficient to cover the in-patient
costs with a balance for incidentals and recuperation expenses. There is no guarantee that the benefit will
cover extreme surgical complications within the class, unless the policy states this expressly (and the insurer
has an agreement with particular hospital chains for fixed price surgery).
The product does not cover out-patient episodes and this may be seen as a serious marketing disad-
vantage; however the compensation is a significantly lower premium. One big advantage to the insurer
lies in the simplicity of a fixed benefit schedule that limits the work to be performed at the claims stage.
Major medical expenses (MME) policies can (and have) existed as both:
• a short-term, annually renewable product
• a long-term, reviewable premium product
N.
What are the main differences between the benefits available under such an MME policy compared to those
available under a CI policy?
The qualifying event for MME is having one of the operations on the insured list. The operation may be
ex
needed to cure a serious illness (e.g heart-bypass operation) or may be to relieve a condition that is serious,
but not life-threatening (e.g hip-replacement operation).
Some CI benefits are payable when a specified operation is required – these tend to be very serious operations
Al
(eg heart-bypass) – and so there is some overlap with MME in this respect. However, most CI benefits are
payable on diagnosis of a specified serious illness and in these cases, there is no requirement to have an
operation. While CI may pay a sum insured for a condition related to some operations, it would not pay for
other conditions that may require operations on the MME list.
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4.2.2 Waiting list plans

Another approach to cover limitation to reduce premiums is to provide standard medical insurance
benefits in circumstances where the public health service is not in a position to provide treatment within a
specified period (often six weeks). If policyholders can find free public healthcare for their condition
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in that period and within a reasonable distance from their residence, the insurance will not
reimburse private expenses; otherwise the policy operates as a normal comprehensive PMI policy. This
approach supposedly meets the customer needs where the desire to buy insurance is to avoid waiting for
treatment. If the customer’s reasoning is different, this alternative is unlikely to be attractive.
Mr
4.2.3 Health cash plans

Health cash plans are a defined-benefit, defined-premium insurance product. For premiums as low as
$2 per week, the policyholder and family are entitled to a range of specific payouts dependent on certain
healthcare-related events. These include: dental, optical, physiotherapy, maternity, hospitalization,
recuperation, hearing aids, consultation, etc.
Limits may also apply to ensure that the claim payments to the customer are not more than, for
example, 50% of the medical bill. This is a form of ‘coinsurance’ with the policyholder.
The products are typically community-rated and a waiting period (maybe six months) often applies be-
fore benefit eligibility. Pre-existing conditions may also impact on ability to claim.
‘Individual rating’ is the most common form of rating in personal insurance. At the underwriting stage
the insurer collects information about the applicant, such as their age, gender and state of health. This
individual-level information is then used (provided legislation permits) to determine the premium rate that
32
the individual will pay.
In contrast, a ‘community-rating system’ does not use individual information. It will only use group-
or community-level information, such as the area in which an individual lives or their occupation
class. All those individuals that have the same values of these ‘community-rating factors’ are considered to
belong to a group and will be charged the same premium. In effect, no individual applicant that meets the
eligibility conditions will be refused insurance, because there is no underwriting at the individual level.
The purpose of a health cash plan is to provide a defined cash benefit in the event of a
claim, rather than to indemnify the individual. As the cash benefit is generally small relative
to the full cost of indemnity, there is less financial incentive for potential policyholders to take
out a policy if they know they are to claim shortly. This reduces the risk of anti-selection for
the insurer.
A waiting period might be used to reduce the risk of any remaining anti-selection for the insurer. Six
months is common, although there are notable exceptions, for example the waiting period for payouts on the
N.
birth of a child is usually at least nine months. As the purpose of a waiting period is primarily to reduce
the risk of anti-selection, there is normally no waiting period on claims resulting from accidents.
The product’s profitability is dependent on long-term policyholder loyalty, on cost-efficient claims
ex
admission procedures and on volumes in force.
Al
As cash plans have low premiums and are (typically) annually renewable contracts, the failure to recover
the fixed costs can have a significant (negative) effect on profitability. However, if:
• policyholders renew their policies for many years, it can be treated like a longer-term contract, and
initial expenses can be spread over a number of years
ti
• claims admission procedures are cost-efficient, then the impact on profits should be reduced
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• there is a large number of policies in force, then the initial fixed costs (e.g product development and
marketing) can be spread across this large number, resulting in a small per-policy cost.
These result in a much smaller expense loading in the premium.
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4.2.4 Dental plans

While some comprehensive PMI policies include dental insurance, this cover is obtainable separately. In-
Mr
surers work closely with dentists to ensure that applicants are screened initially for pre-existing
conditions or imminent treatment and to ensure that dental intervention thereafter is in accordance
with risk expectation. The two principal methods are:
• the capitation basis: where the insurer and dentist agree a sum per annum per insured mouth
• the indemnity basis: where the insurer covers the actual cost of treatment delivered
Under the capitation basis, the patient pays a regular fee to the insurer who deducts an amount for its
expenses and passes the remainder on to the dentist. In return, the dentist provides treatment. Therefore,
the dentist bears the risk that the cost of treatment required will be more than expected. The insurer will
deal with the administration of the arrangement, but will often only cover the cost of accident and emer-
gency treatment (eg where the patient is away from home and unable to visit their own dentist). Therefore,
the patient will be covered for both emergency treatments (by the insurer) and treatments under normal
circumstances (by the dentist).
Under the indemnity basis, the insurer bears the claims risk. This can be on a full indemnity basis,
but often limits, excesses or coinsurance will apply.
33
4.2.5 Optical plans

These provide cover for spectacles, contact lenses, eye-tests and optical treatments. Waiting periods
and pre-existing condition exclusions may apply. Such cover is most often found as part of health cash plans
or some PMI products, but may be purchased on a stand-alone basis.
4.3 Personal accident

Personal accident policies are also short-term renewable products. They provide lump sum benefits to
compensate for bodily injury suffered as the result of an accident. Policies often have a rider
benefit that pays reduced benefits if the policyholder’s children suffer an accident.
4.3.1 Benefit definitions

Benefits are usually specified fixed amounts if an insured party (this may include the policyholder’s
family as well as the policyholder) suffers an accident resulting in the loss of one or more limbs or other
N.
specified injury. This is not indemnity insurance because it is not possible to quantify the value of the
loss, for instance, of a limb.
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4.3.2 Exposure measure
For the purpose of setting premiums, insurance companies try to determine measures that give an indication
of how much risk there is within each policy. These measures are called measures of exposure.
Al
In practice, the chosen measure of exposure should meet two key criteria:
• It should be a good measure of the amount of risk, allowing for both the expected frequency of
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claim and the expected severity of claim (i.e the average claim amount). In other words, the total
expected claim amount should be proportional to the exposure.
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• It should be practical. This criterion embraces several aspects: the measure should be objectively
measurable and should be easily obtainable, verifiable and not open to manipulation.
There are rarely perfect measures of exposure that completely define the amount of risk underlying each
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policy. For most classes, in fact, the exposure measure used is just a basic indicator of risk. Exposure
measures often incorporate time units to reflect the fact that, for example, policies for two years should be
charged twice the premium of one-year policies.
Mr
For personal accident insurance the true measure of exposure is the person-year because the cover is de-
fined in relation to the level of cover normally required by one person, although in many cases, the member
(employee)-year may be all that is available.
In other words, if family members are covered under the group or individual plan then ideally the insurer
would need more details of these members to calculate the exposure measure. However, in practice, this is
not often available and so member-year (or employee-year) is used instead.
The insurance may cover the whole family at a standard rate, but the insurer may or may not be made
aware of number of family members. The insurer might therefore charge a rate assuming an average family
unit size and (hopefully) gets it right on average.
4.3.3 Claim characteristics

Claims are usually reported quickly and settled without much delay, although they are sometimes
subject to dispute. Personal accident claims are as defined in the cover and can be very large (often much
higher than typical claims under other types of health insurance cover).
34
As the claim cost is known for these claims the settlement delays are reduced. The incidence of an event
is usually very clear, so reducing reporting delays. The claim frequency tends to be reasonably stable.
4.3.4 Risk factors and rating factors

Risk factors are those characteristics of the insured event that are known or suspected to influ-
ence the claims cost. A rating factor is a factor that is actually used to determine the premium.
Rating factors are often proxies to risk factors and may be used because the risk factors are hard to measure.
Apart from sum insured, the prime factor affecting the risk is usually occupation. Those employed in
more dangerous occupations such as demolition work will certainly need to be distinguished from those in
safer occupations such as clerical work. Cover for participation in hazardous leisure activities may also
attract higher premiums or be excluded. Premiums will often be independent of both age and gender.
For those that belong to a group scheme the insurer may only know their age and the industry in which
they work. Here the industry in which the policyholder works is being used as a rating factor whereas the
N.
underlying risk factor is the policyholder’s occupation.
Practice Questions
ex
1. Define the following terms and phrases used in private medical insurance:
(a) moratorium Al
(b) coinsurance
(c) age-at-entry pricing
(d) community rating
ti
(e) elective surgery

nso
(f) investigative surgery.

2. Describe the advantages and disadvantages for a private medical insurer of controlling claim costs in
each of the following ways:
.O
• a co-insurance arrangement, whereby the insurer pays 75% of each and every claim
• a no claims discount (NCD) scheme with a 15% discount after one claim-free year and 30%
discount after two claim-free years; after a claim the discount level reverts to 0%
• a maximum claims payment of £15,000 in any policy year
Mr
• an excess of £1,500 applied to each and every claim
3. The following is a possible structure for the benefits under a dental or optical plan:
• for all eligible claims the policyholder agrees to pay 25%, up to a maximum annual limit of £500
• the insurer will pay the remaining 75%
• once the policyholder reaches the maximum annual limit, the insurer will pay 100% of claims until
the start of the next policy year
4. (i) Explain the differences between primary, secondary and tertiary medical care.
(ii) Explain why in many States, insurance companies restrict private medical insurance benefits to
the provision of secondary and tertiary medical care.
35
Chapter 5
Distribution Channels
Introduction
In this chapter we look at how health and care insurance companies go about selling the products they
N.
have to offer through the various distribution channels that are available, and describe the main types of
commission structures involved in remunerating distributors.
We also look at the ways in which the choice of distribution channel affects the insurer. Finally, we
ex
consider the role of the intermediary in the running of group insurance schemes.
The distribution channels we shall be studying are:

Al
• insurance intermediaries, who select products for their clients from all or most of those available
on the market
ti
• tied agents, who offer the products of one insurance company or a small number of insurance com-
panies
nso
• own sales-force, usually employed by a particular company to sell its products direct to the public
• direct marketing via press advertising, over the telephone, internet or via mailshots.
.O
5.1 Main Distribution Channels
5.1.1 Insurance intermediaries (brokers)

Mr
Insurance intermediaries must act independently of any particular insurance company (although they can be
owned by one). Their aim is to find the contract that best meets, in terms of benefits and premi-
ums, the needs and situation of their clients. They may be remunerated, via commission payments,
by the companies whose products they sell, or they may alternatively receive a fee from their clients.
The majority of professional intermediaries will seek the best contracts for their clients, how-
ever, in some markets, it has been known for less scrupulous intermediaries to be influenced more by the
levels of commission payable than by the appropriateness of a particular product. Selling inappropriate
products in this way is sometimes described as ‘mis-selling’.
Often, when faced with several similar products that are all appropriate for the client, the intermediary
will be strongly influenced by commission levels. For this reason, some intermediaries offer their services
for a fixed fee, to demonstrate that they will not be influenced by commission levels. In such cases, any
commission payable to the intermediary would be credited back to the client.
A good intermediary can provide a valuable service for the client. Most individuals will lack the time
and expertise to find the products that are the best value and most appropriate for their needs, but the
36
intermediary can perform the necessary research.
It will often be the client who initiates the sale. However, intermediaries are also likely to promote
themselves actively to existing clients by, for example, instigating a periodic review of finances.
Promotion may also involve mailshots to the existing client base, for example when an innovative product
is launched or tax rules change. Intermediaries may also promote themselves to new customers, for example
by press advertising or through trade associations. Recommendations from current clients is another good
source of new custom. An alternative name for insurance intermediaries is insurance brokers.
5.1.2 Tied agents

These are salespeople who are ‘tied’ to one, or sometimes several, insurance companies – they offer to their
clients only the products of those companies. Typically, they may be the employees of a bank or other similar
financial institution.
N.
A bank might even set up its own insurance company (if local legislation permits), to which it then
becomes a ‘tied agent’, marketing insurance products through its bank branches and through mailshots to
customers. This is often known as ‘bancassurance’.
ex
A bank is not the only possible type of tied agent. Traditional distribution method is done through
individuals who act as tied agents. Legally they work on behalf of the insurance company, without being
Al
employees. This contrasts with insurance intermediaries, who in a legal sense act on behalf of their client.
Where the tie is to more than one company, the product ranges of the companies are usually mutually
exclusive.
ti
Tied agents are remunerated via commission payments from the companies to which they are
tied. Often the prospective policyholder will initiate the sale, but tied agents may actively engage in selling.
nso
The insurance company will certainly be hoping that their tied agents are actively engaged in selling. Bank
staff are often given incentives to introduce products to clients.
5.1.3 Own Sales-force

.O
Members of an own sales-force will usually be employees of an insurance company and hence will only
sell the products of that company. They may be remunerated by commission or salary or a mixture
of both.
Mr
It will usually be the salesperson who initiates a sale, making use of client lists or purchased leads.
However, once he or she has built up a rapport with a client, the client often initiates further sales.
Many salespeople will also be active in trying to make further sales. It is often seen as helpful for a
company to have a full range of products if it is selling through an own salesforce. This way, once it has a
‘warm’ client (one with whom it has an established relationship), it can try to sell that client all kinds of
insurance products – such as life insurance, savings and general insurance – as well as health and care.
Of course, lists of clients have to be acquired in the first place. This might be achieved, for example,
through press advertising or personal contacts, or from marketing companies.
5.1.4 Direct Marketing

There are four main forms of direct marketing.
37
5.1.4.1 Mailshots
To send out a mailshot, the insurer will get a list of names and addresses, for example from its database
of current policyholders, or other affinity groups such as holders of a specific credit card. The insurer will
target the relevant groups appropriately, for example selecting only those aged over 50 for a LTCI mailshot.
The insurer will write to all the names on the list inviting them to take out a policy. The letter will include
details of the contract being offered and enclosing an application form. Hence, the insurance company
initiates the sale.
Telephone selling
The sales process could involve the ‘cold-calling’ of prospective customers, where this is allowed. Alternatively
the customer might call in response to a newspaper or television advertisement, with the sale then being
completed over the telephone. In this latter case, telephone selling and press advertising are really parts of
the same selling process. Therefore, either the prospective policyholder or the insurance company
initiates the sale.
N.
Press advertising
Press advertising may take various forms, for example:
ex
• it may include a short application form for the customer to complete and send in
• it may give a telephone number or address from which further information and an application form
can be obtained
Al
• it may give a telephone number to call for the sale to be completed on the telephone, as described
above
ti
It is debatable who initiates the sale.

nso
Internet advertising and comparison websites

There is considerable use of the internet, both for marketing and for selling products. It is usually possible to
.O
get a quote online, and some sites offer a choice of companies (for example, giving quotes for the 10 cheapest
premiums available). The facility to apply online for a chosen quote is then usually provided.
Internet quotes and applications can take into account basic underwriting information, also requested
online, such as age, gender (if permitted by legislation), height, weight, smoking habits, and a few brief
Mr
questions about health and family history.
5.2 Worksite Marketing

This is a process whereby a broker or insurer representative obtains permission from the employer to address
the entire workforce and sell health and care insurance products.
The complexity of the cover suggested depends on the sophistication of the staff being targeted, but
generally the intention is to offer simple products. The distributor aims to attract those who have not made
their own insurance provision for healthcare needs and do not have adequate employer-paid cover, or who
perhaps have cover for themselves but not for their dependants.
This form of distribution is unlikely to be undertaken for LTCI products, but is already part of the health
cash plan and simple PMI product markets. Similarly, there is scope to sell CI and IP insurances in this
way.
Why is long-term care insurance unlikely to be sold this way?
38
• It is too complex for the target market

• It provides cover for a post-employment need, and a considerably post-retirement need at that. This
makes it much less attractive, especially to younger employees
• It is likely to be too expensive for the target market
5.3 Different Types of Commission
5.3.1 Initial and renewal commission

Initial and renewal commission is a common remuneration structure for the sale of long-term health-care
insurance products. It involves two levels of payment: a high ‘initial’ level, paid for a certain initial
period from the start of the policy (e.g 24 months), followed by a much lower ‘renewal’ level paid thereafter.
The two commission levels are generally expressed as percentages of the premiums payable during the same
periods. The period over which the initial commission is payable may vary by product and also within
N.
products, e.g by policy term. In a similar way, short-term health-care products, such as PMI, will often have
a higher rate of commission payable for a policy that has been sold to a client for the first time, compared
with a policy that has been renewed.
ex
Indemnity commission
Indemnity commission is a form of initial commission. It is a lump sum payment from the insurer to the
Al
distributor (intermediary who sells the insurance policy) in respect of new business written. It is typically
expressed as a percentage of the first premium, but may be expressed as a proportion of sum insured.
Payment of indemnity commission indicates that the insurer is willing to pay the distributor commission
ti
in respect of premiums that the insurer has yet to receive.

nso
Indemnity commission involves the payment of the initial commission immediately when the policy is
sold. It represents advance remuneration to the intermediary for premiums that are expected to be paid in
the future, as well as for the premium paid on day one of the policy. It would be calculated as a discounted
value of the initial commission that would otherwise have been paid under the policy. This will generally
.O
involve the insurer in some form of new business strain.
Indemnity commission may be paid to any distributor who needs cash ‘up-front’ to develop his/her
business, e.g to support the cost of marketing ahead of commission from resulting sales.
Mr
Clawback arrangements
The adviser earns indemnity commission over a defined period, which is normally stated in months. This is
known as the earnings period.
If a policy lapses before the commission is fully earned (ie during the earnings period), then the insurer
will clawback the proportion of indemnity commission that is deemed not to be earned at the point the
policy is lapsed. This repayment is often called clawback.
The extent of clawback is calculated by a formula specified in the commission agreement, such as the
proportion of the initial commission that the number of premiums paid bears to the number expected during
the earnings period. If a policy were to lapse after the earnings period, then the insurer would not require
any further clawback.
Example:
39
You are given the following information:
Earnings period: 24 months

Initial commission: $60
Assuming the policy lapses after 9 months, and ignoring any discounting, calculate the commission clawback
due.
Solution:
The clawback would be:

(24 − 9)
$60 × = $37.50
24
Renewal commission
N.
Where the commission paid is a large initial amount (such as indemnity commission for regular premium
products), there is often a lesser amount payable as renewal commission for the balance of the policy term to
encourage the distributor to promote persistency. This may, for example, be paid annually after the end of
the earnings period for contracts paying initial indemnified commission. For annually renewable contracts, a
ex
renewal commission, usually lower than initial commission, can be paid every time the contract is renewed.
5.3.2 Level commission

Al
Level commission is an alternative commission method whereby every premium paid by the policyholder
entitles the distributor to a set proportion of that premium.
ti
Level commission does not involve the insurer in any strain, but takes longer for the distributor to receive
a full reward. It matches commission outgo to premium contribution and to profitability more appropriately.
nso
Advantages
Level commission:
.O
• encourages persistency, which results in greater profit for the insurer, so more closely relates to the
profit earned by the insurer
• produces less new business strain for the insurer, so makes the policies more capital efficient
Mr
• matches commission outgo to contribution to profitability more appropriately

• is simpler than other commission structures
Disadvantages
Level commission discourages the intermediary from actively seeking new clients, which requires consid-
erably more effort than achieving a renewal.
So the problem is that level commission does not reflect the timing of the work done to earn the commis-
sion. In effect, part of the (higher later) level commissions represents deferred remuneration for the initial
sale of the contract.
This is a significant problem if other companies do pay a high initial / low renewal commission structure.
Intermediaries will be encouraged to sell new policies for these other insurers, with the result that the level
commission insurer’s business volumes will suffer.
40
5.3.3 Alternative commission structures

Between level and indemnity commission is the system of initial commission spread over a limited number
of years.
Commission is sometimes paid in proportion to the sum insured in some territories. This would reflect
an insurer’s preference for higher sums at risk rather than premiums as sources of profit.
There are two main ways in which an insurer can pay commission that reflects the profitability of the
whole contract:
• level commission paid as a proportion of each premium
• high initial commission / low renewal commission, where the initial commission is related to the total
amount of premium payable (eg the amount of annual premium and the number of annual premiums
payable over the policy term).
N.
5.4 The effect of different channels
5.4.1 Demographic Profile
ex
Different channels are likely to appeal to different people, according to their level of financial sophistication
and level of income. These differences will then be reflected in the resulting demographic experience of the
Al
lives taking out contracts through each channel, i.e there will be socio-economic selection.
Effectively it is the target market rather than the distribution channel itself that directly affects the levels
of income and financial sophistication of the customers reached. However, it is via the distribution channels
ti
that the target markets are reached and certain channels will tend to be associated with particular target
markets.
nso
The levels of income and financial sophistication of the customers will tend to be correlated with their
mortality, sickness and persistency experience.
.O
The sales channel can also have a direct effect on the persistency experience. Different channels employ
different sales processes, which can include differences in terms of aggressiveness of the selling approach, the
extent to which customer needs and ability to pay are considered, and who initiates the sale.
These factors can have an effect on persistency, particularly early on, when people who have been ‘over-
Mr
sold’ their policies are most likely to cancel. Highest persistency rates should then be associated with
insurance intermediaries, especially through the effect of client-initiated selling and the sophistication of
the client base, although there can be many exceptions (e.g where an own sales-force channel targets a
sophisticated market and adopts a carefully focused customer-needs based approach).
5.4.2 Contract Design

In broad terms, the higher the level of financial sophistication of the client base the greater can be the
complexity of the products being sold.
Different methods of sale will suit different products. For example, the dynamics of selling via the tele-
phone, press advertisements or the internet mean that the products sold in this way may be less complicated
than products sold face-to-face.
Perhaps the most important thing is that the product should appear simple to the prospective policy-
holder, even if, in actuarial terms, it is quite complex. In particular:
41
• the risk that is being transferred from the individual to the insurer should be straightforward to
understand
• the insured should find it easy to understand which events are covered
• it must be clear as to how much benefit would be paid out on a claim
An insurance company using more than one distribution channel may therefore sell different versions of
the same product, varying by channel.
5.4.3 Contract Pricing

There are two aspects of the effect of distribution channels on contract pricing:
• the effect on demographic assumptions, including the effect of underwriting - The level of
underwriting exercised will be linked to the marketing strategy used. The level of underwriting will
then be reflected in the demographic assumptions used for pricing. The socio-economic selection noted
N.
above will also affect these assumptions. Persistency rates are likely to be affected by the level of
financial sophistication and whether it was the policyholder who initiated the sale.
• the effect on the need for competitive terms - The competitiveness of premium rates is, in
ex
broad terms, likely to follow the order of insurance intermediaries, tied agents, own sales-force, direct
marketing. Insurance intermediaries will recommend to their clients the companies with the most
competitive rates, other things being equal. Al
5.5 Group Risks
The employer purchases group covers on behalf of the employees. There are generally both tax and risk-
ti
pooling reasons why this is an efficient way of arranging insurance.

nso
5.5.1 Small Groups

With smaller groups, products may be distributed through insurance brokers, other intermediaries or may
be sold direct to the client.
.O
5.5.2 Large Groups

In most territories, the largest group arrangements are generally in the hands of certain financial advisers
Mr
(brokers) who specialise in the business (although some may be placed directly with the insurer). The
typically large size of the contract is one reason why specialist brokers dominate the market.
The Role of the Intermediary

The broker will be responsible for most of the communication and data gathering for the insurer and may
also be the conduit for money receipts and payments. The insurer’s ability to influence the risk attitudes of
the employer directly is thus limited, since the relationship may only exist through the broker.
The broker is interested in retaining the business with the employer, but not necessarily with the same
insurer. So the broker will provide a good service to the employer, but not necessarily to the insurance
company. If the insurer wants to control claim costs, this will need to be done through policy conditions
rather than by encouraging the employer to act in a particular way, e.g by introducing a new sickness absence
policy.
42
Benefits to the Employer

The employer is normally assured of a good level of service by dealing with a large national broker operation.
This will include an annual audit of the appropriateness of protection levels and structures, the compar-
ative analysis of the market’s providers in terms of security, products available and price, and quality of
administration.
Benefits to the Insurer

The use of a national broker organization should give assurance to the insurer regarding the quality of the
selection process, and it normally means achievement of a legal contract with minimum additional adminis-
trative expenses.
However, the insurer may be limited in other ways, such as:

• in the opportunity to build a direct relationship with the purchaser of the insurance
N.
• in the chance to influence the retention of this business, for example, with the quality and speed of
service
• in the opportunity to engage directly with those responsible for the lives insured to improve risk
ex
management.
When the insurer is in closer contact with the employer there will be a much greater opportunity for the
Al
insurer to offer help and advice in the management of the risks covered by the insurer. The insurer may
appear unduly generous in offering free advice to the employer. However, the employer is motivated by the
results of the advice. This may result in lower claims, and the opportunity to quote lower premiums in the
future, thus increasing the chances of retaining the business.
ti
Practice Questions
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1. (i) State the four main distribution channels used by health and care insurance companies. Explain
briefly how each distribution channel operates.
(ii) State what is meant by worksite marketing.
.O
2. A health and care insurance company writes the majority of its business through insurance interme-
diaries. Each intermediary is paid initial commission at a multiple of a standard scale. The multiple
is agreed between the company and the particular intermediary. All intermediaries are paid the same
rate of renewal commission.
Mr
(i) the reasons why the company might offer some intermediaries a higher multiple than others
(ii) the risks it accepts from this approach
(iii) how it can reduce these risks
3. Discuss how the different stages of the actuarial control cycle can be used in the management of a
health and care insurer’s sales distribution.
43
Chapter 6
Reserves and Embedded Value
6.1 Purpose of Calculating Reserves

• to determine the liabilities to be shown in the insurer’s published accounts
N.
• if separate accounts have to be prepared for the purpose of supervision of solvency, to determine the
liabilities to be shown in those supervisory accounts
• to determine the liabilities to be shown in internal management accounts of the insurer
ex
• to estimate the cost of claims incurred in recent periods and hence provide a base for estimating the
future premiums required to attain a given level of profitability
Al
• to value the insurer for merger or acquisition
• to influence investment strategy
ti
• to assist with the assessment of reinsurance arrangements

nso
6.2 Types of Reserve
6.2.1 Long-term insurance

.O
• Reserves for polices: typically the discounted value of future expected claims, expenses and premium
cash-flows. This is the reserve held to meet all future cash-flows. It is determined by
Reserve = EPV of future claims + EPV of future expenses - EPV of future premiums
Mr
It is held for instances when the future outgo is more than the future income.
• Reserves for claims that have been incurred but not reported (IBNR).
Note: when setting the IBNR component, the actuary needs to consider whether there have been any
claims reported with abnormally long delays. These may arise in circumstances where policyholders
learn, some years after the disability itself, that their insurance policy provided protection against such
an event and then lodge a claim. Such late notification is becoming increasingly common in critical
illness insurance.
• Reserves for claims that have been reported and not yet fully settled. For instance, IP claims that are
currently in payment or CI claims that are still in their assessment period.
44
6.2.2 Short-term insurance

For the long-term contracts described above, the insurer is committed to honoring claims for a specified
(possibly large) number of future years, which is why in its reserves and solvency capital calculations the
insurer has to allow (prudently) for all the liabilities arising over that period.
Under short-term insurance contracts, assuming annual policies, each year’s premium effectively covers
the expected outgo for that policy year. As the terms of the contract, including the premium, can usually
be changed at each renewal, the insurer does not (normally) have to hold reserves for cover beyond the next
renewal date.
However, the short-term insurer will need to hold reserves for, amongst other things, those claims that
will arise between the valuation date and the next renewal date. This is because the insurer will be con-
tractually committed to honour claims that may occur during this period, and must therefore cover these
liabilities sufficiently prudently. The reserves held to cover this unexpired risk for short-term contracts are
called unearned premium reserve (UPR) and unexpired risk reserve (URR).
N.
Reserves that may be held for short-term insurance contracts include:
• Unearned premium reserve (UPR): the balance of premiums received in respect of periods of
ex
insurance not yet expired.
This is effectively a retrospective approach: how much of the premiums that were charged should the
insurer be holding in respect of the unexpired risk?
Al
Apart from the initial expenses, all the elements of the premium (claim payment and profit) may be
assumed to be earned with the incidence of risk. Collectively, these elements make up the risk-related
premium. If the policy under consideration has m% of the risk before the year end and (100-m)% of
the risk after the year end, then (100-m)% of the risk-related premium is unearned at the year end.
ti
The UPR for this policy could then be calculated as:
nso
(100 - m)% × risk related premium
• Unexpired risk reserve (URR): in respect of the above unexpired insurance premium where it is
felt that the premium basis is inadequate to meet future claims and expenses.
.O
This is effectively a prospective approach: how much is needed now to cover the expected claims and
expenses from the unexpired risk period?
If the UPR is inadequate to cover the claims and expenses for unexpired risk due to insufficient
premiums, then more will be needed. The URR is an estimate of what is actually needed to provide
for the unexpired risk, rather than simply taking a proportion of premium.
Mr
The URR would typically be calculated by estimating the future loss ratio and applying it to the
proportion of premium unexpired.
• Incurred but not reported: in respect of claims that have arisen but that have yet to be notified
to the insurer. This is the IBNR, which also applies for long-term insurances met earlier.
• Claims in transit: in respect of claims reported but not assessed, or not recorded. These are reserves
held aside for claims that are ‘in the pipeline’.
• Outstanding claims reserve: in respect of claims notified to the insurer but not yet fully settled.
This is a reserve for claims that are currently known about (and maybe some claim payments have
already been made), but have yet to be settled fully.
6.3 The Role of Statistical and Case Estimates

The two primary methods used to calculate the reserves for health and care products are case estimates
and statistical estimates. The method used will depend heavily on the characteristics of the product for
which the reserves are being calculated, and the purpose of the calculation.
45
6.3.1 Case estimates

For the case-by-case method, an experienced claims manager inspects the claims papers and estimates the
ultimate outgo for each case individually.
This is straightforward where the claim payment is for a known lump-sum amount. Where the claim
payments form a known income, this will involve assessing the likely duration of the claim.
For indemnity products (ie PMI), the following factors will be considered:
• procedure type: this will indicate the cost of the procedure itself and the likely inpatient duration for
accommodation costs
• hospital (medical center) to be used
• name of surgeon, consultant or other medical principal
N.
• policy coverage (full indemnity, excess, limits, recuperation benefit etc)
• age, gender and past claims history of claimant may have some bearing
• current levels of medical inflation
ex
6.3.2 Statistical estimates Al
Statistical estimation is appropriate for particular types of homogeneous claims where the portfolio is large
enough and the experience is deemed to be stable.
Outstanding claims are assessed in aggregate in relatively homogeneous cohorts, based on historical
ti
trends and patterns, adjusting for known or anticipated future changes. The portfolio might be segmented
by contract type, by distribution type or by geographical region and a statistical distribution fitted to the
nso
past experience to estimate the claims incurred from the earned premium (which is generally a better unit
of exposure than man-years).
Current claims provisions are then derived from the model by applying the relevant premium earned and
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adjusting for trends in incidence and in cost.
6.3.3 Long-term insurances

Mr
For most forms of long-term insurance, the amount of benefit payable is known once a claim is submitted.
However, for contracts that pay income, the duration for which benefits will be paid will not generally be
known at the point a claim is submitted. This is typically true of IP insurance and LTCI, but not CI insur-
ance. The insurer will hold a reserve for claims that have been notified but not yet settled, using the amounts
in the policy document, increased where appropriate by relevant inflationary indices or other increments.
Where benefits are paid as an income (income protection or long-term care insurance, for example), the
actuary will normally use statistical methods. Case estimation would only be used for very small volumes of
claims, where the reserve can be determined by asking the claims manager to estimate the likely duration
of each claim.
Most of the long-term insurance provisions held are in respect of future claims, acknowledging that a level
premium (or one increasing at a similar rate to the benefit) is being paid to cover an increasing probability
of claim.
The actuary may utilize deterministic or stochastic models to estimate potential future claims outgo and
thus set current provisions.
46
6.3.4 Short-term insurances

Private medical insurance is typically an indemnity cover, ie the amount payable on claim is determined
by the costs incurred by the claimant and thus is not known with certainty until the particular course of
treatment is complete.
The approach that is usually adopted to estimate the amount of claim is one of statistical estimation,
though certain large or unusual claims will warrant reserves on a case-by-case basis.
Statistical estimation involves calculating expected total claim amounts for outstanding claims based on
relevant past experience. However, each claim is unique in that many different claim causes can arise, and so
the cost of treatment for such claims can vary considerably. The (relatively few) large outstanding individual
PMI claims can therefore significantly distort the average cost per claim, so it is more sensible to exclude
these from the bulk of typical claims and value them separately using case estimation.
Case-by-case estimation is generally more important for smaller PMI insurers, due to the greater potential
N.
impact of a large claim.
6.4 Embedded Value
ex
The concept of embedded value is of most relevance to long-term insurance business.
Embedded value (EV) is the present value of future shareholder profits in respect of the existing business
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of a company, including the release of shareholder-owned net assets.
Embedded values are often used as a realistic assessment of the value of an insurer. The embedded value
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not only recognizes the value of any assets in excess of the reserves, but also recognizes the value to the
shareholders of future releases of the margins in those reserves.
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6.4.1 Purpose of Embedded Value

EV is calculated include to:
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• establish a value of the business, possibly for internal management accounts or information
• include in published financial statements

• assess the major part of an appraisal value for sale or purchase
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• analyze the value of future surpluses for reinsurance embedded value financing
• assess growth in EV for the payment of bonuses to staff or salespeople Note: embedded value financing
is a type of financial reinsurance under which a reinsurer advances a loan (often expressed as commis-
sion) to an insurer, in return for a stream of future surpluses that will emerge from business in force,
reflecting any prudence in the valuation basis.
6.4.2 Calculation of Embedded Value

Embedded values have two parts:
• shareholders’ share of net assets
• present value of future shareholder profits

Embedded value can be calculated as the sum of:
47
• The shareholder-owned share of net assets, where net assets are defined as the excess of assets held
over those required to meet liabilities.
Example:: An insurer is required to hold solvency capital of 100 in respect of a particular cohort of
policies. This capital is assumed to be locked in until all these policies mature in ten years’ time. The
solvency capital is invested in assets earning only 4% pa. However, the embedded value is calculated
using a risk discount rate of 5% pa.
The discounted value of the assets backing the solvency capital is then given by:
1.0410
100 × = 90.874
1.0510
So these assets may be included in the embedded value at a discounted value of 90.874 rather than
their market value of 100.
N.
• The present value of future shareholder profits arising on existing business. The process of determining
this amount is similar to performing a profit test, bearing in mind that some elements will not be
applicable (eg new business expenses).
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6.5 Appraisal Value
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The starting point in valuing a long-term insurance company for merger or acquisition will be the embedded
value. However, an important element of the price is likely to be goodwill, corresponding to the estimated
profits expected from future business.
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An embedded value considers the present value of future profits from the in-force business only. How-
ever, the insurance company should be able to use its expertise and brand name to add value to the business
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through sales of profitable new business in the future too – and this will be represented by the goodwill
element of the purchase price.
The sum of embedded value and goodwill is generally known as ‘appraisal value’.
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Practice Questions
1. List and define the types of reserve held to meet the claims liabilities of the following insurers and,
with reasons, give indications of their sizes.
Mr
(a) A long-term insurer selling only conventional individual annual premium critical illness policies.
(b) A health and care insurer selling only individual private medical insurance business, where pre-
miums are paid annually and cover is renewable every year.
2. A block of business has two years left until maturity. The cash-flows (premiums plus investment return
less claims and expenses) expected at the end of the first and second years are 15 and – 100 respectively.
The insurer has assets of 120. The current reserve is 100. The insurer expects to hold a reserve of 110
at the end of the first year after allowing for the cash-flow received at that time.
Calculate the embedded value of this block of business using a discount rate of 8% pa.
3. (i) State when case estimation is more suitable than statistical estimation of claims reserves.
(ii) List the factors that a claims assessor would consider when estimating the ultimate claims cost
for an individual private medical insurance claim.
48
Chapter 7
Approaches to Setting Reserves and Solvency Capital

Requirements
This chapter discusses how health insurers calculate reserves and solvency capital.
N.
To place a value on the liabilities, the insurer must use a reserving basis. There are many possible ap-
proaches that could be used in practice. Several factors help determine what an appropriate basis may be
in a particular situation, the most important of which is usually the purpose of the investigation.
ex
Changing the reserving basis does not affect the true financial position of the insurer, but it usually
changes its disclosed result. While using a different valuation basis has no direct effect on the real situation,
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there may be indirect effects. For example, if an over-cautious basis caused an insurer to conclude that its
solvency was in doubt, then the insurer might choose to change investment policy. Thus the true situation
would have been indirectly influenced by the choice of valuation basis.
ti
An insurer’s available capital is the excess of its assets over its liabilities. Regulation is likely to require
insurers to hold solvency capital in addition to its reserves. So to be solvent, the insurer needs to have
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available capital in excess of this required capital, ie its free capital needs to be positive.
7.1 Solvency Capital Requirements

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7.1.1 Purpose
It is usual for insurance supervisors to require that an insurer maintains at least a specified level of solvency
capital in addition to the reserves or technical provisions held.
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This solvency capital can be seen as providing an additional level of protection to policyholders.
The level of solvency capital required under regulation may be specified as a formula, or it may be based
on a risk measure such as Value-at-Risk (VaR).
A simple formula might set the solvency capital as 3% of the reserves to cover a fall in asset values and
0.3% of the sum at risk to cover adverse morbidity experience.
7.1.2 Interplay between reserves and solvency capital requirements

In considering the adequacy of the reserves that have been set up, it is important to do this within the
context of the solvency capital requirements and not in isolation. Similarly, the adequacy of the solvency
capital requirements cannot be looked at in isolation of the reserving requirements.
The aim of risk-based capital is to establish the extra amount of capital required to protect the insurer
from the risks.
49
7.1.3 Value-at-Risk (VaR) approach

An example of a risk-based solvency capital requirement approach is the use of a VaR measure, normally
expressed at a minimum required confidence level (e.g 99.5%) over a defined period (e.g one year).
So the insurer calculates the amount of capital it needs so that its assets will exceed its liabilities in one
year’s time with a probability of 0.995, say.
For example, a VaR of £10 million over the next year with a 99.5% confidence level means that there is
only a 0.5% probability of losses being greater than £10 million over the next year.
N.
ex
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ti
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The supervisory balance sheet (which would typically be on a market-consistent basis for this type of
approach) is subject to stress tests (or ‘shocks’) on each of the identified risk factors, at the defined confidence
level and over the defined period. The (marketconsistent) surplus is then recalculated at the end of the period.
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The insurer determines an adverse outcome (or shock) for the next year that it considers to be so severe
that an even more extreme outcome would only occur with probability 0.005 (ie only 0.5% of the time). For
example, the adverse outcome might be a fall in the value of the stock market of 35% over the year.
The insurer then projects its assets and liabilities at the end of the year under this shock. The risk-
Mr
based capital is then the amount of capital required to be held at the start of the year, which will ensure
its assets are no smaller than its liabilities at the end of the year, on the assumption that the shock hap-
pens. Any excess of the insurer’s available capital over its required capital is called free capital or free surplus.
Example: Consider an insurer with assets worth 100 and liabilities of 80, so the current surplus is 20.
A stress test leads to revised values of assets of 85 and liabilities of 76, so the surplus is now only 9 and
the capital required is 20 – 9 = 11. So there are assets of 80 backing the reserves, 11 backing the capital
requirement, and 9 that is free surplus.
7.2 Market-consistent reserves
7.2.1 Market-consistent methodology

In theory, a market-consistent value of a liability is the price that someone would charge for taking respon-
sibility for (ie ownership of) the liability, in a market in which such liabilities are freely traded. In the usual
absence of such a market, an approximate approach has to be taken.
50
To determine the liabilities, future unknown parameter values and cash-flows are set to be consistent
with market values, where a corresponding market exists.
For example, the expected cash-flows on an immediate needs long-term care contract, allowing for mor-
tality, could be projected. A market-consistent value for the immediate needs contract can be calculated by
valuing the cash-flows as the maturity proceeds of a series of zero coupon ‘risk-free’ bonds of matching terms.
One way of calculating the value of the liability is then to work out the current total price of the assets
(the zero coupon bonds) that need to be bought in order to generate these cash-flows exactly. In other
words, a portfolio of assets whose cash-flows exactly replicate those of the liabilities is determined, and then
the current market price of this ‘replicating portfolio’ becomes the market-consistent value of the liabilities.
Equivalently, the (same) market-consistent valuation could be produced by discounting the cash-flows at
current risk-free rates of interest.
In particular, assumed future investment returns are based on a risk-free rate of return, irrespective of
N.
the type of asset actually held, and the discount rates are also based on risk-free rates. ‘Risk-free’ rates may
be determined based on government bond yields or on swap rates.
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7.2.2 Illiquidity premium
It may be possible to derive the market-consistent discount rate from corporate bonds rather than govern-
Al
ment bonds. At first sight this might appear to be an odd thing to do, because corporate bonds are more
risky than government bonds: firstly, corporate bonds usually have a higher probability of default than gov-
ernment bonds, and secondly, corporate bond prices tend to be more volatile than government bond prices
(ie corporate bonds are less liquid), which can be a problem if the bond needs to be sold before its maturity.
ti
Corporate bonds typically have a higher yield than risk-free (eg government) bonds, where this reflects
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both the greater default risk and the relative illiquidity of such assets. The latter contributes the ‘illiquidity
premium’ to the yield.
Investors will require a higher expected return on an asset to compensate them for any additional risks,
eg the higher probability of default on a corporate bond compared to a government bond. The illiquidity
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premium (often confusingly called the liquidity premium) is the extra return that investors require to com-
pensate them for the risk of greater price volatility of corporate bonds.
Even under a market-consistent approach, it may be possible in some jurisdictions to take credit for
Mr
the illiquidity premium and thereby discount liabilities at a higher yield than the risk-free rate within the
supervisory valuation.
7.2.3 Risk Margin

It may be difficult to obtain a ‘market-consistent’ assumption for some elements of the basis, such as mor-
bidity, persistency or expenses, for which there is not a sufficiently deep (ie of such capacity that large trades
would not materially affect the prices) and liquid market in which to trade or hedge such risks.
The product of the cost of capital rate and the capital requirement at each future projection point is
then discounted, using market-consistent discount rates, to give the overall risk margin:
X kt × Ct
Risk Margin =
t
(1 + rt )t
where kt is the cost of capital ‘charge’ for time t, Ct is the required capital at time t and rt is the risk-free
interest rate for maturity t.
51
For some chosen regulatory frameworks, the projection of required capital can be relatively straightfor-
ward, for example where it is defined as a fixed percentage of reserves.
However, for others it can be complicated if the calculation of required capital itself requires projections,
stochastic modelling and/or application of correlation matrices.
7.3 Active and Passive Valuation Approaches
7.3.1 Passive valuation approach

A passive valuation approach is one that uses a valuation methodology that is relatively insensitive to changes
in market conditions and a valuation basis that is updated relatively infrequently.
A change in market conditions can affect both the value of the assets and the value of the liabilities (eg
if the valuation interest rate is derived from the yield available on assets). However, under some valuation
methods, the value of the assets and/or the value of the liabilities change very little with market movements.
N.
Under a passive valuation approach, the assumptions for mortality and expense inflation would rarely
change. An example would be the net premium valuation approach for liabilities, which is insensitive
to yield changes due to the net premium also being recalculated under the new assumptions.
ex
Under passive approaches, assumptions may be ‘locked in’. That is, they remain unchanged from those
used when that policy was first written and the liability for it first determined. It may be a requirement,
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however, that non-economic assumptions are updated if experience worsens, in order to recognize the related
loss and the need for higher reserves at that time.
So, the same valuation interest rate may be used throughout the term of the policy (ie the interest rate
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is locked in). This might be considered acceptable because any increase (decrease) in interest rates would
decrease (increase) both the value of the assets and the value of the liabilities. If assets are chosen that
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are well matched to the liabilities the true solvency of the insurance company will be unaffected by market
changes.
For the valuation of assets, an example of a passive approach would be the use of historic cost or ‘book
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value’, possibly with amortization (or ‘write-down’) over time.
By using a book value approach to valuing assets, the impact of changes in market prices is being ig-
nored. This might be suitable if the valuation of liabilities is also largely ignoring market conditions, eg if
the valuation interest rate is locked in or if a net premium valuation is used.
Mr
Solvency capital requirements may be determined using a simplified approach such as holding a prescribed
percentage of best estimate liabilities.
Advantages of using a passive valuation approach

Passive valuation approaches tend to be more straightforward to implement, involve less subjectivity and
(to the extent that they are used for accounting purposes) result in relatively stable profit emergence.
Disadvantages of using a passive valuation approach

A passive valuation is at risk of becoming out of date. It is relatively insensitive to changes in market
conditions and has a valuation basis that is updated relatively infrequently.
For example, if the stock market crashes then the book value of the assets will be overvalued relative
to their value if sold in the market today. Similarly, the net premium valuation is relatively insensitive to
52
changes in interest rates (as described above).
If the valuation basis is changed infrequently, then it may not have taken account of important trends,
eg rising expense inflation or deteriorating claims experience.
So there is a danger that a passive valuation approach provides a false sense of security. Management
may fail to take appropriate actions in response to emerging problems until too late, because the solvency
position hasn’t appeared to change.
7.3.2 Active valuation approach

In contrast, an active approach would be based more closely on market conditions, with the assumptions
being updated on a frequent basis.
An example would be the use of market-consistent valuation approaches for both assets and liabilities,
and a risk-based capital approach to solvency capital requirements.
N.
Advantages of using an active valuation approach
Active valuation approaches are more informative in terms of understanding the impact of market conditions
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on the ability of the company to meet its obligations, particularly in relation to financial guarantees and
options. Al
Disadvantages of using an active valuation approach
However, results are potentially more volatile using an active value approach. Under adverse equity market
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conditions (eg a stock market crash), an active valuation approach using risk-based capital would indicate
that higher capital requirements are needed. To reduce this requirement, companies would need to sell
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equities – which itself could exacerbate the market conditions. There is also systemic risk, as this would be
the case for all health and care insurance companies at the same time. Therefore, it may be the case that
regulators include amendments to the valuation approaches under such conditions, to avoid this situation.
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7.3.3 Combinations
The overall valuation approach may instead be somewhere between the two extremes, including elements of
each.
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This can result in a greater mismatch between assets and liabilities, and hence greater profits/losses or
changes in free assets when market conditions change. For example, an approach that uses a net premium
valuation for liabilities and market value of assets could experience greater volatility of results than one that
uses a market-consistent valuation for both.
If the assets and liabilities are well matched, then the true impact of market movements on the insurer’s
solvency should also be quite small. Under an active valuation approach, any change in the value of the
assets should be reflected in a corresponding change in the value of the liabilities (eg if interest rates fall then
both valuations should rise), so the solvency position should be little changed. Under a passive valuation
approach, the value of the assets and liabilities might be little changed by market conditions, so again the
solvency position should be little changed.
However, if a combination of active and passive approaches is used then solvency might appear to change
dramatically (when in reality it hasn’t changed). A change in interest rates would change the market price
of assets, but would have little impact on the net premium valuation of liabilities.
53
Practice Questions
1. A health insurance company sells accelerated CI insurance contracts with term of three years. Premi-
ums are payable annually in advance. The sum insured of £50,000 is payable at the end of the year
that a claim occurs.
The pricing basis uses the following best estimate assumptions:
Claim rate: 0.1% per annum

Interest: 3% per annum
Expenses: Initial £70 incurred at outset
Renewal £5 incurred when second and third premiums are received
Claim £80 incurred when the benefit is paid
Profit loading: £30
N.
Note that the cost of capital associated with the solvency requirements has been ignored in the pricing
calculation for simplicity.
(i) Calculate the premium for this policy
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The regulator believes that the following assumptions would represent a prudent estimate of future
experience:
Claim rate:
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0.13% per annum
Interest: 2% per annum
Expenses: Renewal £6 incurred when second and third premiums are received
Claim £90 incurred when the benefit is paid
ti
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The regulator is prepared to allow companies to calculate reserves on a best estimate basis if they
hold additional solvency capital calculated as 0.091% of the sum at risk.
(ii) The contract has just been sold, the premium has been paid and the initial expenses have been
incurred. Calculate:
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(a) the change in the assets

(b) the supervisory reserves calculated on the best estimate basis used in pricing (assuming there
is no solvency capital requirement)
(c) the supervisory reserves calculated on the regulator’s prudent basis (assuming there is no
Mr
solvency capital requirement)

(d) the sum of the supervisory reserves calculated on the best estimate basis and the solvency
capital requirement
(iii) Comment on the results of your calculations above
2. A health insurance company has a large and well-established portfolio of single premium without-
profits pre-funded and immediate needs long-term care contracts. Both contracts pay pre-specified
annual amounts when the insured requires care. No benefits are paid on withdrawal for the immediate
needs contract, or death.
(i) Describe how this insurance company could use a market-consistent approach to value its liabili-
ties.
(ii) Explain whether it would be appropriate to take credit for the illiquidity premium in the valuation
of the liabilities
(iii) Explain whether the regulator would consider the market-consistent value of the liabilities to be
adequate for the calculation of statutory solvency
54
Chapter 8
Investment
This chapter covers how a health and care insurance company should invest its assets. The investment strat-
egy followed by the insurer can be of considerable importance to its commercial success, financial results and
security.
N.
However, it is important to realize that most health products are protection products and therefore tend
to have low reserves. For these products, investment returns will be far less important.
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8.1 Asset characteristics
8.1.1 Conventional government bonds

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This refers to loan stock (bonds) issued and guaranteed by governments. Conventional bonds offer a nominal
return, which is guaranteed if held to redemption. (Note however, that it is not guaranteed if it is sold prior
to redemption, which is an important point when it comes to consideration of matching issues.)
ti
nso
It is normally considered the most secure asset type, other than cash (depending on the government issuing
it). Although the market value of such bonds may fluctuate with the market, the eventual redemption value
will be unaffected by such fluctuations. In most countries, it is the commonest and most marketable asset
type. Dealing costs tend to be very low.
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8.1.2 Index-linked government bonds

Index-linked bonds differ from conventional (fixed-interest bonds) in that the coupon payments will be de-
fined with reference to some index or value – such as local price inflation.
Mr
The amounts and variety of index-linked bonds issued by a government are often smaller than the amount
of conventional bonds, which can render the index-linked bonds slightly less marketable.
8.1.3 Corporate bonds

This refers to loan stock (bonds) issued and guaranteed by private companies.
Corporate bonds should offer a higher expected return than government bonds of equal term to reflect
default risk and lower marketability.
Security could be a significant problem, especially if the issuing company has a low credit rating. The
value of the bonds may fluctuate with the markets, but this will not be too important if the investor is
prepared to hold the bonds to redemption.
Marketability of such bonds is often poor, and dealing costs high.
55
8.1.4 Equities
Equity investment (shares) offers an income (the dividend) that is expected to increase in real terms. The
market value of the shares should also increase in real terms. As there is both growth in income and capital
value, the income yields on equities tend to be low (compared to bonds).
The income and capital value of shares can be highly volatile, which can be a problem if the dividends
are being used to meet liability outgo and/or the market value is being used to help demonstrate solvency
(or the share needs to be sold).
In many markets, equities can be highly marketable. In other markets, equity investment may not really
be an option because of the size and reliability of the local market, in which case the investor might consider
overseas investment in (more mature) overseas stock exchanges.
8.1.5 Property
N.
Property investment might be direct (ie actually buying a property) or indirect (eg through shares in a
property company or a collective investment scheme that invests in property).
Investment Characteristics of Direct Property
ex
• Like equities, property normally has a relatively high expected return. The rental income typically
gives a low income yield, although this should eventually increase in real terms
Al
• Property investment is normally seen as secure, however, the rental income may suffer occasional
interruptions and the market value can vary significantly over the long term
• It is a very illiquid investment, with significant dealing and management / maintenance expenses
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• It is a very long-term investment. As with equities, it can be thought of as a perpetuity, however,

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unlike with equities, buying and then selling quickly is not practical due to high dealing costs
• Direct property investment can only be made in large chunks – so a small investor may have problems
with diversification
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• Each property is unique, and so valuation can be difficult.
8.1.6 Cash
Mr
Cash usually refers to money held on overnight accounts earning spot rates of interest.
It is the most secure asset type, with the least variability in value. It is very liquid, and dealing costs are
almost non-existent. However, the expected return on cash is relatively low.
8.2 The principles of investment

These can be stated as follows:
(a) a company should select investments that are appropriate to the nature, term and currency of the
liabilities
(b) the investments should also be selected to maximize the overall return on the assets, where overall
return includes both investment income and capital gains
(c) the extent to which (a) may be departed from in order to meet (b) will depend, among other things,
on the extent of the company’s free assets and the company’s appetite for risk.
56
These principles can be expressed also as: the company should invest to maximize the overall return on
the assets, subject to the risk taken on being within the financial resources available to it.
This states the fundamental approach towards balancing risk and return. The aim is to maximize return
subject to an acceptable level of risk. The level of risk will depend on the financial resources of the insurance
company – ie its free assets.
8.3 Asset-liability matching requirements
8.3.1 Nature, term and currency of the liabilities

The first of the three investment principles above is about reducing risk, and essentially concerns the amount
and timing of the income, or proceeds, arising from the assets. If it is possible to buy assets whose income is
identical in amount and timing to the outgo of money being paid out on the liabilities, then the assets and
liabilities would be perfectly matched and there would be no investment risk.
N.
Perfect matching is a theoretical concept that is usually neither achievable, nor desirable.
However, the best starting point in determining an investment strategy is to consider the assets that
would best match the liabilities. In order to do this, it will be necessary to consider what components make
ex
up the liability outgo and what the characteristics of these components are.
The liability outgo consists of:

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Benefit payments + Expense outgo - Premium income
The expected liability outgo in any year, or month, depends on the monetary value of each of the
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constituents and the probability of it being received or paid out.

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Nature
The nature of each of the components of net liability outgo can be considered separately. Benefit payments
can be subdivided into four types:
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Mr
57
Expenses of an insurance company will consist largely of salaries, which should move in line with a rele-
vant earnings index. Other expenses will include property costs, computer costs, office equipment etc, and
these should move broadly in line with price inflation. In each case, the rate of increase will not be strictly
comparable as it will depend on the particular expenses of the insurance company, which depend on its pay
rise structure and its mix of other expenses, however, the link to national indices should generally be adequate.
Premium payments are usually fixed in monetary terms (or may be linked to an index) and hence can
be thought of as negative benefit payments guaranteed in monetary terms (or in terms of a prices index or
similar).
Term
As well as matching liabilities by nature, the insurance company will want to try to match by term so that
asset proceeds are available at the right times to meet liability outgo.
N.
Currency
Liabilities denominated in a particular currency should be matched by assets in the same currency, so as to
reduce any currency risk.
ex
An alternative way of matching liabilities denominated in other currencies is to invest in overseas assets
and then to hedge the currency risk by use of appropriate currency options.
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An insurance company might also choose to invest in overseas assets to increase diversification, invest in
assets not available in the domestic currency and/or take advantage of attractive overseas investments. If
this leads to a currency mismatch, eg if the insurance company’s liabilities are denominated in the domes-
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tic currency, then the insurance company can (again) hedge the resulting currency risk using appropriate
currency options.
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8.3.2 Effects of the nature of liabilities

Guaranteed in monetary terms
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A company will ideally want to invest so as to ensure that it can meet the guarantees. This means investing
in assets that produce a flow of asset proceeds to match the liability outgo. This will involve taking into
account also the term of the liability outgo, and hence the probability of the payments being made, so as to
indicate the term of the corresponding assets.
Mr
Except for certain types of company it will probably be impossible in practice to find assets whose proceeds
exactly match the expected liability outgo. In particular, the terms of available fixed-interest securities are
often much shorter than the corresponding liabilities; usually a best match is all that can be hoped for.
Guaranteed in terms of a prices index or similar

A suitable match would be securities that are linked to the same index in which the guarantee is denominated,
if available, ideally chosen to match also the expected term of the liability outgo. In their absence, a substitute
would be assets that are expected to provide a ‘real’ return.
Indemnity
The insurer will monitor the likely costs arising from the various treatments that are covered by these medical
insurance contracts. Normally, private medical insurance (and similar products) are short-tail business with
little scope for significant investment return.
58
This is because the premium income from all policies should be (broadly) sufficient to pay for the claims
of the unfortunate few, and to cover the insurer’s expenses. Therefore the reserves under PMI policies will
be very small, and so investment income on them will be negligible.
However, an insurer will occasionally need to establish reserves where it is aware of future treatment that
could persist over some future years. The amounts payable will be unknown at the time of setting these
provisions and any current costs will escalate in line with medical inflation (often higher than price inflation)
prior to final settlement.
Therefore, the assets recommended in these circumstances should be those that are expected to provide
a ‘real’ return over the relatively short period until the case goes off the books.
Investment-linked
The benefits are guaranteed in the sense that their value can be determined at any time in accordance with a
definite formula based on the value of a specified fund of assets (or investment index). Clearly the company
N.
could avoid any investment matching problems by investing in the same assets as used to determine the
benefits.
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8.3.3 Free assets
The existence of free assets in an insurance company means that it can depart from the matching strategies
outlined above so as to improve the overall return on its assets and thereby benefit its policyholders, through
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lower premium rates, and its shareholders (if any), through higher dividends.
It is almost always the case that assets with the highest expected return also have the highest variance
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of that return.
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If the assets supporting guaranteed benefits were invested in the assets with the highest expected return
the probability that the asset proceeds will become inadequate may be too high for comfort, ie the risk of
insolvency is too great.
This assumes that only enough assets are held so that their expected proceeds will cover the benefits. If
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there are free assets, they can be used as a cushion to reduce the probability of becoming insolvent.
8.3.4 Regulatory framework

Mr
The regulatory framework within a country may limit what a company can do in terms of investment. The
following controls may be implemented:
• restrictions on the types of assets in which an insurer can invest - Investment in assets
perceived to be risky, such as equities, property and derivatives, might be restricted (eg to x% of total
funds or liabilities) or even forbidden.
• restrictions on the amount of any type of asset that can be considered for demonstrating
solvency - For example, equities might only be allowed to count for 25% of assets in demonstrating
solvency. So an insurance company with, say, 40m in equities and 60m in government bonds would
only be able to show assets of 80m in its supervisory balance sheet.
• restrictions on the maximum exposure to a single counterparty / country - For example,
there may be a restriction that shares in any one company may not amount to more than 1% of the
assets used to demonstrate solvency. This is to prevent over-concentrations in individual assets.
• a requirement to hold a proportion of total assets in a particular class – for example
government stock
59
• a requirement to match assets and liabilities by currency

• a requirement to hold a mismatching reserve
• a limit on the extent to which mismatching is allowed at all
• restrictions on the valuation method used
• custodianship of assets eg restrictions on who is permitted to look after them.
Matching requirements
There may be a regulatory requirement to allow for mismatching. This could involve the setting up of
an investment mismatching reserve. The more a company decides to invest in riskier assets with a higher
expected return, the higher the resulting reserve might be. This would increase the value of the liabilities
and reduce the available free assets.
N.
8.4 Developing an appropriate investment strategy
8.4.1 Using a model office to determine an investment strategy
ex
Using a model of the business in force, a model investment portfolio can be built up using the company’s
proposed investment strategy and incorporating an appropriate proportion of the free assets.
The Model Approach are summarized below:

Al
1. allocate a certain amount of free assets to support the assets underlying the reserves
ti
2. perform asset-liability model projections of the insurance company’s future assets (arising from the
starting assets defined above), and compare these total assets against the reserves
nso
3. check that the excess of these assets over the liabilities exceeds any statutory solvency capital require-
ment (or possibly, exceeds some comfy multiple of that requirement) for the entire projection period
for most (eg 99%) of the model runs
.O
4. calculate some measure of aggregate profitability

5. repeat these last three steps assuming different (more or less risky) investment strategies until the
target probability of insolvency is achieved
Mr
6. identify which of the possible strategies, having equal insolvency risk, produces the highest profitability
Note that there are several potential weaknesses in this particular approach:
• the issue of modelling risk – the conclusions of the asset-liability modelling process will only be valid
to the extent that the model, and the inherent parameterisation, are valid
• the issue of considering only a portion of free assets – although the shareholders might not want all
of those assets to be put at risk in supporting an unmatched investment strategy, that does not imply
that the model should necessarily exclude certain assets
8.4.2 Fund manager assessment

Given that ‘The company should invest to maximise the overall return on the assets, subject to the risk
taken on being within the financial resources available to it’, it is important that the actuary or other ana-
lyst should monitor the results of the fund manager.
The results of the fund manager should be assessed against:
60
• the targets originally set for overall return

• the riskiness of the strategy undertaken
• the performance of other fund managers with similar investment briefs
The fund manager could be an internal department, or may be a third party. For external managers, an
even more careful approach to monitoring should arguably be taken, since there may be less control and it
may be more difficult to access performance data.
8.4.3 Liquidity
If an insurer is writing products of a type that can produce widely fluctuating levels of claims or if the insurer
is in a state of run-down, it will be wise to maintain access to ready (liquid) funds.
The matching requirements may have suggested that a longer-term approach, such as investing in equities
and property, would normally be appropriate. However, even if the nature of the liabilities have not changed
N.
in terms of term or underlying risk, the need for ready cash may mean that shorter-term investments would
be a better idea.
ex
8.4.4 Effect on product development and pricing
The return on investments to support the liability outgo for any product will enable the actuary to price
(and design) more competitively. The company’s ability to invest more widely than its competitors, due
Al
possibly to higher free assets, may result in a higher overall investment return. This may enable the company
to quote lower prices or to include further features at the same price.
ti
This is particularly the case for longer-term contracts, where the investment return is likely to be more
significant.
nso
8.4.5 Asset valuation

When assessing an insurance company’s financial strength, putting a value on its liabilities is only half the
story. There are also different ways that the assets could be valued.
.O
The method of valuation of assets will depend on the purpose of the exercise and the market’s perception
of fair value.
Mr
For PMI business, as it has typically only short-term liabilities, there would be little alternative but to
value the backing assets (normally cash) at their market price.
For long-term liabilities, there are two possibilities:

1. Discount the likely returns on these assets, including eventual disposal, on a basis consistent with the
valuation of liabilities.
2. Use market values as an objective and readily-understood methodology. This method has become the
norm in many territories.
8.4.6 Treating customers fairly

It is unlikely with conventional health and care insurance products that the policyholders have any expec-
tation of investment gain through their insurances.
Nevertheless, the insurer will be wary of relying on investment returns to support the costs of benefits to
an excessive degree such that under-performance in this area would necessitate a price increase at a policy
61
review. This would almost certainly raise questions regarding treating customers fairly.
Practice Questions
1. State four rating factors that may be used for an IP product (4 Marks)
2. A health and care insurance company has sold individual Long-Term Care Insurance (LTCI) business
for many years. The insurer is reviewing its investment strategy for the assets backing its LTCI
business.
(i) State the principles of investment for a health and care insurance company
(ii) Discuss the process the insurer would undertake to develop an appropriate investment strategy
for its LTCI business
(iii) Discuss the factors to be considered in determining an appropriate assetliability matching strategy
for the insurer’s LTCI product
N.
3. Describe how an insurer’s investment strategy may be affected by the regulatory framework in which
it operates.
4. A long-term health insurer transacts all types of without-profits, health insurance business. Discuss
ex
the extent to which assets and liabilities should be matched.
Al
ti
nso
.O
Mr
62

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SMS 3230 - Principles of Health-care and Reserving

1 Income Protection (IP) Insurance 4

2 Critical Illiness (CI) Insurance

2.2.1 Core "Major" Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.2.3 Terminal illness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

3 Long-Term Care Insurance (LTCI) 21

3.2 Types of long-term care insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

4 Private Medical Insurance (PMI)and Related Products 28

4.2.5 Optical plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Reserves and Embedded Value

6.2 Types of Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

6.3.2 Statistical estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

6.4.1 Purpose of Embedded Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

7 Approaches to Setting Reserves and Solvency Capital

Income Protection (IP) Insurance

Concept of Health and Care

(iii) Long-term care insurance

(vi) Private medical insurance and

1.1 Income Protection (IP) Insurance

1.1.1 The Product Cycle and the Nature of the Product

shows the main elements of the product cycle:

the claim, the date it ceased, and why.

Marketing and Sales

Underwriting and Claims Management

(say) as a result of illness/accident is affected by many more factors, e.g occupation.

Experience Monitoring and Valuation

1.2 Product features of individual IP business

1.2.1 General Policy Conditions

1.2.2 Benefit definitions (amount)

• multiple policies or receipt of other non-disclosed sources of income

Escalating Benefits and Premiums

perhaps by a desire to encourage a return to work

Proportionate or Rehabilitation Benefits

Waiver of Premium Benefit

1.2.3 Benefit Definitions (Timings)

• integrate with employer-supplied benefits

How does a linked-claims period encourage claimants to return to work?

Expiry age or term

1.2.4 Claim definitions

(i) the price charged

(a)The effect of occupation on the price charged

(b) The effect of occupation on the claim payment

Most definitions are occupational – examples are as follows:

1.3 Risk and rating factors

Residence and location

• determine expected claim costs by place of residence

• where the policyholder lives when benefit is payable

1.4 Variations of the Product

• guaranteed and reviewable premium rates

With-profits and unit-linked designs

Guaranteed and Reviewable rates

Guaranteed insurability options (GIOs) and other options

What are the characteristics of a satisfactory life-event to associate with a GIO?

1.5 Accident and sickness insurance

(iii) Describe ways in which these problems might be mitigated

Critical Illiness (CI) Insurance

2.1 Critical Illiness (CI) Insurance

but is chosen independently by the policyholder.

Perceived to be serious and to occur frequently

2.2 Conditions Covered

2.2.1 Core "Major" Conditions

• AIDS / HIV contracted during occupation

2.2.3 Terminal illness

2.2.4 Total and permanent disability