Health & Care INCOME PROTECTION AND CRITICAL ILLNESS RESERVING SURVEY RESULTS AND DISCUSSION OF ISSUES ARISING. Prepared by:

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1 INCOME PROTECTION AND CRITICAL ILLNESS RESERVING SURVEY RESULTS AND DISCUSSION OF ISSUES ARISING Prepared by: H&C Reserving Working Party May 2008

2 Contents PAGE 1. Introduction 1 2. Summary Results and Conclusions 3 3. Appendix: Copy of IP/CI survey sent to actuarial function holders 4. Appendix: Provisions, Provisions, Provisions

3 1. Introduction Purpose of this Report 1.1 The purpose of this report is to present the results of the Health & Care Reserving Working Party survey for Income Protection and Critical Illness lines of business. The results of the Private Medical Insurance reserving survey will be presented in a separate report. 1.2 The terms of reference of the Working Party are set out below. Working Party Terms of Reference Scope 1.3 To study the reserving practices of different firms with reference to the health & care insurance products namely Critical Illness (stand alone and accelerated), Income Protection, Private Medical Insurance (including medical expenses and hospital cash) with a view to determine good business practice in health & care reserving. Long-term care will be included among the products studied only if it is an interlocking product. 1.4 The territory covered will be UK-only and it will cover both individual and group risk. Issues 1.5 The issues to be considered by the Working Party will include, among others: The role of ICAs / implications for ICAs in reserving in relation to preparing for Solvency II PS06/14 implications Reserving methodology, for example deterministic versus stochastic The impact of options and guarantees by product (for example, Waiver of Premiums, buy-back for accelerated CI) Allowance for data issues FSA regulatory oversight (for example reserving and capital). Page No. 1 May 2008

4 Process 1.6 The Working Party will carry out some initial work to prepare and send out questionnaires to Actuarial Function Holders/other actuaries in firms providing the products listed above. Organisation 1.7 The working party is divided into three subgroups with the following leads 1. PMI/Cash plans Joanne Alder 2. Term Assurance and CI Sheila Anstead 3. IP Chris Coote Membership Sheila Anstead (chairperson), Joanne Alder Chris Coote Neil Hilary Andy Chan Sue Elliott is acting as a consultant to the working party. Robert Kipling from the FSA acted as a consultant to the Working Party where specific regulatory issues arose. Acknowledgements 1.8 The Working Party would like to thank Fiona McNeil at the Institute of Actuaries for putting the survey questions into the web-survey format and collating the responses. The Working Party would also like to thank all the participants in the survey for taking the time to respond to the questions in detail. Page No. 2 May 2008

5 2. Summary Results and Conclusions 2.1 The survey was sent to over 100 actuaries at insurers, reinsurers Friendly Societies and consultancies known to write or act for long term insurers.. The survey received 25 responses from CI insurers and 27 responses from IP insurers. Of these responses, the majority (68% for CI, 62% for IP) were from direct insurance writers, 20% for CI/19% for IP from Bancassurers, 4% for CI/8% for IP from Friendly Societies, and 2 CI and 1 IP response from reinsurers. The vast majority of the CI and IP markets were covered, with all the largest players represented. Not all participants answered all questions, but the majority of respondents answered most questions. 2.2 The responses were received between April and July Survey respondents were asked to respond on their practices as at the 2006 year end. 2.3 The most important distribution channel (48% CI, 56% IP) was through IFAs with direct sales accounting for most of the remainder. 2.4 At the end of this report are appended a copy of the CI and IP surveys together with a summarised copy of the results, which was presented to the 2007 Life Convention. Key results General Approach to Reserves 2.5 The vast majority of respondents now reserve on a gross premium basis. 2.6 Although the majority of IP respondents use an inception/annuity or multistate model approach, a few still use Manchester Unity. This could be considered surprising, since the deficiencies of the MU approach are well known, but the companies involved all had small volumes of in force business. Valuation Margins 2.7 Compared to Term business, margins in IP valuation bases were greater. However margins were similar or lower than those used in CI reserving. This is a change from results reported in the previous Institute of Actuaries CI survey of Appointed Actuaries that was carried out in 1997, where 79% of respondents indicated that their valuation margins for IP were either the same or greater than for CI. Use of stochastic models in reserving calculations of the 25 CI respondents either have or intend to develop stochastic mortality models for their ICA calculations. All except one have no plans to use stochastic mortality Page No. 3 May 2008

6 methodologies for statutory reserving calculations. The main aim of a model would be to analyse impact of mortality fluctuation. 2.9 No respondents have any plans to use stochastic morbidity models for their statutory reserving calculations. 4 CI and 3 IP respondents either already use stochastic morbidity models in their ICA work or intend to do so in future. Experience Investigations 2.10 Most respondents review lapse and expense assumptions at least annually. One very small CI provider answered Not regularly for all investigations A surprisingly large number of IP respondents do not review morbidity assumptions regularly, including some companies with quite sizeable exposures The period over which experience was averaged to arrive at best estimate assumptions was 3.5 years for IP morbidity and 2.5 years for lapses. 3.5 years could be regarded as quite a short period over which to derive average morbidity rates, given the long length of economic cycles, and in particular unemployment trends, which are believed to play a significant part in morbidity experience. Firms should consider the extent to which economic conditions have been favourable or unfavourable during the period and take this into account when setting the margin in the morbidity basis For CI the equivalent average periods were 3.5 years for mortality and morbidity and 3 years for lapses. There is a wide variation with 2 offices using 2 years for mortality and morbidity and 4 offices using 5 or more years. Where CI business is material, a 5 year plus period is desirable to allow trends in experience to emerge. Care is required when identifying trends The experience needs to be adjusted to allow for IBNR and the effect could be material for the most recent year. Firms should check how the incidence date is defined and whether any change over the period under investigation has distorted the results Firms may have sufficient data to analyse trends by cause of claim. This would give an insight into whether there are specific illnesses which have affected past trends. Future deterioration must allow the possibility of medical advances leading to earlier detection Only 1 respondent used some form of rolling average in calculating their best estimate lapse and morbidity assumptions. Morbidity tables, adjustments and valuation margins - IP 2.17 The most common tables used for inceptions and terminations was CMIR12. Several respondents answered other, this usually meaning that reinsurer rates were used. Page No. 4 May 2008

7 2.18 Several respondents adjusted the standard tables, more for inceptions than terminations. Of the 24 offices making adjustments to the standard inception tables, 20 adjusted for gender, 19 for deferred period, 15 for occupation and 14 for smoker status. The most popular adjustments made to termination tables were for duration of sickness (11 offices), deferred period (11 offices), and gender (10 offices). Of interest was the use of adjustments for terminations dependent on type of sickness, which were made by 2 offices. This is a sensible refinement given the significant difference in claim term between, for example, an accident and a stress related claim Valuation margins average around 20% for both inceptions and terminations. It is interesting to note that very similar margins are used for both guaranteed and reviewable rate business on average. This is surprising given the additional long term risk of business written on guaranteed rates. Reinsurers are accustomed to implementing rate reviews, but for direct writers any increase in premiums must be consistent with Treating Customers Fairly. If reviewable IP business is only a very small part of the portfolio firms may choose to take a prudent approach and not allow for premium increases The survey asked whether future deteriorations in morbidity rates were allowed for in the valuation, which could explain the apparent inconsistency above. Only 4 companies made allowance for this at an average deterioration rate of 1.3% p.a. for both guaranteed and reviewable business. Mortality tables, adjustments, and valuation margins - CI 2.21 No clear favourite mortality table emerged, and the top 5 offices all use different tables. 6 offices are using reinsurer rates, 4 offices are using T00 series and 4 are using 90s series. 3 offices use a table based on their own experience This is not consistent with the majority of companies using CIBT93 for accelerated CI since CIBT93 has a composite claim rate including mortality assumptions. 2 of the 3 offices which answered other stated that they use CIBT93. We did not ask in the survey whether a composite rate or separate rates for mortality and morbidity were used of the 25 offices made adjustments to the standard tables. 13 offices adjusted for smoker status, 11 for gender, 6 for age, 5 for product and 4 for duration in force. Only 2 adjusted for sales channel offices allow for future mortality improvements in their best estimate mortality assumption and 2 also allow for it in their statutory reserving calculations INSPRU G(S) prohibits assuming future mortality improvements in the statutory valuation unless this would increase the liability. If mortality is assumed in SACI reserving calculations, it would be prudent to assume future mortality improvements The average margin above best estimate used for statutory valuation calculations was about 20%. However, there is a wide variation with 3 offices using 5-9%, 3 offices using Page No. 5 May 2008

8 35% or higher, and the most popular response of 6 offices using 15-19%. Some offices may include a margin in their best estimate due to data uncertainties which might explain the low additional margins used by some offices. Comparisons are difficult when there is no consensus on the underlying mortality table. Morbidity tables, adjustments, and valuation margins - CI 2.27 Most offices use either CIBT93 or reassurer rates. One large office and the reassurers use their own table. Two offices with very small business volumes are using IC In the previous Institute of Actuaries CI survey of Appointed Actuaries that was carried out in % of respondents used reinsurer rates (this was before CIBT93 was introduced in 2000) of the 25 offices made adjustments to the standard tables. 12 offices adjusted for smoker status, 11 for gender, 6 for age, 8 for product and 4 for duration in force. Only 1 adjusted for sales channel. We feel consideration should be given to all these factors when considering morbidity reserving assumptions 2.30 Of the 13 offices which responded, 2 assume no future morbidity deterioration in the statutory reporting calculations. The average assumption for guaranteed business was 1.1% pa best estimate and 1.4%pa for statutory reporting. The equivalent figures for reviewable business were 0.9% and 1.3%. Allowance was usually for the whole term, even for reviewable business The average margin above best estimate used for statutory valuation calculations was 23% for guaranteed business and 21% for reviewable business. However, there is a wide variation with 8 offices using 10-14% and 3 offices using 35% or higher for reviewable business. For guaranteed business the most popular response was 6 offices using 25-29%. The size of the margin must be combined with the allowance for future deterioration in assessing its adequacy. Theoretically there should be an allowance for both components, but for practical reasons the firm may approximate the deterioration over the term of the contracts and make a compensating addition to the percentage uplift to the base table We investigated the correlation between the future morbidity deterioration allowance and the margin over morbidity best estimate assumed in the statutory valuation. We expected to find negative correlation, with offices justifying a low assumption for future morbidity deterioration assumption by a high margin in their morbidity assumption. However this was not the case, the correlation was small but positive. Lapse assumptions and PS06/ Around half of the IP respondents and all but 3 of the CI respondents had either implemented or proposed to implement the relaxations permitted by FSA Policy Page No. 6 May 2008

9 Statement 06/14 to allow lapses to be taken into account and negative reserves to be held in the statutory valuation We believe the reason why fewer IP offices have decided to make this implementation is due to greater materiality of CI business and complexity of the IP change Only a small number of respondents answered questions around the margins included for lapses in the valuation, and at what level they determined whether the margin should be positive or negative, to ensure that potentially negative reserves are conservatively calculated. Given that the options under PS06/14 were available for the first time in the 2006 valuation, this is likely to be an area where methodologies are still developing Most firms used their own experience as the main consideration when determining lapse assumptions 2.37 For CI business, of the 10 offices that responded almost all firms had the same lapse margin above and below best estimate. A few firms had a margin below 10%, but most were between 20% and 35%. Average margin was 30% ACI, 25% SACI with no significant addition for guaranteed business. For IP business only 3 offices outlined their lapse margins, which averaged between 20% and 30%.above and below best estimate. Interest Rates IP 2.38 Average interest rates used to value active lives (those not in claim) and disabled lives (those in claim) were 3.4% and 4.0% respectively. The corresponding 15 year gilt yield was 4.62% and the maximum reinvestment yield under FSA regulations was 3.98%, so valuation rates appear to be conservatively set particularly for disabled lives where a matching portfolio of assets could probably justify a higher assumption. A few respondents who had implemented PS06/14 stated that they had conservatively used interest rates above actual rates, which is likely to be appropriate if reserves are negative. Interest Rates CI 2.39 Average interest rates used to value UK guaranteed and reviewable business for the statutory valuation where a low interest rate is prudent were 3.15% and 3.45% respectively. The corresponding 15 year gilt yield was 4.62% and the maximum reinvestment yield under FSA regulations was 3.98%, so valuation rates appear to be conservatively set. Expenses IP 2.40 Average per policy expenses assumed in the valuation were expressed in either pounds per policy per annum ( 29 for individual, 68 for group business) or as a percentage of premiums (9.5% for individual, 10.4% for group business). In addition, investment related expenses averaging 0.13% of reserves for individual and 0.16% for group Page No. 7 May 2008

10 business were assumed. The size of claims reserves is such that firms may use corporate bonds to back these. This could explain the higher investment expenses than for CI where reserves are low Claims related expenses were expressed in either pounds per claim (average 345 for individual, 562 for group business) or as a percentage of the projected claim amounts (average 8.8% for individual, 11.0% for group business) 2.42 A very small number of respondents made assumptions based on both pounds per policy and percentage of premium The average expense inflation assumption was 3.9% (best estimate) and 4.1% (statutory valuation). As at 31/12/06 implied long term inflation as measured by the difference between long term gilt yields and index linked gilts was 2.7%. RPI was 4.4%, NAE was 3.9% and CPI was 3.0%. Expenses CI 2.44 A variety of different expense structures are assumed, the most popular being a flat per policy rate only (9 offices) and a flat per policy rate plus a percentage of reserves (10 offices). The average per policy expense assumption per annum was 25. for guaranteed business and 26 for reviewable business There was a wide variation by distribution channel, the averages for guaranteed business for Direct sales, IFA, Bancassurers and internet sales were 30, 24, 22. and 7 (1 office only) respectively The average percentage of reserves assumed for investment expenses was 0.11%. The average percentage of premium assumed was 3.2% (5 offices including 2 reinsurers) Additional reserves IP 2.47 Respondents were asked whether they reserved for additional contingencies. The most common ones were Incurred But Not Reported claims (56%), Reinsurer credit risk (50%), claims already notified but currently within the deferred period (44%), and disputed claims (44%). Reserving actuaries should consider the list of potential areas where additional reserves may be required. Additional reserves CI 2.48 Respondents were asked whether they reserved for additional contingencies. The most common ones were Incurred But Not Reported claims (63%), Reinsurer credit risk (68%) and substandard extra risk (60%). Other additional reserves were held for notified claims awaiting authorisation, unearned premium reserves, guaranteed insurability Page No. 8 May 2008

11 options, premium deficiency, data quality and TCF considerations. Reserving actuaries should consider the list of potential areas where additional reserves may be required. ICA scenarios IP 2.49 The survey asked which scenarios were used in ICA calculations. Of the 20 offices which responded, the most popular basis was one-off shocks (13 offices) followed by future trends (8 offices) and mis-estimation of relevant parameters (8 offices) Morbidity margins, intended to represent a 99.5% confidence level over 1 year averaged 27% for inception rates and 16% for termination rates. Curiously the margins were almost equal for guaranteed and reviewable rate business whereas it might be expected that guaranteed rate business would have a higher assumed margin. ICA scenarios CI 2.50 The survey asked which scenarios were used in ICA calculations. Of the 21 offices who responded, the most popular basis was one-off shocks (15 offices) with future trends (14 offices) coming a close second. 9 offices considered a mis-estimation of relevant parameters and 9 offices considered all 3 scenarios. A much higher proportion of CI offices than IP offices model adverse future trends Mortality shocks are likely to be the same as for the term assurance book No CI offices apply different stresses for different critical illnesses (eg heart attack, stroke, etc) in their ICA reserving. We believe this is worth consideration for large offices Morbidity margins, intended to represent a 99.5% confidence level over 1 year averaged 41% for reviewable business and 39% for guaranteed business. The margins were almost equal for guaranteed and reviewable rate business whereas it might be expected that guaranteed rate business would have a higher assumed margin. No office used a lower rate for guaranteed business than reviewable business. As for the statutory reserves (paragraph 2.31), the combined effect of percentage deviation from the base table and deterioration determines the strength of the basis. Asset Mix 2.54 Respondents were asked what the asset mix of the investments backing their reserves was. The average mix for IP business was: 69% gilts, 27% corporate bonds, and 4% cash. For CI the average mix was 73% gilts, 14% corporate bonds and 13% cash. IP policies have larger average reserves, so it makes sense to have a higher % of bonds and gilts for IP. Options - CI Page No. 9 May 2008

12 % of respondents calculate option reserves within the main reserving model, with 2 offices using spreadsheets and 3 not responding Of the 20 offices responding, only 30% review the suitability of their option reserves at least annually offices are using prospective valuation methods including 3 of the top 5 offices. The others are using various estimation methods. The importance of this depends on the materiality of the options written. Developing appropriate reserving methods can be quite complex. Conclusions - IP 2.58 It is believed that this is the first detailed inter-office survey around IP reserving practices since the Paper Practical PHI Reserving was prepared in May A key recommendation of that paper was to encourage the inception/annuity approach to reserving rather than the use of Manchester Unity tables, and it is pleasing to see that more modern reserving approaches are now generally favoured The 1997 paper also encouraged proper consideration of the potential need for IBNR reserves including potential claims which may only be reported at the end of the deferred period. The majority of respondents appeared to give proper consideration to latent claims A further recommendation of the 1997 paper was around valuation margins, where a common response was that margins were in the range 0-10%. Higher morbidity margins are now evidently in use, although it is curious that guaranteed rate business does not appear to have the increased margin that might be expected given the additional risk, particularly in the event of an economic downturn. This is tied in with the average period over which morbidity experience assumptions are based, where it might be expected that a longer average period than the 3.5 years from the survey results would be appropriate 2.61 Methods for determining the size and direction of lapse and interest rate margins following the reinsurance directive relaxation of the regulations (PS06/14) need monitoring no consensus has developed yet 2.62 The valuation actuary should consider whether there should be an additional reserve for each item listed in slide 40 of the accompanying Powerpoint presentation. Conclusions - CI 2.63 The Institute of Actuaries last examined CI Reserving in detail in 1997 with a survey sent to Appointed Actuaries. Although there have been many significant developments since then, notably the publication of CIBT93, there is still surprisingly little consensus around valuation assumptions in a number of key areas. Page No. 10 May 2008

13 2.64 Where CI business is material, the experience investigations for mortality and morbidity should cover a sufficiently long period (ideally 5 years or longer) to allow trends in experience to emerge. Where there is sufficient data, an analysis by the major critical illness groups should be considered. It may also be worth considering ICA scenarios for heart attack and cancer rates separately Morbidity margins seem very low for some offices and the accompanying low morbidity deterioration rates assumed are concerning. Taken together, offices should ensure that there is a sufficient level of prudence in the morbidity assumptions Methods for determining the size and direction of lapse and interest rate margins following the reinsurance directive relaxation of the regulations (PS06/14) need monitoring no consensus has developed yet Where options are material the reserving methodology and assumptions need to be reviewed at least annually The valuation actuary should consider whether there should be an additional reserve for each item listed in slide 40 of the accompanying Powerpoint presentation There was only a small amount of difference between assumptions for business written on guaranteed and reviewable terms. It appears that direct offices are not taking full credit for reviewability in view of potential difficulties in implementing reviews. The reinsurers, who can implement reviews much more easily, did take credit for reviewability. Attachment: Copy of IP/CI Survey sent to actuarial function holders Attachment: Provisions, Provisions, Provisions Powerpoint presentation given by the Working Party at the 2007 Life Actuaries Convention. Page No. 11 May 2008