Artice from: Heath Section News December 2000 No. 39
DECEMBER 2000 HEALTH SECTION NEWS PAGE 19 Part One: A Short History of A New Product by Johan L. Lotter Critica Iness insurance is sti in its infancy in the United States, but it is gaining ground. Whie oca information is scarce, foreign deveopments are being cosey foowed by U.S. speciaists. History. A physician, Marius Barnard, invented Critica Iness Insurance in South Africa, circa 1985. Barnard first verbaized the obvious: for amost a his patients, a catastrophic heath event such as diagnosis of cancer, heart attack or stroke was a ife transforming event, eading, in the vast majority of cases, to persona financia ruin due to massive non-reimbursabe epenses, truncation of productive working ifetimes and uncompeted asset accumuation. Barnard fet strongy that insurance companies shoud address this probem, offering suitabe protections. South African insurance companies uicky saw the potentia market associated with Barnard s idea. In devising products to fi Barnard s void, insurers reaized that every poicyhoder s financia needs after diagnosis woud be uniue: one poicyhoder woud have an unpaid mortgage, another woud have chidren to send to coege, a third woud have insufficient savings to support dependents when earning powers are reduced. Thus there coud be no basis for projecting and adjudicating utiization. Instead, it made sense to have every appicant estimate his/her future financia eposure just as one woud for ife insurance, and then appy for an appropriate face amount. Product Properties. Barnard was concerned with the most common Critica Iness incidences such as cancer, heart attack, and stroke, but aso reaized that protection against financia devastation by kidney faiure and cost of organ transpant shoud be insured. Over time, Critica Iness coverages were etended to other caamities such as: oss of sight, oss of hearing, oss of speech, parapegia, uadripegia, and mutipe scerosis. Many Critica Iness poicies today provide for partia payment of the Face Amount for coronary bypass surgery and angiopasty. Some modern Critica Iness poicies provide for as many as 30 different caamities. Paradoicay, whie Critica Iness Insurance pays out on diagnosis of very serious maadies, it has amost none of the features of heath insurance and most of the features of ife insurance. A working knowedge of Critica Iness Insurance is best attained by ooking at the product through a ife insurance microscope and not through a heath insurance prism. Basic Actuaria Issues Critica Iness Insurance is a straightforward incidence product free of any utiization concepts. This simpifies the Critica Iness Insurance product actuary s work, reducing it to the determination of age-specific critica iness incidence rates that ook and sme just ike mortaity rates. Since there is a known poicy Face Amount to be paid on diagnosis, ony incidence rates matter; utiization rates are of no conseuence. Sticky issues such as infation of heath-reated epenses can safey be ignored. A you need are appropriate tabes of age-specific incidence rates. Like mortaity rates, these incidence rates are binomia, and subject to the same aws of arge numbers as mortaity rates. This is not to say that the actuaria issues in managing Critica Iness Insurance are trivia. Ratemaking for Critica Iness Insurance adds ayers of compeity to the processes empoyed in modern actuaria pricing modes. Basic Underwriting Issues. The major Critica Iness caim diagnosis events (cancer, heart attack, stroke) are aso the major kiers of human beings. Overa, neary 75% of a deaths are caused by these three diseases. Hence, it shoudn t surprise you that scientific Critica Iness underwriting cosey tracks ife underwriting. If you are underwriting individua ives for ife insurance, you need to know whether the appicant is in norma good heath and whether the amount of the insurance is justified. In Critica Iness underwriting, you aso need to cassify risks in appropriate heath categories, and to eiminate financia anti-seection. The concerns of Critica Iness underwriters and ife insurance underwriters shoud be, and very often are, the same. Whie Critica Iness Insurance underwriting practice generay is very much ike ife insurance underwriting practice, there are some differences. Critica Iness Insurance is purchased for the insured s own sake, whie ife insurance is purchased for beneficiaries. One shoud epect sef-interest stronger than the usua concern for oved ones and a tendency towards stronger anti-seection among Critica Iness Insurance appicants. On the other hand, suicide risks in ife insurance have no counterpart in Critica Iness. You can underwrite Critica Iness Insurance as an individua product or as a group product. Whatever your Critica Iness Insurance marketing opportunity, you can make a good practica start by modeing your underwriting on your company s ife insurance product most cosey resembing your proposed Critica Iness Insurance product. Finding Suitabe Incidence Rates Finding suitabe Critica Iness incidence rates appicabe to insured ives was no simpe matter in 1985, when the product was invented: there were no critica iness insured portfoios that coud be studied by actuaries. In 1985, Critica (continued on page 20)
PAGE 20 HEALTH SECTION NEWS DECEMBER 2000 Part One: A Short History of A New Product continued from page 19 Iness Insurance incidence rates were in the same dark ages as ife insurance mortaity rates were 150 years ago. Fortunatey, actuaries working for internationa reinsurance companies found cever ways to cacuate Critica Iness incidence rates for members of the genera popuation on the basis of avaiabe popuation statistics and aso invented powerfu caibration techniues to adjust these popuation incidence rates to Critica Iness incidence rates that woud be appicabe to insured portfoios. Even today, these foreign actuaria techniues are not we-known or widey understood in the U.S.A. They are not part of the SOA s syabus for students. As far as we know, no schoary papers deaing with Critica Iness have been pubished by any U.S. actuaria body. Incidence Rates for Two Distinct Products The first sets of rates actuaries deveoped through caibration techniues were used to price two distinct types of products: Product One: Standaone Critica Iness Poicies. The contract is simpe. The poicyhoder pays premiums. The Face Amount is paid on diagnosis and the poicy is canceed. Product Two: Critica Iness Acceeration Poicies. The basic poicy is a ife insurance. The Face Amount is paid on diagnosis of a Critica Iness or on death. Premiums cease after the Face Amount is paid and the poicy terminates. Given a known Critica Iness annua unit incidence rate i at age, the cash fow cost of a Critica Iness eposure of E for the year of age to +1 is simpy i E. This ast epression is the net oneyear term cost of a standaone Critica Iness poicy. It is suitabe for pricing Product One above. Given a known critica annua unit incidence rate i at age, and the proportion of deaths due to Critica Iness at age, k, the cash fow cost at age of a benefit of E payabe on diagnosis of Critica Iness or on death during the year of age to +1 is E {i +(1 k ) }. This ast epression is the approimate (sighty overestimated) net one-year term cost of a one- year term ife poicy which is payabe on death or Critica Iness diagnosis. It is suitabe for pricing Product Two. Eport of Critica Iness Product Ideas After its birth in South Africa, the reinsurer Critica Iness midwives uicky eported the Critica Iness concept to the U.K., Canada, Europe, Austraia, and the Far East. In Austraia and in the U.K., Critica Iness products became an instant success. Avaiabe Austraian information is anecdota, but observers in the Pacific rim warn that it is amost impossibe to se a ife insurance contract in Austraia if you are unabe to offer a Critica Iness Acceeration Rider, and that reinsurance companies that are unabe to offer Critica Iness product deveopment support in the far east are unabe to get any traction with the major direct ife insurance companies. Hard data covering annua Critica Iness saes in the U.K. show that saes of individua Critica Iness poicies increased seven-fod from 100,000 insurance poicies in 1990 to 700,000 poicies in 1998. This can be compared to stagnant, decining saes of pure individua ife insurance poicies (without Critica Iness rider), which decined over the period by roughy 20%. In the U.K., fuy 86% of Critica Iness poicy saes cosed on ife insurance poicies with the CI Rider; ony 14% of poicies sod were of the standaone type. Sow Growthin the United States. Athough Critica Iness Insurance has been so successfu esewhere, it has not yet taken off in the U.S.A. Why has the U.S. been sow to deveop Critica Iness Insurance Products? Reasons for the sow takeoff may be among the foowing: I-considered criticism by industry pundits and eperts. A sma number of pundits/eperts have said things ike: If you are going to insure your automobie, woud you separatey insure the fenders and the doors and the trunk id? So why purchase Critica Iness Insurance, since it works this way? This sound bite is pausibe, but the anaogy is fawed, since the purpose of a persona insurance is to ameiorate financia oss, not to repace or repair heath conditions and human body parts. These pundits often appear to be under the mistaken impression that Critica Iness Insurance pays out on death due to CI, not diagnosis. Lack of oca rate-making epertise. To our knowedge, none of the U.S. professiona actuaria or insurance bodies offer any training in Critica Iness Insurance product design, ratemaking, or underwriting. Unti the SOA provides training in the mathematics of Critica Iness Insurance, many U.S.-trained actuaries may, for the most part, be unabe to provide their companies with appropriate technica support. Over-speciaization of the U.S. Actuaria Profession. In the United States, few actuaries practice in ife insurance and aso in heath insurance. Actuaries tend to speciaize. Most U.S. heath insurance actuaries focus on empoyer-provided group heath pans with underwriting and ratemaking processes competey unreated to ife insurance practices. Critica Iness Insurance, with its ife-ike features, is, therefore, a strange anima for many heath insurance actuaries. Yet, when your CEO first recognizes Critica Iness Insurance as a major marketing opportunity, he wi most ikey refer his reuest for evauation of a Critica Iness Insurance product idea to his heath insurance actuaries. Since Critica Iness Insurance does not fit anywhere in heath actuaria practice, this product s chances of a favorabe evauation by heath actuaries are practicay zero. Most U.S. ife insurance actuaries are comfortabe with mortaity rates and not
DECEMBER 2000 HEALTH SECTION NEWS PAGE 21 famiiar with current heath insurance issues. If a U.S. ife actuary is asked to evauate Critica Iness Insurance as a product opportunity, his/her first reaction might be to route it to the heath insurance actuaries who wi very ikey reject the product idea. Thus any good Critica Iness Insurance idea in your company may very we circuate from your ife insurance actuaries to your heath insurance actuaries and back, remaining in product deveopment imbo unti its origina saesman champion moves on to another company, and it dies a natura death in a dusty fie. Inimica and Ponderous State Reguatory Processes. In our work, we have found that Critica Iness Insurance is poory understood by reguators. Reguators are not certain whether it shoud be vetted by departmenta heath actuaries or ife actuaries. Some reguators appear to find the serious conseuences of CI diagnosis too frightening to even think about and have, perhaps visceray, paced the insurance on their ist of coverages that are never to be approved. Reasons given by reguators in private conversations for their animosity to Critica Iness Insurance generay come around to the conviction that the mere prospect of Critica Iness wi scare consumers. Ironicay, in conversations with numerous state egisators, we have seen tremendous and voca support for the Critica Iness Insurance idea, once the features and benefits are epained. Lega Overhead in Product Deveopment. The sheer weight of work in getting 50- state approva for a revoutionary product ike Critica Iness Insurance wi ikey discourage very arge, surpus-rich, and widey icensed insurance companies from deveoping the product. This view appears to be supported by the fact that most Critica Iness Insurance products in the U.S. are currenty marketed by regiona companies that are not househod names and are not strongy capitaized. Finding Incidence Rates. Hampered by zero avaiabe insured ives eperience, actuaries have had to turn to incidences eperienced by the genera popuation containing the members of the portfoio to be insured against critica iness. Since critica iness Insurance benefits are paid on first Critica Iness diagnosis, popuation incidence rates have to be scrubbed cean of repeat incidences before they can be used in ratemaking. Suitabe mathematica techniues eist for doing this. They were mosty invented by demographers, not actuaries. Once you have a set of scrubbed incidence rates, you need to empoy caibration techniues to adapt your popuation critica iness incidence rates to the insured portfoio. Miracuousy, techniues for such adaptation have been invented. These techniues were first pubished by Dash & Grimshaw in their andmark paper Dread Disease Cover: An Actuaria Perspective. (At the time the Dash & Grimshaw paper was written, the term dread disease was commony used to refer to critica iness. ) Dash & Grimshaw were the first researchers to produce popuation critica iness incidence rates for the United Kingdom. The Dash & Grimshaw incidence rates as pubished in 1990, remain an important standard of comparison for British actuaries. They are used etensivey in this primer in a comparative capacity. The Rate Caibration Formua. Ceary, popuation critica iness incidence rates, no matter how accuratey derived, cannot be directy used in insurance ratemaking. They have to be carefuy caibrated from a popuation eve to a eve appropriate to the risks to be insured. In their 1990 paper, Dash & Grimshaw pubished the Rate Caibration Formua. Unfortunatey this very important resut was ony one of many interesting mathematica resuts pubished in the Dash & Grimshaw paper. Many actuaries may not have accorded it the importance it deserves. This may be the reason that it appears to be ess we understood than one might have hoped. It aso seems as if its amost universa appicabiity has not yet been appreciated by many technica workers. The Rate Caibration Formua furnishes a method for caibrating critica iness incidence rates of a seed popuation P to critica iness incidence rates for a target popuation G. The formua is as foows: Where and w G i G And where w P = k G k P G P G P =i P 1 = D1.G 1 D1.P w G k G G w P k P P D2.G (1- ) G k G G G D2.P P k P P P is the proportion of deaths due to critica cause occurring between age and age +1 in the target popuation, is the proportion of deaths due to critica cause occurring between age and age +1 in the seed popuation. is the number of ives eposed to death due to critica cause at age in the target popuation, is the number of ives eposed to death due to critica cause at age in the seed popuation. is the mortaity rate at age in the target popuation, is the mortaity rate at age in the seed popuation. (continued on page 22)
PAGE 22 HEALTH SECTION NEWS DECEMBER 2000 Part One: A Short History of A New Product continued from page 21 is the number of ives that are suffering from a critica iness at age in the target popuation, is the number of ives that are suffering from a critica iness at age in the seed popuation. i G is the critica iness incidence rate in the target popuation, i P is the critica iness incidence rate in the seed popuation. D1.G D1.P D2.G is the death rate at age appicabe to heathy ives contracting a critica iness after age in the target popuation, is the death rate at age appicabe to heathy ives contracting a critica iness after age in the seed popuation. is the death rate at age appicabe to ives criticay i at age in the target popuation, D2.P is the death rate at age appicabe to ives criticay i at age in the seed popuation. The Rate Caibration Formua is derived from a differentia euation describing a genera process of transition from critica iness to death. The Rate Caibration Formua says that, if you know the critica iness incidence rate in a seed popuation P, and you know the proportion of deaths due to critica cause for P as we as for the target popuation G, and you can make reasonaby accurate estimates of the w factors for both P and G, you can derive reiabe critica iness incidence rates for target popuation G. Appication of the Rate Caibration Formua is perfecty genera. You can define your seed popuation in any way you wish. Proper impementation of the Rate Caibration Formua reuires that critica iness definitions for your seed and target popuation correspond very cosey. It aso reuires that cause of death certification in the target popuation and the seed popuation are consistent. This means that critica iness diagnosis protocos and cause of death registration systems of the Seed popuation and the Target popuation must be simiar. unfortunatey, these correspondence and consistency reuirements void the appication of the Rate Caibration Formua to derive critica iness incidence rates for U.S. insurance underwriters from U.K. popuation critica iness incidence rates. The Rate Caibration Formua is widey used by practitioners to derive insured portfoio Critica Iness incidence rates from popuation Critica Iness Incidence Rates. But its genera appicabiity to other types of transitions is ess we understood, even by foreign practitioners. A itte refection may convince you that the Rate Caibration Formua can be even more effectivey appied when one wishes to transition from one group of risks in a portfoio to another group of risks in the same portfoio. The Rate Caibration Formua is a powerfu too that can enabe actuaries to transition from utimate critica iness incidence rates to seect critica iness incidence rates in the same insured portfoio. The Rate Caibration Formua is aso directy appicabe in deriving substandard underwriting etra mortaity ratings under the numerica rating system. These powerfu intra-portfoio adjustments are possibe because of the amost assured correspondence between critica iness diagnosis protocos and cause of death registration systems. Johan Lotter wrote this artice. It is the first part of our Primer on Critica Iness. Aistair Cammidge, FIA, ASA, of Lotter Actuaria Partners Inc. reviewed it. Johan Lotter wi provide Part Two: An Overview Of Foreign Critica Iness Caims Eperience in the net edition of this newsetter. Johan Lotter, FIA, ASA, MAAA, is a consuting actuary and President of Lotter Actuaria Partners Inc., 915 Broadway, New York, NY 10010. For additiona information about Critica Iness Insurance, see the Lotter Actuaria Partners Web site at www.otteract.com. He can be reached at otteract@earthink.net.